Avoid Closed-End Bond Funds for Now

Many high dividend yield closed-end bond funds profit from borrowing at short term rates to purchase longer term bonds that pay higher rates. As long as the spread between the short and long term rates is wide enough, playing the rate spread is profitable. But when the difference between the short term and long term rates narrows, as it appears to be doing now, profits are reduced and the price of the fund drops quickly. And the fund managers are eventually forced to cut dividends.

This double whammy is bad news for the owners of a closed-end bond fund because income is lost when the dividend is cut and principal is lost as the price of the fund falls. For now the dividends are stable but prices have already started to decline. The dividend cuts will follow.

John Hancock Preferred Income Fund II (HPF), Van Kampen Strategic Sector Municipal Fund (VKS), Blackrock Municipal Income Trust (BFK) and Blackrock High Yield Trust (BHY) are examples of closed-end funds that have recently fallen in price.

Posted March 29, 2005.