It’s Dicey Time for Closed-End Bond Funds

It’s time to start waving the yellow flag for closed-end bond funds.

Like a slippery stretch of track at Indy, these investments demand extra caution at the moment. Prices are high, interest rates are low and some yield-conscious shoppers don’t seem to understand what they’re buying, experts say.

It all adds up to a potentially dangerous situation for unwary investors. “Things are very pricey right now,� says Douglas W. Beck, assistant vice president and head of closed-end fund research for brokerage Raymond James & Associates in St. Petersburg, Fla.

To recognize the risks, it helps to understand how closed-end portfolios work. These investments are related to regular or open-end mutual funds, in that both offer diversification and professional management. In fact, many big-name mutual fund companies--including Franklin, Kemper, Putnam, Scudder and Templeton--also run closed-end portfolios.

But the two fund categories behave differently when it comes to investment performance. In short, there’s an extra way to gain or lose money with closed-end products.

With regular mutual funds, prices rise and fall in sync with the underlying securities held. That is, if the bonds in a portfolio decline 5% because of rising interest rates, the value of your investment would drop by the same amount.

There’s a good reason for this direct link: By law, regular mutual funds must stand ready to sell new shares or buy back existing ones at a specific price--the “net asset value� or NAV--which is the per-share value of the underlying securities held.

But with closed-end portfolios, it’s more complicated. These funds don’t issue or redeem shares on an ongoing basis. With a fixed supply of shares outstanding, they trade like stocks, subject to the whims of the marketplace.

As a result, closed-end funds usually sell at either a premium or discount to their NAVs. In effect, this means that buyers get less or more than $1 in assets for every $1 invested (depending on whether the fund is purchased at a premium or discount, respectively).

With interest rates now down and people chasing after just about every fixed-income investment that moves, most closed-end bond funds are selling at premiums--a warning sign.

As a rule, investors should avoid bond funds selling at premiums of more than 3% or 4%, suggests Albert J. Fredman, a finance professor at Cal State Fullerton and co-author of “Investing in Closed-End Funds� (New York Institute of Finance, 1991).

“The best thing is to look for opportunities in the form of attractive discounts,� he says. “It’s always risky to pay a premium on a fund that normally trades at a discount.�

Peter von Raits, associate editor of Cappiello’s Closed-End Fund Digest in Santa Barbara, isn’t so adamant about avoiding premiums, but he does believe that people should at least be able to recognize the risks. “Certain investors seem to be chasing yields, without being aware of the NAV or its significance,� he says.

Another potential danger is that many closed-end portfolios, particularly in the municipal bond area, use leveraged or borrowed money. This tends to boost returns during favorable periods of falling interest rates but augments losses when rates rise sharply.

Relatively few open-end bond funds use much leverage.

Although many closed-end bond products appear expensive at the moment, they sometimes make better investments than comparable mutual funds. Because the closed-end portfolios don’t issue new shares all the time, they don’t have to worry about reinvesting cash inflows during periods of declining interest rates.

This often gives closed-end bond funds a yield advantage over their open-end cousins.

For patient investors willing to do their homework, many closed-end portfolios, when bought at the right time, offer good opportunities.

As with regular mutual funds, you can make money if rising stock or bond prices push up the NAV. Also, you would profit if the discount on your closed-end fund narrows or, better yet, turns into a premium.

But you also have two ways to lose with closed-end funds, and in the current environment--with interest rates low and premiums high--the outlook calls for caution.

“You’re setting yourself up for a double whammy if the market corrects,� Beck says.

Weekly Mutual Fund Leaders and Laggards

Average total return, including dividends, in percent for periods ended Thursday, May 21.

TOP 10

Fund Type Notes 12 mos. Yr. to date Week Oppenheimer Global BioTech H L +17.08% -26.57% +4.89% Fidelity Select BioTech H LL +12.20 -21.50 +4.76 Equi-Wright: Hong Kong PC NL +42.98 +29.70 +3.10 Reynolds: Opportunity G NL NA NA +3.03 Harbor: Growth G NL +7.05 -6.42 +2.98 Fairmont Fund CA NL +15.33 +5.58 +2.57 Franklin Global Health H LL NA NA +2.52 Shearson 1990s G L +8.92 -8.36 +2.01 Nautilus Fund SG L +9.41 -7.73 +1.99 Fidelity Select Air Transport S LL +12.94 +2.19 +1.95

BOTTOM 10

Fund Type Notes 12 mos. Yr. to date Sherman, Dean Fund CA NL +3.95% +21.02% Equity Strategies S NL +0.10 -0.37 Steadman Oceanographic G NL +6.17 -9.16 Schield: Value G LL -10.96 -19.21 Steadman American Industry CA NL -3.47 -9.15 Steadman Associated Fund EI NL +10.17 -8.45 Fidelity Select Electronic TK LL +9.20 +3.88 Carnegie Capp: Growth G LL +9.43 -1.97 Monitrend Gold Fund AU LL -7.22 -9.75 Carnegie Government: Intermediate FI LL +7.30 -4.02

Fund Week Sherman, Dean Fund -9.24% Equity Strategies -5.66 Steadman Oceanographic -5.15 Schield: Value -4.77 Steadman American Industry -4.14 Steadman Associated Fund -2.99 Fidelity Select Electronic -2.54 Carnegie Capp: Growth -2.44 Monitrend Gold Fund -2.35 Carnegie Government: Intermediate -2.00

TYPE: AU = gold, B = balanced, CA = capital appreciation, CV = convertible securities, EI = equity income, EU = European regional, FI = fixed income, FS = financial securities, FX = flexible portfolio, G = growth, GI = growth and income, GL = global-international and U.S. stocks, GX = global flexible portfolio, H = health/biotechnology, I = income, IF = international, MI = mixed income, NR = natural resources, OI = option income, PC = Pacific regional, RE = real estate, S = specialty/misc., SG = small company, TK = science and technology, UT = utility, WI = world income.

NOTES: NL means no sales charge, LL means sales charge of 4 1/2% or less; L means sales charge of greater than 4 1/2%; R means redemption fee may apply.

Source: Lipper Analytical Services