What are the pros and cons of closed-end bond funds?

QUESTION: What are the pros and cons of closed-end-bond funds? What are the risks, and what's the average return of this type of investment?

-- Anonymous

ANSWER: Closed-end funds are a little like mutual funds on steroids. Like their more staid open-end counterparts, closed-end funds hold a basket of securities, giving investors diversification with a single share. But unlike traditional mutual funds, closed-end funds issue a fixed amount of shares (offered initially through an initial public offering), and trade like stocks. These funds generally enjoy greater flexibility in their investment strategies than closed-end funds (for reasons we'll explain later), with many closed-end funds using leverage to give their returns more bang for the buck. For investors in the right fund at the right time, these instruments can pay off handsomely. But "they can bite you if you're wrong," warns Don Cassidy, closed-end-fund analyst for Lipper, a mutual-fund research firm.

The vast majority of closed-end funds hold fixed-income securities, particularly municipal bonds (which offer federally, and often state-tax-free returns). Thanks to their generous yields and (in most cases) additional leverage, closed-end bond funds have recently had a good.

Part of the appeal of closed-end funds is that they can be bought at prices that are discounted to their net asset value. Since a closed-end fund trades like a stock rather than a traditional mutual fund (which simply creates more shares to meet investor demand), share prices are bid up or down based on market demand. And these funds often -- but not always -- trade at a discount. (The biggest discounts are often found in the stock-oriented closed-end funds; the premiums and discounts for fixed-income funds are affected by interest rates as well as the investment quality of the portfolio itself.) So if, for example, a fund's net asset value per share is $30 but it trades at $27 a share, its discount is 10%. Investors benefit when the spread between the share price and the value of the fund's assets has narrowed (assuming the fund was bought at a discount).

Because of these premiums or discounts, closed-end-fund returns are calculated in two ways: market-price return and NAV return. Both return figures factor in the current portfolio value and dividends, but in different ways. The NAV return examines the change in NAV, just like the return calculation for an open-ended fund, and can be used to measure the manager's effectiveness. The market-price figure (which ignores the NAV and factors in the change in a fund's premium or discount) is used to see how investors in the fund have fared, explains Cassidy.

Leverage can change a closed-end's returns dramatically, increasing volatility and, when big bets pay off, yields as well. "If you just simply look at a (closed-end) fund's yield without digging deeper to find out how it works, you might be overly impressed by the fact that it can easily yield much more than a conventional open-end bond fund," says Eric Jacobson, senior analyst at Morningstar, an investment-research firm. But that extra yield comes at a price. "The closed-end bond funds that use leverage are generally much more volatile in terms of their prices than plain-vanilla open-end bond funds," Jacobson warns.

Closed-end funds have some other potential advantages. Like exchange-traded funds, these instruments are traded throughout the day, rather than at the end of the day (as is the case for open-ended mutual funds) -- a perk for active investors. And since the number of shares is fixed, a closed-end fund doesn't have to sell shares to meet redemptions when investors flee the fund, says Cassidy. This gives the manager greater control over the portfolio.

Still interested in a closed-end bond fund? A word of caution: Should the economy heat up again -- a situation that would precipitate a rise in interest rates -- many of these funds will bet clobbered, particularly those with leveraged portfolios of longer durations. Granted, no one's predicting a rapid recovery with soaring interest rates. But investors looking for a muni-bond fund may want to seek the best yield they can get at a lower duration, says John Maier, closed-end-fund analyst at UBS Warburg. "The shorter the duration, the less interest-rate sensitive and the better off (an investor) will be in a rising-rate environment," says Maier. When interest rates rise, "they will all get hurt," he adds. "But some less than others." Keep in mind, actively managed closed-end funds can shift their portfolios to shorter durations during times of likely interest-rate increases, but those that aren't actively managed cannot.

Finally, it goes without saying that investors should fully understand a security before buying it. "I really wouldn't recommend these for novice investors, because there are a few different moving parts to understand," says Jacobson. Investors looking to become more educated on these funds can check out the Web site of the Closed-End Fund Association or ETF Connect (which includes information on exchange-traded funds as well as closed-end funds). Both sites offer educational materials as well as information on specific funds.