Are there any closed-end bond funds with low risk that I could invest in as a substitute for the pitiful interest rate of 2.5% that my brokerage pays on uninvested cash? My broker is Brown & Co., and it doesn't currently offer regular mutual funds. -- Dan Borden
You've encountered a fairly widespread phenomenon: discount brokers paying significantly below-market interest rates on uninvested cash. (In fact, that's the subject of a whole other story.)
Unfortunately, there isn't much you can do about it without switching brokers, which may not make sense if you take heavy advantage of Brown & Co.'s low commissions and margin rates. There really aren't any low-risk closed-end bond funds that could take the place of a money-market fund in your portfolio, says Mariana Bush, a closed-end fund analyst at
Why not? Think about why people buy closed-end funds. They expect them to outperform open-end funds because they can take more risk. Because closed-end funds don't have to meet redemptions, they can stay fully invested and also invest in relatively illiquid securities in order to post higher yields. Add to that the fact that many closed-end funds can use leverage, and you're dealing with an asset class that, on the whole, is more volatile than your average open-end fund.
The only possible solution I could come up with requires at least a $25,000 outlay, pays a tax-free yield and isn't available through Brown: preferred shares issued by municipal-bond closed-end funds.
Preferred shares are the means by which closed-end muni funds leverage themselves. Here's how it works: Suppose a closed-end fund raises $1 billion in an offering of common shares. It may be allowed to leverage its assets, typically up to a ratio of no more than 1 to 3. In other words, total assets must always exceed leveraged assets by at least three times. So the fund raises an additional $500 million in an offering of preferred shares. Now the fund has a total of $1.5 billion in assets, $500 million of which are leveraged, for a 33% leverage ratio.
The preferred shares earn an interest rate that resets every seven or 21 days. So the fund pays the preferred shareholders a short-term interest rate, invests the proceeds of the preferred offering in higher-yielding long-term debt and keeps the difference for the common shareholders.
Because their interest rate is short term and variable, the preferred shares are immune from interest-rate risk. And because preferred shareholders have the first claim on the assets of the fund, which exceed what's owed them by a large margin, the shares are secure from a credit standpoint as well, with the vast majority carrying triple-A ratings. So like a money-market fund, it's a dollar-in, dollar-out product, except with a slightly higher yield. Bill Meyers, product manager for
John Nuveen's MuniPreferred
shares, the most widely available muni closed-end fund preferred shares, says yields historically have averaged 35 to 45 basis points higher than tax-free money-market fund yields.
But one can't easily substitute muni closed-end fund preferred shares for a tax-free money-market fund for two reasons. First, the shares are denominated in $25,000 increments. Second, the shares trade over the counter. All the big full-service brokers make markets in them. Meyers says other brokers can get the shares for their clients at no cost disadvantage from a market maker. But that's a service they may or may not offer, and Brown doesn't, says a spokeswoman for
Chase Manhattan Bank
, which owns Brown.
The market for preferred shares issued by taxable closed-end bond funds is dominated by institutional investors because, unlike individuals, they can deduct 70% of the dividends, according to Laurence Kwoh, vice president at
Moody's Investors Service
. Most are not even eligible for sale to individuals, according to Francesca Neilson, director at
Standard & Poor's
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