In Focus
April 26, 2004
afe and secure closed end bond funds? Think again!
To increase yield, many closed end bond funds have borrowed money, as much as one-third of their total assets, to invest. This leveraging strategy is backfiring. And the fact that the funds are closed end only adds to the problem.
As interest rates rise, these funds are suffering more than mutual funds that do not use leverage. For example, while the average open end bond fund has lost 3% for the month ended April 21st, closed end bond fund Van Kampen Municipal Opportunity Trust lost 12.4%, and Nuveen's Muni Value Fund lost 7%.
The same can be said for closed end real estate funds using leverage. For example, Cohen & Steers Quality Income Realty Fund lost16.9% during the same period while the average open end real estate fund lost 11.3%.
Investors must examine the way that closed end funds are investing. However, duration, the usual measure of a fund's interest rate sensitivity, has little value in the analysis. That is because duration does not consider the effects of the fund's use of leverage, which can "significantly understate a fund's actual risk exposure", according to the Wall Street Journal.
Instead, investors need to try to ascertain the fund's "undistributed net investment income." That is a possible source of cash that the fund's investment manager could use, in a time of need, to prop up the fund's dividend payments. The data is not easy to find (it is typically buried in the fund's balance sheet) so investors may want to simply call the fund company. And undistributed net investment income is no panacea; just a temporary crutch, perhaps for several months if interest rates rise.
Investors will do well not to put themselves in a position to need to use that crutch!
— James J. Eccleston
FinancialCounsel.com
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