You could call it the year of the closed-end fund. In 2003 so far, 33 new funds have raised $20.6 billion in initial public offerings, topping a previous record of $18.5 billion for all of 1993. Rights offerings, which allow current holders of a fund to buy new, often discounted shares, are being issued at their fastest pace in at least five years.
The funds have been attractive to investors craving higher yields, and indeed, the average return of the 570 closed-end funds now trading is up 5.1% this year. Unlike mutual funds, which make new shares available when investors want to buy and redeem when they sell, closed-end funds issue a fixed number of shares that trade on a stock exchange. Depending on demand, closed-end funds trade at a price higher or lower than their net asset value (NAV), the value of the securities owned by the fund. But if you're just now thinking of buying a closed-end fund, this may be a case of the party ending before the final guests arrive.
The reason: Most of the funds, including nearly all the recent issues, are leveraged funds holding bonds, which perform best when interest rates are falling or flat. As rates creep up, bond prices drop, punishing the funds' NAVs.
The leveraged funds, which borrow money at low, short-term rates and invest it at higher, long-term rates, can offer yields reaching 10%. The problem is that rising rates might prompt funds to reduce leverage by selling assets, which could cut the dividends.
Some fear is already setting in. Muni funds, which account for about half of all closed-end funds, have fallen 6.4% since mid-June and are up just 3% for the year. "People who buy leveraged bond funds could lose a third of their money in the next five years," warns Thomas Herzfeld, whose Miami firm specializes in closed-end funds. Also avoid funds trading at large premiums over their NAVs, such as DNP Select Income, which invests in public utility stocks and debt (table).
O.K., never mind buying -- is it time to sell? Maybe. First, says Don Cassidy, a senior research analyst at Lipper (RTRSY), check how exposed the fund and your entire portfolio are to rising rates. You'll want to know the average maturity of the bonds in the fund and, if applicable, the amount of leverage it has. A leverage-to-asset ratio of more than 40% should raise a red flag. You can find that out from the fund -- or from an industry site, closed-endfunds.com. The longer the maturities, and the greater the leverage, the greater the risk if rates rise. "If you can't stand swings up and down of 10%, you shouldn't be in the leveraged closed-end pool," says Wachovia Securities (WB) analyst Mariana Bush.
It's important to examine the makeup of the fund's borrowings. Amy Hawkins, director of closed-end-fund research at Raymond James & Associates, likes funds that have locked in their borrowing costs at low rates, making them less vulnerable if rates head upward. Also look for funds with cash cushions; they will be less likely to cut dividends.
The high yields offered by leveraged closed-end bond funds are tempting. But as interest rates climb, you might be better off sitting on the sidelines. By Ian Katz