Should You Buy High-Yield Closed-End Funds?

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK (TheStreet) -- At a time when money-market funds yield almost nothing, some closed-end funds offer an intriguing option for income-oriented investors.

The closed-ends aim to pay fixed annual yields. In a typical arrangement, a fund announces its intention to pay out 5% or more of its assets annually. Investors can spend the cash payments or reinvest the money.

The Closed-End Fund Association tracks 36 funds with managed distribution policies. Funds on the list include Gabelli Equity (GAB), which seeks to pay out at least 10% of its assets annually, and Royce Micro-Cap Trust (RMT), which pays out 5%. Other funds that have distributed more than 5% include Cohen & Steers Dividend Majors (DVM), H&Q Healthcare Investors (HQH), and John Hancock Bank & Thrift (BTO).

Should you buy funds with fat managed distributions? Perhaps. For retirees and other income-oriented investors, the funds offer a steady source of cash that can be used to cover bills. But the funds can be hazardous. When distributions are too steep, they can quickly erode long-term returns.

Like conventional mutual funds, closed-end funds hold portfolios of stocks or bonds. In an ideal situation, the portfolio holdings generate dividend income and capital gains, which can be distributed to shareholders.

Say a fund has a 6% managed distribution. During a bull market, the fund can easily cover the distribution by paying out capital gains and income. But if the fund suffers big losses in a market downturn, then there might not be enough income and capital gains to cover the distribution. In that case, the portfolio manager would be forced to liquidate fund assets in order to obtain cash for the distribution. This is known as a return of capital, and shareholders should not welcome it, says John Cole Scott, a portfolio manager with Closed-End Advisors, an investment advisor. "It makes no sense to own a fund that is just going to return your own money to you," he says.

Scott says some investors buy funds with big distributions and don't understand that much of the cash represents a return of capital. "If you see a fund with a 13% distribution, then you have to wonder where the money is coming from," he says.

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