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Opportunities Abound in High-Yield Funds

Investors can find double-digit yields in this small group of funds.

With bond yields skimpy, plenty of investors are starved for income. To find rich opportunities, consider a small group of funds with double-digit yields. That's a tempting payout, especially at a time when 10-year Treasuries yield 3.84%, and stocks have been gushing red ink.

This is an ideal time to go for a high yield opportunity, since this yield also dwarfs what's being offered by local and national banks.

High yields can be a sign of risk, but these high-yielding funds are relatively stable. After being pounded in the market downturn, the funds sell at bargain levels.

A solid choice is

Kensington Select Income


, which yields 10.2%. The fund focuses on preferred shares of real estate investment trusts (REITs), an obscure corner of the investment world. Many preferred securities -- which resemble bonds -- are issued by financial companies.

When the credit markets started going haywire last summer, investors dumped bank preferred shares. Then the selling spread to preferred shares of all kinds, including REIT securities.

In the arithmetic of the markets, as prices drop, yields rise. Average yields on REIT preferreds climbed from 7.55% in June 2007 to 9.90% a year later. Investors may be demanding the high yields as compensation for the risk of default. But so far, default rates have been small among REITs, which own portfolios of properties, such as malls and office buildings.

Even if the economy slows, default rates should remain low, says Joel Beam, portfolio manager of Kensington Select. "Most plain-vanilla REITs have plenty of cash flow to cover the interest payments on their preferred shares," he says.

Kensington favors preferreds from reliable REITs, such as

Kimco Realty


, which owns neighborhood shopping centers. These shopping centers are often anchored by supermarkets and drugstores, businesses that tend to produce steady results during recessions.

Another choice that got punished in the market downturn is

Alpine Dynamic Dividend


, which yields 16.99%. The fund achieves the payout by using a strategy known as dividend capture. Normally, stocks pay dividends every quarter.

To increase the income, an investor using dividend capture doesn't hold shares for 12 months. Instead, he buys a stock just before the dividend payment is due. To avoid paying short-term capital gains taxes, the investor holds the shares for 61 days, and then buys another stock that is about to pay a dividend. The aim is to receive more than four checks a year.

Alpine portfolio manager Jill Evans buys solid dividend payers, such as




Procter & Gamble


. She also boosts yields by keeping about 25% of assets in foreign markets.

Overseas investors have long demanded high-dividend yields, and companies have a tradition of delivering the income. "The U.S. is one of the lowest-yielding markets in the world," says Evans. "Many stocks in Italy and the U.K. yield more than 4%."

To get a rich yield while obtaining some downside protection, consider funds that use call writing. In the simplest form of call writing, an investor who owns shares sells someone else the right to buy them at a fixed price in the future. An attractive choice here is

Nuveen Equity Premium Income


, which yields 10.82%.

Call writing works like this. With

General Electric


shares at $29.64 recently, an investor could receive $3.30 a share by selling the right to buy the shares at $30 in January 2009.

What can you gain from the transaction? If the shares languish, the investor keeps the $3.30 in option premium and holds the stock, collecting the dividends. The danger is that the shares could skyrocket to $40. Then the option seller must turn over the shares, losing the right to appreciation.

Lately, option selling has been an effective strategy. Sellers keep the premiums, which help to cushion the declines in stock prices. Though they can lose money in downturns, call-writing funds tend to be less volatile than the stock market.

For example, the shares of Nuveen Equity Premium dropped 5.3% during the first seven months of 2008, compared to a loss of more than 12% for the

S&P 500

. "A call-writing fund can help to diversify a portfolio," says Anne Kritzmire, managing director of Nuveen.

Nuveen Equity Premium is a closed-end fund, which trades on an exchange like a stock. In unfavorable markets, the shares can drop until they sell for a discount to the value of the fund's net assets. With investors wary about complicated funds that pay high yields, Nuveen's shares sell for a discount of 13.4%. So investors can buy $1.00 worth of assets for less than 87 cents.

A relatively stable closed-end fund is

Eaton Vance Tax-Managed Diversified Equity Income


, which yields 12.14%. The fund holds blue-chip dividend-paying stocks, such as

Exxon Mobil





. Part of the portfolio is dedicated to a dividend-capture strategy. In addition, the fund sells calls on part of its portfolio.

During difficult market periods, the portfolio managers increase the call sales. This boosts premium income and provides more downside protection. This year the fund has sold more calls. That helped Eaton Vance outpace the S&P 500 by seven percentage points during the first seven months of the year. The closed-end fund sells for a discount of 10.88%. The big discount suggests that now could be an opportune time to go shopping for this high-yielding fund.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.