Despite the credit crunch, experts see good buys in closed-end funds that borrow to enhance their returns. Of course, leverage can also...

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Despite the credit crunch, experts see good buys in closed-end funds that borrow to enhance their returns. Of course, leverage can also exaggerate losses.

Earlier this year, the market for a key source of financing — auction-rate preferred securities (ARPS) — froze. This drove up some funds’ borrowing costs, hurting returns, at a time when the funds should have been benefiting from a series of interest-rate cuts by the Federal Reserve.

“At the very beginning, there was a misperception of how ARPS were going to affect closed-end funds,” says Cecilia Gondor, executive vice president of Thomas J. Herzfeld Advisors. The rate cuts mitigated much of the damage to the sector.

Closed-end funds, which trade like stocks, issue a set number of shares so they sell at discounts or premiums to the net asset value of their holdings, depending on investor demand. Average discounts for closed-end funds were a bit wider in February on ARPS concerns, but are now at a more normal 5.07 percent, she says.

If the Fed raises interest rates later this year, it could cause many funds’ borrowing costs to rise, notes Mariana Bush, closed-end analyst with Wachovia Securities. But for now, concerns are easing as funds are retiring outstanding ARPS and using other sources of financing.

Gondor likes leveraged funds Clough Global Opportunities Fund and John Hancock Patriot Premium Dividend Fund II. Both recently replaced ARPS with other short-term loans. For Clough, the change has already reduced costs, she says.

Morgan Stanley analyst Paul Mazzilli is positive on most closed-end bond funds. He likes Van Kampen Dynamic Credit Opportunities Fund, which has higher than average credit risk but may offer above-average returns, and Nuveen Performance Plus Municipal Fund.