Investors in closed-end funds should brace themselves for distribution cuts in the months ahead as the Federal Reserve forges ahead additional interest rate hikes, a top industry executive says.

The Fed is increasingly expected to raise rates by the end of this month and again in December.

And as rates rise, many closed-end funds, especially those focused on muni bonds and other fixed-income investments, will face growing pressure to cut the distributions they pay to investors, experts noted in a recent panel discussion on closed-end funds hosted by TheStreet.

Bonds are already highly susceptible to interest rate increases, which drive down bond prices and hurt existing investors who locked in their money at lower rates.

However, closed-end bond funds are particularly vulnerable because they often borrow at short-term rates to buy higher paying long-term bonds. As short-term rates rise, the spread narrows between what the funds borrowed and what they paid for those long-term municipal bonds.

That reduces the amount of money closed-end bond funds have available to pay out to investors in the form of distributions.

"So, all I can say is to remind people that cuts are part of the process of mixing in an investment changing environment with interest rates," said John Cole Scott III, chief investment officer of Closed-End Fund Advisors.

"We can opine about them (distribution cuts) but we're going to experience them as they happen. And we can't control interest rates."

Cutbacks on distributions, in turn, can be painful for closed-end investors, with closed-end fixed-income funds often popular among retirees for the steady stream of income they can provide.

Bill Meyers, a vice president at Nuveen, which offers several closed-end funds, offered a similar assessment on the impact of the looming Fed increase may have on closed-end fund distributions.

The Fed is expected to raise rates by a quarter-point this month, to 2.25%, followed by another bump in December, with more increases to follow in 2019. Strong economic growth and to some extent, rising inflation, are behind the Fed's moves, analysts have said.

"Generally speaking, if the funds are borrowing at shorter term rates, those rates moving higher over time, that will lead to lower distributions or distribution cuts," Meyers said.

(Full disclosure: Nuveen is an advertiser on TheStreet, but did not participate in the preparation of this article.)

The majority of closed-end funds are fixed-income, Meyers noted, in a reference to potential distribution cuts. In addition, about two-thirds of the closed-end market uses leverage, typically borrowing at short-term rates, another factor that can lead to cuts.

For investors, it is critical to understand in advance what the policy of various closed-end fund managers is towards distributions, Meyers said. If they pay out all their income that it takes in, there may be no reserve to fall back on to reduce the need for a cut in distributions.

However, other fund companies like Nuveen may instead opt to put aside money to be used to smooth out distributions and prevent sudden cuts, he noted.

"Our policies frequently retained earnings over time to smooth out some distributions," Meyers said. "And if the expenses of leverage might be increasing, we don't want to be in a position where we might have to immediately reduce the dividend of the fund."

Make Money on Closed-End Mutual Funds. TheStreet's Robert Powell recently hosted an all-star panel of experts who explained everything you need to know on closed-end mutual funds, and often-overlooked investment class. Click here to register and watch for free.

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