Don't Let These High Yields Fool You

With interest rates as low as they are, many investors are doing everything they can to find investments that will provide them with solid, dependable income. Yet when you see a payout that looks too good to be true, beware -- it probably is.

Paying more than an investment's worth
Over the weekend, an article in the Wall Street Journal discussed how a number of closed-end funds are sporting extremely attractive yields right now. When you look more closely, you'll see that some of those yields are illusory -- and may be unsustainable in the long run.

Yet that hasn't stopped investors from bidding up shares well beyond their actual value. Take a look at some of these top offenders:

Source: CEF Connect, Yahoo! Finance. As of Feb. 22.

Why would anyone pay as much as $1.57 for a dollar's worth of assets in such a fund? The answer is the supply and-demand dynamic that uniquely affects closed-end funds.

How closed-ends work
Most investors are more familiar with regular open-end mutual funds and exchange-traded funds. Open-end funds are free to create new shares or redeem old ones whenever an investor wants to buy or sell. ETFs are a bit more complicated; ordinary investors don't transact directly with fund managers, but large institutions can buy or sell blocks of ETF shares in a similar way. The fact that at least some investors can interact with fund managers typically keeps share prices from getting too far out of line with the value of the assets held within the fund.

Closed-end funds, however, don't work that way. Once the fund company does a public offering of shares, the only place they trade is in the secondary market. So when demand goes through the roof for a particular fund, then it can trade at a huge premium to its actual value. Similarly, if demand dries up for a given closed-end fund, then it will trade at a discount below the current value of the fund's assets.

Paying you with your own money
The reason some investors are willing to pay huge premiums for these funds is that their yields are extraordinarily high. Is that because these funds have found investments that aren't available to the general public?

At least in these cases, the answer is a resounding no. Consider:

• The Gabelli and Evergreen funds both count Constellation Energy (NYSE:CEG) and Great Plains Energy (NYSE:GXP) among their top holdings.
• PIMCO's global stock fund has positions in S&P index futures as well as several bond positions in issuers like Fannie Mae and General Electric (NYSE:GE).
• Cornerstone's two biggest holdings are ExxonMobil (NYSE:XOM) and Johnson & Johnson (NYSE:JNJ) -- stocks you'll find near the top of even the simplest S&P 500 index fund.
• Alpine, which sounds like a foreign-oriented fund, nevertheless has nearly 60% of its assets in U.S. stocks like Microsoft (NASDAQ:MSFT) and Avon Products (NYSE:AVP).

So, if these are just normal investments, how are these closed-end funds goosing their yields? There are two things closed-ends do that most mutual funds don't: They borrow money to take leveraged positions, and they make distributions that don't necessarily correspond to their actual income.

We saw the dangers of leverage quite clearly back in 2008. But with short-term rates low, the cost of borrowing in order to make leveraged investments is equally low. That works fine -- until those short-term rates start to rise.

Moreover, by making distributions that include not just actual income but also some of your original investment, closed-end funds can make their distribution yields look like any number they want. What you see when you look closely at these funds' actual returns on net asset value is that while they all rose in 2009, several of them didn't match the S&P's return despite the additional risk they've taken.

Beware
Sometimes, a high-yielding investment might seem like the best answer to your financial problems. Unfortunately, closed-end funds with high yields are much riskier than you think. If you're lucky, you'll sell out before the premium disappears -- but if you're unlucky, you could end up losing not only that attractive income but also a good chunk of your principal.

Dividend investors, do you hear that? It's a stock screaming, "Buy me!" Read all about it from James Early, the Fool's dividend stock expert.