(06/27/12) 6 Income Funds for the Bernanke Era

Beyond the QEs and Twists and whatever else the Fed can conjure, solid and stable income has been tough to find for defense-minded income investors. But no more, writes Martin Hutchinson of Money Morning.

With the economy beginning to stall, Ben Bernanke's war on the nation's savers rolls on.

From his promise to keep the Fed funds rate near zero through late 2014, to his efforts to push ten-year note yields even lower, the Fed Chairman is a saver's worst nightmare.

You see, in Ben's world, the safety of money in the bank earning a reasonable interest rate is a dangerous thing. It's why folks with savings have been virtually forced into the market these days in search of higher yields.

One place where income investors can find them is in closed-end funds. A few of these funds even pay juicy double-digit yields—like the one my Permanent Wealth Investor subscribers have earned 20% on in two years.

But here's the best part. You can actually buy closed-end funds like these on sale. Let me explain.

Buying Closed-End Funds at a Discount
Developed in the 19th century, closed-end funds are the oldest type of mutual fund. If you understand the idea behind a mutual fund, then understanding a closed-end fund is easy. In essence, they are the same thing—pools of money controlled by a professional money manager.

However, in contrast, a typical mutual fund is also what's known as an open-ended fund. This means that the fund itself can issue as many shares as it needs to meet the demand on any given day. So the total number of shares in this type of fund isn't fixed at all—hence the term open ended. Shares are added as needed.

As a result, the cost of any share in one of these funds is always bought or sold at its current Net Asset Value (NAV). That's why shares of open-end funds don't trade per se on the exchanges.

A closed-end fund, on the other hand, is totally different. Unlike an open-ended fund, closed-end funds issue a limited number of shares. That means the number of shares outstanding is fixed. So closed-end funds actually trade on an exchange like a stock, and are bought or sold minute-by-minute with a price driven by market sentiment.

That means that just like a stock, shares may trade at a premium or discount to their net asset value. That's a key difference, and why I say closed-end funds can be bought on sale. In fact, the typical closed-end fund trades at anywhere from a 2% to 10% discount to its net asset value.

However, just like mutual funds, closed-end funds invest in a portfolio of shares or bonds according to the fund's stated objectives. They can also use leverage and invest in private equity. While they generally pay out dividends as received on the underlying investments, they are not obliged to do so.

Closed-end fund managers also use a number of strategies to prevent their funds from trading too far below net asset value (which leaves them vulnerable to a takeover). Paying out dividends is one way to achieve this, which is why closed-end funds often achieve a high dividend payout or yield.

How to Choose Closed-End Funds
These come in several different types, some of which have hidden risks attached, so I'd like to provide you with a guide through this investing jungle. Primarily, the ones with high dividend yields are of four types. They include:

Dividend harvest funds: These funds buy shares in companies that are about to pay a dividend, and then sell the stock after the dividend is paid. By doing this, they can rotate through companies with different payment dates, and thereby achieve a high dividend payout.

The problem is that shares generally trade lower after a dividend is paid, by the amount of the dividend. Two funds of this type, the Alpine Global Dividend Fund (AGD) and the Alpine Dynamic Dividend Fund (AOD), have seen their net asset value decline substantially since their inception. For us as investors, that's generally not attractive, since we are getting taxable dividends at the cost of a capital loss.

Leveraged funds: These funds achieve their high dividend by leverage and investing in shares or bonds whose yields exceed the cost of the leverage. A very popular type of this fund in recent years has been the mortgage REIT, such as American Capital Agency (AGNC) and Annaly Capital (NLY); both have dividends of 14.9% and 13%.

The problem with these is that when interest rates rise, the price of the mortgages declines and their funding costs rise, so most of the income disappears and the funds have a capital loss. Similarly, funds achieving the same effect by leveraged investing in stocks have much more risk in a bear market.

Still, AGNC and NLY have between them $26 billion of market capitalization, so their marketing strategy works even if their investment model fails in the long run.

Option-income funds: These funds buy shares and sell call options, paying out the call-option premiums they receive as income.

By definition, the net asset value of these funds normally underperforms the market indices, since shares are called away from them in bull markets. However, on an overall basis, skillful management can enable the funds to provide a total return, including dividends and capital returns, which is at least competitive.

The Eaton Vance Tax-Managed Buy-Write Income Fund (ETB) currently makes a quarterly payout of 32.4 cents a share, giving it a yield of just under 10%. What's more, it's currently trading at about 11% below net asset value. For me, it's always attractive to buy $100 of assets for $89.

International unleveraged funds: Finally, there are a few international closed-end funds, normally invested in single-country markets. They provide support to their share prices simply by paying out a percentage of net asset value each quarter, even though only part of the payout is covered by dividends.

Provided the market in which the funds invest is growing satisfactorily and is not overpriced (so dividends are a substantial part of the payout), these funds can maintain their net asset values as well as making good payouts.

For example, the Aberdeen Chile Fund (CH) is the one I mentioned earlier as being part of my Permanent Wealth Investor portfolio. It invests in one of the world's premier growth markets and currently makes quarterly payouts at a rate of 10% of net asset value per annum.

So keep in mind there's more than one way to beat Ben Bernanke at this game. The right closed-end fund can give you both a decent yield and decent growth prospects.