Are Investors Really This Dumb?

In searching for the best investments, value investing legend Benjamin Graham had a simple philosophy: buy dollars for $0.50. That sounds simple, but apparently, some investors haven't gotten the message -- and they're happily paying as much as $1.75 for the same dollar.

The best place to find these sorts of discrepancies is in the world of closed-end funds. In some cases, investors pay way too much -- but in other cases, you can pick up some interesting bargains.

The priciest bonds out there
Bill Gross has said that he thinks Treasury bonds are overpriced. Yet his own PIMCO closed-end funds are currently the biggest offenders for charging premium prices for their shares. As a recent Barron's post discussed, the Pimco High Income Fund (NYS: PHK) and the Pimco Global StocksPlus & Income Fund (NYS: PGP) both had premiums to their net asset value of more than 70%.

Why would this happen? The answer has to do with the hugely attractive dividends these closed-ends pay. Based on their most recent monthly payments, the funds have distribution yields of 11.6% and 10.8% respectively. But after digging a little deeper, what becomes clear is that those distributions don't necessarily reflect the income the funds' investments generate -- and slowly but surely, investors are having their own capital handed back to them.

Consider these facts:

  • Both funds use significant leverage, with the High Income Fund having $1.41 billion in total assets but only $840 million in net assets after taking its borrowings into account, according to Morningstar. With current low rates on borrowing, that allows the funds to double up on higher-yield bonds -- but it also leaves investors dangerously exposed if the value of those bonds falls.

  • Both funds have had part of their monthly distributions characterized as a "return of capital" for tax purposes. That's a positive from a tax liability standpoint, but it's a negative if you want to live off your income and preserve your principal.

  • Perhaps most important, neither fund has particularly rare investments. With a combination of derivatives and various types of bonds, the portfolio resembles something you'd expect to see in many high-yield portfolios.

To be clear, I'm not knocking those investments themselves. AIG (NYS: AIG) bonds appear in both portfolios, and while that's undoubtedly a risky proposition, the current value of AIG's shares show investors' belief that those bonds will eventually pay in full. Similarly, Ford (NYS: F) may currently have junk bond status, but many expect the company to climb back to investment-grade status in the near future.

The long-term perspective
What bothers me, though, is what has happened to the per-share value of the funds' assets over time. Just in 2011, Pimco High Income saw its net asset value fall from $9.10 to just $7.27. Back in early 2007, its net asset value was more than $15. Even after considering the dividends it paid out, the fund lost money on a net-asset-value basis -- yet the stock climbed. For the other fund, NAV went from more than $27 in early 2007 to less than $11 at the end of 2011.

More troubling is the fact that as recently as 2008, these funds traded at a discount to their net asset values. It's true that the low-interest-rate environment has helped all leveraged investments, from these dividend-paying closed-end funds to high-yielding mortgage REIT Annaly Capital (NYS: NLY) and its peers. But just as Annaly is vulnerable to a rise in short-term interest rates, so too will these closed-end funds face big challenges once the leverage punch bowl gets taken away.

Don't pay up
When closed-ends like these trade at discounts -- as they did in 2008 -- they give investors big bargains. But trying to jump in now just because of their inflated yields is riskier than it's worth. Even if you're hungry for income, look elsewhere to get payouts you can count on going forward.

Let me suggest just such a place to look. The Motley Fool's latest special report looks at several stocks that have the features you need to have a rich retirement. It doesn't cost a dime -- but grab it today while it's still available.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time thisarticle was published Fool contributor Dan Caplinger sticks with discounted closed-ends. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital and Ford. Motley Fool newsletter services have recommended buying shares of Annaly Capital and Ford, as well as creating a synthetic long position in Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never charges a premium.

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