Income Funds at a Discount

In today's low-interest-rate world, we think it's high time to take another look at closed-end funds. Many of these funds, which trade on exchanges as stocks do, use borrowed money and options, among other strategies, to pump up yields, making them ideal for income-hungry investors.

The closed-end format provides fund managers with other advantages. Because shareholder cash doesn't generally flow into or out of a closed-end fund after its initial public offering, a manager can invest for the long term and doesn't need to keep low-yielding cash on hand to meet potential redemptions. This stability is particularly well suited to investing in volatile asset classes, such as emerging-markets stocks.

We highlight here six promising closed-end funds -- four that focus on stocks, two on bonds. In selecting them, we have used many of the same criteria we use when picking open-end mutual funds. We prefer lengthy manager tenures, solid track records, modest fees and reputable management companies with strong analyst teams. In the closed-end arena, we also give higher marks to funds that trade at discounts to their net asset value (NAV) per share -- that is, to the value of their holdings.

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A focus on cash producers

Claymore Dividend & Income (symbol DCS) is a case of new wine in an old bottle. Claymore hired Manning & Napier, a fund manager with a fine pedigree, to take the reins of Dividend & Income in July 2009. That was after Claymore dumped the previous adviser, Dreman Value Management, which succeeded in losing a remarkable 85% of the fund's assets in 2008.

M&N is off to a good start: Over the past year, the fund returned 12% on its assets, four percentage points better than the return of Standard & Poor's 500-stock index. (A closed-end's return on assets typically differs from the return on share price because the share price moves independently from the underlying assets; return on share price measures what you actually earn, but return on assets is a better measure of the manager's performance.) At $13.71, Dividend & Income trades at a 14.3% discount to NAV and yields 2.9% (all data are through the September 10 close).

Patrick Cunningham, chief executive of M&N, says his team uses quantitative screens to identify attractive large-company stocks. The managers look for companies that generate copious amounts of cash but whose stocks sell at modest prices. The strategy, says Cunningham, protects capital well in bear markets and delivers solid returns over a full market cycle.

To goose returns, Dividend & Income employs leverage, borrowing money at short-term interest rates to invest in additional securities. It also puts about 20% of its money in corporate bonds to lessen volatility and to generate more income. The fund has large weightings in the consumer-staples, health-care and energy sectors but almost nothing in financial stocks.

A clone to remember

Source Capital (SOR) may not be a familiar name, but it's a fund we know well: Source is a virtual clone of FPA Paramount, one of our favorite commission-charging funds (see Our Favorite Broker-Sold Funds). Both are managed by Eric Ende and hold virtually identical portfolios of small- and midsize-company stocks.

Ende says he aims to invest in superior companies, by which he means businesses with strong brands, market shares, managements and balance sheets. These businesses typically achieve high returns on capital. Ende, who has run Source since 1996, holds stocks for seven years, on average.

Source returned an annualized 8.2% on assets over the past ten years, besting the S&P Midcap 400 index by an average of 3.4 points per year. The fund uses a modest amount of leverage and distributes much of its investment return each year in the form of quarterly dividends. At $43.78, Source sells at an 11.2% discount to NAV and currently yields 5.5%.

Income-paying health fund

The flexibility of closed-end funds is on full display in BlackRock Health Sciences (BME). The fund, which invests in companies of all sizes, is a virtual clone of BlackRock Health Sciences Opportunities (SHSAX), an open-end fund. Both are ably run by Erin Xie, a Chinese-born scientist with an MBA from the Massachusetts Institute of Technology and a doctorate in biochemistry from the University of California, Los Angeles. But there's one key difference: The closed-end fund targets a minimum annual distribution yield of 6%. Xie achieves this largely by selling options on the health-care stocks the fund owns (a strategy that is known as covered call writing).

Xie thinks health care is an attractive group for long-term investors. All the major economies have aging populations, she says, and technological innovation and new products are hallmarks of the sector. Xie believes that health-care reform, by bringing 30 million uninsured Americans into the system and raising taxes on individuals and corporations to finance the overhaul, will turn out to be largely positive for health-care stocks.

Xie says that in recent months, she's boosted her allocation to drug stocks while paring stocks of medical-device and service companies, which are being hurt by the weak economy and high unemployment. Drug stocks are cheap, boast high yields and tend to be defensive, she says. The fund's top holdings, at last report, included Amgen, Novartis and Stryker.

BlackRock Health sells for $24.98, or a 4.7% discount to the value of its assets, which have appreciated an annualized 6.8% over the past five years. Xie did better than most stock-fund managers in protecting capital during the bear market. In 2008, her fund surrendered less than half as much as the S&P 500. It yields a juicy 6.2%.

A legend tackles China

Negative headlines about the Chinese economy -- a property boom here, a slight industrial slowdown there -- are obscuring a remarkable economic story. The country has sustained high growth rates for 30 years. The economy continues to expand by 10% a year, and in 2010, it surpassed Japan's to become the world's second-largest.Templeton Dragon (TDF), run by emerging-markets pioneer Mark Mobius, invests in the economically tethered "Three Chinas": the mainland, Hong Kong and Taiwan. One of Mobius's favorite themes is rising domestic consumption in China. "Growing per-capita income and spending power, and increasing demand for consumer products and services in China point to tremendous potential for growth in consumption," says Mobius. For instance, he holds auto and retailing stocks and is warming to consumer banking, as millions of Chinese open their first bank accounts and access their first consumer loans and credit cards.

No surprise that Mobius thinks all U.S. investors should have a China allocation in their portfolios. "It wouldn't be wise to ignore the world's second-largest economy," he says. Dragon, whose assets appreciated at 16.8% annualized over the past ten years, sells for $26.44, representing a 9.7% discount to NAV.

Solid to the core

As the name implies, BlackRock Core Bond (BHK) assembles a diversified portfolio of debt securities. But that doesn't mean this is a middle-of-the road bond fund. Yes, the fund considers Barclays Capital Aggregate Bond index, a widely used measure of the U.S. bond market, its benchmark. But co-manager Matthew Marra says the fund deviated this year from the index by boosting the maturities of its holdings (the better to benefit from falling bond yields) and by holding a high weighting in junk bonds.

Marra says that BlackRock, a fixed-income powerhouse with 200 bond professionals, correctly figured that interest rates would decline because of the lackluster economy. More recently, Marra (who picks the fund's investment-grade bonds, while co-manager James Keenan invests in the high-yield credits) reduced the fund's average maturity. "We still think we're in a slow-growth environment and that rates will stay low for an extended period," he says, "but we don't have as high a level of conviction that they'll keep declining." Core still holds a fair amount of junk bonds, including a bunch in bonds rated double-B (4.1% of the portfolio at last word), as well as some non-agency and commercial mortgage securities.

As Marra notes, most buyers of closed-end funds are yield-hungry. So Core borrows money to generate more income. At a price of $13.65, the fund offers a handsome 5.9% yield and trades at a 1.7% discount to NAV.

A play on taxable munis

Since its launch in April 2009, the Build America Bond program has been one of the great successes of the federal government's economic-stimulus plan (see Munis' Worthy Rivals). These taxable municipal bonds have attracted new types of muni investors, such as foreign-government-owned investment funds, pensions and life-insurance portfolios. BABs offer attractive risk-adjusted yields -- for example, yields that are significantly higher than those of corporate bonds of similar maturity and credit rating but with a much lower default probability based on historical patterns.

Dan Close manages Nuveen Build America Bonds (NBB), the first BAB closed-end fund. Nuveen, the leader in muni closed-end funds, deploys a 20-member research team that has recommended such issues as East Baton Rouge Sewer bonds and North Texas Tollway Authority bonds, both of which are top NBB holdings.

The attraction of this fund is its high, 6.9% yield combined with the solid underlying credit quality of its holdings. The manager pumps up yield by borrowing money at short-term interest rates, a particularly effective strategy when long-term-bond yields are well above short-term interest rates, as is the case now. Most BAB issues have had long maturities, and the fund's average maturity is nearly 29 years, which means its NAV will be highly sensitive to interest-rate movements. Close reduces his leveraged portfolio's rate risk by short-selling Treasury bonds (those short positions would rise in value if interest rates rose). Still, the fund would suffer if interest rates spiked, although Close expects them to stay within a narrow range for a while. At $20.34, the fund sells for a 3.0% premium to NAV.