Last week I suggested that even yield hogs should avoid junk bonds. That, however, was just a warning against trap number one. As you scour the investment universe looking for alternatives, sooner or later you’re likely to encounter a whole different and for many, lesser known set of traps...closed end funds. Not all are bad and some may be pretty good. But it’s essential that you visit the web site for each fund you consider and that you study the literature, especially the part about “distributions.” If you can’t find what you’re looking for, then stay away from the fund.

Introducing Closed-end Funds (CEFs)

CEFs are funds that in many ways look a lot like the ETFs we’ve all come to know and love. These are portfolios of securities in which you participate by purchasing shares on the stock exchange. Both are alternatives to the traditional open-end mutual funds, where instead of buying shares of an entity that holds the portfolio, you contribute to and withdraw directly from the portfolio itself. (The differences between ETFs and more traditional open-end mutual funds have been discussed extensively elsewhere and need not be rehashed here.)

CEFs have been around longer than ETFs and might even be called ETFs v. 1.0, as opposed to all the others you heard of that can be deemed ETFs v. 2.0. The difference involves the relationship between the market price of the shares and the per-share value of the underlying investment portfolio; i.e. how to assure that if your stake in the underlying portfolio is worth $15 per share, you pay only $15 per share to get in or receive $15 per share if you’re getting out.

Answer: There is no assurance at all. You hope a good flow of information and the wisdom of the supposedly efficient market will somehow or other get the shares to be correctly priced, just like the professors who preach the doctrine of market efficiency tell you it is. Outside the classroom, however, the market is about as efficient as an office that still uses typewriters, carbon paper, rotary dial phones and first-class mail. So it’s entirely possible that you may pay $18 per share for your proportional interest in an investment portfolio that’s worth only $15 per share. And if you sell at a time when the portfolio is worth $23 per share, you may find that the market price is only $20.

This is why CEFs never really caught on big but wound up instead a tiny niche portion of the market in which the main investment play was trying to buy at a big discount to asset value and sell at a small discount to asset value, or if very lucky, a premium to asset value (most CEFs trade at discounts to asset value unless the portfolios consist of an asset class to which it’s hard to otherwise get exposure, as with the early generation of emerging-market equity funds). If extremely lucky, one would buy at a big discount and then a proxy fight would force the CEF to convert itself into an open-end mutual fund (assuming management didn’t get fed up with the discount and do it on its own) at which point, the discount would vanish as you would be able to get out at the per-share value of the portfolio.

The ETFs popular today, v. 2.0, correct the premium/discount flaw through provisions buried in prospectuses that say institutions can put together baskets of securities that mimic the ETF portfolio and tender them to the ETF in exchange for newly issued shares of the fund. They can also go the other way; they can tender ETF shares and demand that the ETF give them the equivalent amount of each security in the portfolio.

Don’t give yourself a headache reviewing the details. Just recognize that this is a way to get arbitragers to make darn sure that ETF shares are priced, if not exactly at the value of the underlying portfolio, than at a premium or discount that’s trivial (“tracking error”). It works because if a gap opens, arbitrage-hungry institutions will cash in by exercising their rights to exchange thus causing supply and demand to force price and NAV back into alignment.

Mainstream investors thus deserted the inefficiently priced CEFs, to the extent they were ever there, and flocked to ETFs. That forced the CEF industry to re-think the rationale for its continuing existence and to eventually settle onto its current theme; off-the-beaten-track strategies the most popular of which all involve delivering high yields, with many today winding up in the 6%-8% range.

Calm down. If it looks too good to be true, well, you know.

The Art of the Enhanced Yield

There are many fixed-income CEFs that portray themselves as high-yield bond funds. OK. That’s fine. There are no traps. We know what we’re getting and we can avoid or go in as we choose.

The problem is that there are many generalist fixed-income funds but which have, in fact, boosted their yields by allocating large portions of the portfolios to junk bonds. They won’t actually say they own junk. More likely, they’ll do the minimum the lawyers require and if you can’t follow the breadcrumbs, that’s on you.

For example, semi-annual and annual reports may contain graphic presentations showing the distribution of S&P/Moody’s rating categories and densely-worded footnotes mentioning that ratings above such-and-such are considered to be investment grade. Perhaps you’ll connect the dots and notice that much of the portfolio is not in the investment-grade category and understand that non-investment-grade is a euphemism for junk. Or maybe you won’t. I’ll spare you the trouble. If you see a fixed-income CEF yielding 4% or higher, assume it’s loaded with junk bond funds regardless of the fund’s name description. Maintain this view unless or until you’ve been able to dig into the details and learn otherwise.

Many high-yielding CEFs are preferred stock portfolios. This is a form of capital, less popular than in days of yore, that officially lives in the equity portion of the balance sheet but acts a lot like fixed income because the dividends are contractually fixed (albeit with penalties for default that are a little bit less legally horrible than in the case of bonds). If we weren’t at the very bottom of a generational interest-rate cycle, I might recommend these but I won’t now because their maturity is the 20^th of Never (unless the company chooses to exercise a call feature which you can be sure it will only do if such action benefits the company, not necessarily you). In fixed income, the longer the maturity, the worse the downside performance if rates rise. Preferred, which have infinite life spans, would fare worst of all.

Moving onto the equity side, we find a set of yield-enhancement strategies that can actually be very interesting that involve use of options (some fixed-income CEFs may also use these to enhance yield). If I do find a CEF I want to recommend, it will most likely be one of these.

There are many different ways to use options (or futures) to enhance yield. To get a sense of how this works consider as an example an ordinary equity portfolio, nothing fancy; mainstream S&P 500 type stocks will do.

Emphasize stocks with decent dividend yields. Well, maybe not decent. We know how unenhanced yields look these days. Let’s say, instead, emphasize stocks with yields that are as high as one can go without taking significant risk of dividend cuts.

Now comes the enhancement part. The CEF dividend is based on the income the fund earns. So far, z-z-z-z. Here’s the catch. Don’t assume that income has to come 100% from dividends it receives from its portfolio holdings. Income can come from other sources as well and in this case, the income comes from options, for example from premiums received by selling call options.

Assume the portfolio owns ABC, which is priced at $50 and pays an annual dividend of $1 per share.

The portfolio sells an option to John Doe allowing Doe to buy the fund’s holdings of ABC for $50 per share. The option is good for three months; if not exercised by then, it expires. Mr. Doe pays $0.50 to get this privilege and the fund gets to keep (and pay dividends based on) that income no matter what happens in the future.

Hence ABC now produces income of $1.50 ($1.00 dividend plus $0.50 received from selling the option).

Then, one of two things can happen:

• Alternative 1: Assume the market goes down or sideways and so, too, does ABC. John Doe does not exercise the option so it expires. The fund can sell a brand new option, get another $.0.50 and wait again for three months to see if the option is exercised. Either way, another $0.50 is added to income. And so on and so forth.
• Alternative 2: The market goes up and just before the end of the three month period, ABC trades at $52. In this case, Doe, who paid $0.50 for the right to buy ABC for $50 is definitely going to exercise his right. So the fund is forced to sell a $52 stock for $50. If it wants to maintain a position in ABC, it will have to go into the market and make a new purchase at $52.

The enhanced yield is real; it’s legitimate. There is no trickery here.

If the goal is to track or beat the S&P 500 and if it’s a bull market, things may not work so well. In the above example, you can’t expect to do well relative to a benchmark if you are constantly selling $52 stocks for $50 (the $0.50 premium you got for the option offsets some but not nearly all of the pain). But if your goal is to generate funds for particular purposes (retirement, college tuition, current living expenses, etc.), this can be a good thing since you’re getting a bigger portion of your total return as cash that can be spent as opposed to paper gains that may vaporize.

An option strategy can also help ease the pain of down markets. In such cases, options won’t be exercised so the fund will get to keep ABC, in which case, it “benefit” to the extent the $0.50 option premium it received mitigated a portion of its loss. This is not a good thing, but if the market does go down (it happens), it helps to have option premium income to make our pain a bit less than what is felt by others.

So why are option-enhancement strategies discussed in an article about yield traps? Actually, if done capably, and if expectations about yield are reasonably established, these aren’t traps at all and are darned good ideas. That, however, is a big “if” and leads us into the final catchall cover-the-bases of CEF yield trap.

Distribution Smoothing

CEFs tend to have very smooth distribution patterns, eerily smooth at times, much smoother than the income they generate. This is based on policy.

Think of this in terms of the Joseph in Egypt Bible story. During good years, Joseph and the CEFs store excess output (grain and income respectively) for future emergencies. During lean years, they supplement resource shortages by drawing from the stored stockpile.

If the stockpiles get exhausted but lean periods continue, there will be famine (in the case of grain) or reduced distributions (in the case of CEFs). So if today’s 7% yield is being funded by stockpiles of stored income generated in the past, it might eventually turn into a 4% yield, or a 2% yield.

That sounds awful, doesn’t it? CEF managers agree, so they try like you-know-what to avoid this.

One thing they can do is sell portfolio holdings in order to generate cash that can be added to the distribution. This is not inherently bad. Notwithstanding guru-speak extolling the virtues of holding through Y9K or longer, there is absolutely positively nothing wrong with cashing in on gains and spending the money. A return is a return and if the investor’s goal is to generate cash to spend for something or other (as is usually the case), it’s perfectly legitimate to cash in on the capital gains. In CEF literature, these will be clearly identified as “capital gains distributions” (as your accountant would expect).

That’s been a godsend for many CEFs that have struggled with the same declining yields that have plagued the rest of us. If you check the literature (as you absolutely must), you’ll see many instances in which capital gains distributions dwarf distributions from income.

What happens, though, if/when, a fund runs out of unrealized gains that can be cashed in? This is a already a problem for many CEFs, and if the absence of the former 35-year interest rate market tailwind, or even worse, a rising rate headwind, prevents the market from delivering future gains, so much the worse.

That leads us to the final distribution fail-safe, the return of capital. Here, the fund simply sells portions of its own portfolio, even if there is no gain, and uses those proceeds to fund its distribution.

This is the “eeew” of CEF distributions. It’s like it would be if you simply put your money into a money market fund, withdrew 10% each year, and lived of your 10% pseudo yield. You can get away with this for a while, especially if you have a short life expectancy and are willing to die broke (and have really good timing). But for most investors, the shrinking principal will eventually catch up to you. Funds disclose these as “returns of capital.”

Picking a high-yielding CEF

Do not, not, not, not buy a high-yielding CEF unless you have (1) hunted for and found data on fund distribution details, (2) determined that return of capital has not been used for funding, and (3) determined that the combination of income and capital gains is likely to be sustainable at a level you consider satisfactory even if we don’t have a 35-year plummeting-interest-rate driven bull market.

If you don’t want to dig for the data, or if you dig and have trouble finding, that means “avoid” (and in the latter case, I don’t care if it's really there somewhere; if a fund company chooses to bury it deeply and torture those who try to find it, that in and of itself is a very clear message about the merits of the fund, and one that comes from those who know best, the managers).

So, you’ll really need to work for your yield. Even though Portfolio123 has CEFs, I can’t use automated models because data on distribution components remain clunky to get (which in and of itself may tell you something about the mindset of the CEF industry). All I can do is screen for possibilities, and then see which, if any, survive fund-specific scrutiny. This is a slow process. I’m hunting, but so far, I have no recommendations to offer.