Closed End Funds and the Yield Trap

Jason Zweig warns investors against chasing high yields offered by some closed end funds in the column High Yields Aren’t Always a Good Thing.

Problem number one arises from the fact that the yields posted by the funds can include both income and return of capital.  Income, of course, is a good thing, but return of capital simply means that you are getting back a portion of what you have already paid for — why get excited about that?

The second issue Zweig highlights is that investors are paying a premium over net asset value (NAV) for high yield funds. Turns out that 11 of the roughly 650 closed-ends tracked by Lipper Inc. traded for at least 20% more than their portfolios are worth.

The lessons for investors are twofold:  1) understand what is behind a fund’s yield — Zweig recommends the Closed-End Fund Association’s website to uncover what portion of a fund’s yield is attributable to income, and 2) be careful about paying a premium for a fund with an inflated or unpredictable yield.

Exchange traded fund investors can gain access to high yields without worrying about NAV premiums since ETFs typically track very close to the value of underlying assets.  For example, the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) has a 30-day SEC yield of 8.77% and currently trades at a 1% premium.  The ETF has a weighted-average maturity of 5.48 years and carries an expense ratio of 0.50%.  Top holdings include bonds from NRG EnergyHCA Inc and Echostar DBS Corporation.

Another option is the High Yield Corporate Bond Portfolio (PHB) from Invesco PowerShares.This ETF has a 30-day SEC yield of 8.56% and typically trades at less than a 1% premium.  The fund has an average maturity of 6.91 years and expense ratio of 0.50%   Top holdings include bonds from Opti CanadaSabine Pass LNG and Teck Resources Limited.

For more investing choices, see the special report, Investing for Income with Exchange Traded Funds.