NEW YORK ( Thestreet ) -- Yield-hungry investors should consider closed-end bond funds.
According to Closed-End Fund Advisors, the average tax-free municipal fund yields more than 6%. That is the equivalent of a taxable bond yielding more than 9% for high-income investors. The closed-end yields are tempting at a time when 10-year Treasuries yield 2.6%.
Make no mistake, closed-ends come with risks. When interest rates rise, all kinds of bond funds tend to fall. Closed-end funds can be especially volatile. But chances are rates will not climb much for at least the next year or two. In the meantime, investors should be able to collect rich yields from closed-end funds without suffering significant capital losses.
Closed-end funds, which hold portfolios of stocks or bonds, issue a fixed number of shares that trade on exchanges like stocks. In bull markets, the shares can command hefty premiums to the value of assets. During hard times, closed-ends shift to discounts. Fixed-income funds currently trade at average discounts of almost 6%. So an investor can get a dollar's worth of assets for 94 cents.
The funds slipped into discounts last year after interest rates rose. The discounts remain wide because investors worry about the impact of increasing rates on the leverage that many closed-ends use. To appreciate the impact of leverage, consider a fund with a portfolio of $100 million in bonds. The portfolio manager borrows $30 million against the assets. The fund pays an interest rate of 1% to borrow the cash and invests the money into bonds that yield 4%. The resulting spread boosts the yield of the fund, but it also comes with risks. If bond prices sink, the leverage could magnify losses.
Worried about rising rates, investors have dumped bond funds and shifted to cash or short-term bonds. But the move to cash has been an overreaction, says James Kochan, chief fixed-income strategist for Wells Fargo Advantage Funds. "The fears about rising rates are premature," he says. "Closed-end funds are still good buys."
Kochan says that short-term rates will not rise for another year or two. It could be even longer before long rates rise significantly. Rates typically climb as the economy grows and more borrowers compete for loans. But in the current cycle, there is little demand for loans, says Kochan. Homeowners are paying down their mortgages, and few new buyers are taking on debt. Home construction remains well below healthy levels. Single-family housing starts are now running at an annual rate of only 940,000. "At this stage of the cycle, we should be at 2 million starts," says Kochan.
Many economists now expect the Federal Reserve to begin raising rates in 2015. But even after the Fed moves, closed-end funds will not necessarily start gushing red ink, says Mike Taggart, director of closed-end fund research for Nuveen Investments, which manages funds. Taggart studied what happened to closed-end returns during earlier cycles when the Fed raised rates. In the three years after the tightening began in 2004, long-duration municipal funds returned a total of 31.5%. Municipals also gave positive returns in cycles that began in 1994 and 1999.
The funds proved resilient partly because they continued making interest payments. If a fund yields 5% annually, the interest income can enable the portfolio to stay in the black -- even if the share price drops slightly. In some cycles, funds avoided losses because interest rates did not move smoothly upwards. Bonds suffered when the Fed began raising rates in 1999. But by 2001, the Fed started lowering rates. That boosted bond prices and helped closed-end funds.
John Cole Scott, executive vice president of Closed-End Fund Advisors, likes municipal funds. He recommends BlackRock MuniHoldings (MUE), which comes with a 6.7% discount and a distribution yield of 6.4%. "The fund is reasonably cheap, and the distribution seems sustainable," he says.
Scott also recommends Nuveen Enhanced Municipal Value (NEV), which has a 4.9% discount and a distribution of 6.7%.
At the time of publication, Luxenberg had no positions in stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.