Income investors would be wise to consider closed-end funds or CEFs. They would be even wiser still if they understood the dividends and distributions that come with CEFs.
 
According to the Closed-End Fund Association (CEFA), CEFs pay out their earnings to shareholders in two ways:
  • Income dividends pass through to shareholders the interest or dividends collected by the fund, net of expenses, according to the CEFA. Fixed-income CEFs typically pay out income dividends monthly or quarterly and these dividends are generally taxable to shareholders as ordinary income (if held in a taxable account). Income dividends paid by municipal bond funds are exempt from certain taxes.
  • Capital gains distributions pass through to shareholders the "realized" capital gains of the fund, net of expenses. But, what's really important to know is the fund's policy toward distributions and whether the fund does anything to "smooth" distributions, says Bill Meyers, a senior managing director with Nuveen Investments.
According to Meyers, the majority of CEFs are fixed-income (tax-exempt bond funds make up 42% of the market and domestic taxable bond funds make up 20%) and the majority of CEFs also have leverage. In fact, about two-thirds of the CEF market is levered, he says.
"Leverage is generally tied to short-term borrowing," he says. 'And with short-term rates rising, funds that employ "borrowing to help finance some distributions" might reduce distributions over time. "Those costs are an expense of the fund," says Meyers.
 
What to do? "You need to look at how the manager manages distributions," he says. "Certain managers try to smooth distributions over time, others might pay out all the income it gets and if expenses move higher it will lower distributions right away."
In other words, review the fund's policy toward distributions and whether it does anything to smooth distributions or not. That way you can "maybe anticipate what can happen for income going forward," says Meyers.
 

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