Which Are Better: Open- or Closed-End High-Yield Funds?

Also, a handful of analyst recommendations for high-yield closed-end funds.
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This week's topic: high-yield closed-end funds. Reader

Peter Trefonas

wonders how they compare with open-end high-yield funds, and

Peter Cleaver

, shut out of U.S. open-end funds because he's Canadian, is looking for specific recommendations in the high-yield closed-end arena.

In answer to Peter T.'s question, closed-end funds of all types have the potential to outperform their open-end counterparts for at least two reasons. Because closed-end funds don't need to keep cash on hand to meet redemptions, they can stay fully invested at all times. Also, closed-end fund expense ratios are generally lower, and all fund performance figures are net of expenses.

In addition, many closed-end funds have the ability to use leverage. They borrow money at short-term interest rates and invest it at long-term rates, and the shareholders get the difference. As long as short-term rates don't spike, leverage should goose a fund's yield and return.

Thus, in the high-yield arena at the end of May, according to

Lipper

, the average open-end high-yield fund yielded 9.19%, compared with 10.88% for closed-end high-yield funds and 11.10% for the leveraged variety.

The Choice for Illiquid Assets

There's another reason to consider closed-end funds if you're going the high-yield route, explains Mariana Bush, closed-end fund analyst at

Everen Securities

. The less liquid the asset class, the more the closed-end structure makes sense, and high-yield is among the least-liquid asset classes.

When illiquid assets are held in an open-end fund, the manager may have to realize losses in order to meet redemptions in a market downturn. Unless money flows back into the fund when prices start to recover, it won't bounce back as heartily as a closed-end fund.

The risk, of course, is that you'll

need

to sell when the market is down, at which point a closed-end fund may be trading at a wider discount to its net asset value than it was before. In that case, Bush says, you have "the potential to lose more than the actual market did."

Recommendations

Peter C., you asked for recommendations in the high-yield closed-end fund arena, so I asked a few widely followed analysts what they like at the moment. This is in no way a comprehensive list of analyst-recommended funds; I did not consult the closed-end income fund analysts at

Merrill Lynch

,

PaineWebber

,

Salamon Smith Barney

,

A.G. Edwards

or

Raymond James

, all of whom presumably have their own fave junk funds. (See a recent

Fund Forum for a discussion of closed-end fund analysis.)

Bush likes

High Income Opportunity

(HIO) - Get Report

, a nonleveraged Smith Barney fund currently yielding 9.77% and trading at a 3.03% discount. She notes that discounts aren't common in the high-yield arena, and that the fund's dividend appears to be safe. Everen has not performed underwriting services for the fund.

Prudential Securities

closed-end fund analyst Kristoph Rollenhagen also likes HIO and its sister fund

Managed High Income Portfolio

(MHY)

, rating both a strong buy. Both are nonleveraged, "which in this interest-rate environment, might not be a bad place to be," he says. MHY is yielding 9.60% and trading at a 0.1% discount.

Rollenhagen likes the funds because they've been managed by John Bianchi at

Smith Barney Asset Management

"forever" and have consistently outperformed. In addition, Bianchi recently finished improving the funds' average credit quality, which depressed their income. But the funds are now in a position to earn their dividends, Rollenhagen says.

In the leveraged arena, Rollenhagen likes

Blackrock High Yield Trust

(BHY)

, which he rates an accumulate, and

Conseco Strategic Income

(CFD)

, which he rates a strong buy. Prudential has performed underwriting services for both funds.

BHY is yielding 10.38% and trading at a 1.36% discount, and CFD is yielding 11.39% and trading at a 2.97% premium. Rollenhagen likes the funds because they are relatively new, which should enable them to keep their income steady for a longer period and because both fund managers have "exceptional track records in high yield."

Prospect Street High Income Portfolio

(PHY)

is also interesting, though at a 12.48% premium he thinks it's "a little expensive these days."

Gruntal

closed-end fund analyst Michael McGrath thinks the fund's 13.71% yield justifies the premium, rating the fund a strong buy. The fund is earning its dividend and has a substantial reserve fund, he notes.

McGrath also likes

DLJ High Yield Bond Fund

(DHY) - Get Report

, rating it a buy. It's yielding 10.78% and trading at a 4.76% premium. The fund made its debut last August, which gave it the opportunity to buy bonds at deeply discounted prices, he says. And despite the premium, it "still offers value now because it's well-positioned for the continuing recovery in the high-yield market," and DLJ is extremely experienced in the high-yield arena. Gruntal has performed underwriting services for both funds.

More on Duration and Convexity

Readers of last month's three-part series (

May 14,

May 21 and

May 28) on duration and convexity will appreciate this very simple and clear explanation of negative convexity (the characteristic of callable bonds), courtesy of reader

Larry Weiner

: "As interest rates rise, the bond becomes more price sensitive at a time when you don't want it to be more sensitive, and as rates fall it becomes less price sensitive at a time when you wish it were more sensitive." Thanks, Larry!

In addition, I've been meaning to mention that in preparing those columns, a forthcoming book was extremely helpful. If you're interested in cultivating a deeper understanding of these and other basic investment concepts from a delightfully easy-to-read textbook, look next year for

Fundamentals of Investments: Valuation and Management

(Irwin/McGraw-Hill) by Charles Corrado and Bradford Jordan.

Send your questions and comments, along with your full name, to

fixed-incomeforum@thestreet.com .