Pimco recently announced that it will postpone monthly dividend payments for 6 municipal closed-end funds.
Back in October, we cautioned investors against jumping into closed-end funds due to the fact that most of them are leveraged. The combination of a declining market and hard to replace leverage are causing Pimco and other closed-end fund managers to delay dividend payments.
In the past, fund managers borrowed money as a way to pump up fund returns. Many managers issued auction rate preferred securities as a way to raise debt. That market has dried up and left managers scrambling for other ways to borrow.
At the same time, the declining value of assets has created an asset coverage problem for closed-end fund managers. The 1940 Act requires that funds have at least $2 in assets for every $1 of senior securities. For funds that were at or close to the leverage limit, declining asset values means that they must delever by buying back debt. In Pimco’s case, the manager plans to redeem a portion of their auction-rate preferred shares by December 19 according to an article in the Wall Street Journal.
A better alternative to closed-end funds are Exchange traded funds or ETFs. Because they are not levered, managers don’t have to react to changing asset values and worry about covering or replacing debt. As a result, managers don’t redirect cash and the dividends are passed through to the shareholders.
Both funds deliver a 30 day SEC yield in excess of 4% and carry low expense ratios.