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Investors need to be reminded that equity closed-end funds (CEFs) that appear to be offering overly generous distributions and yields may not be able to support those distributions over time and at the very least, there usually is a cost to the fund's Net Asset Value (NAV) to have to absorb those high distributions. Anybody who thinks they are getting something for nothing is mistaken though time and time again I see investors flocking into the highest yielding funds and often times bidding them up to lofty premiums.

Last year, I pointed out several BlackRock (NYSE:BLK) option-income funds that were paying too high a NAV yield and that either the fund's distribution should be cut or investors could expect to see continued erosion of the fund's NAV. Since the time I wrote that article, all of the BlackRock funds I identified have cut their distributions and most of the fund's valuations have dropped significantly. In fact, some of the fund's valuations dropped so much, going from premiums to -10% to -15% discounts, that I felt the risk/reward had dramatically improved to a point where I recommended several of the funds to investors.

Just when I thought investors had learned what can happen to these funds, along comes another that has jumped to an all-time high premium valuation ahead of its distribution declaration. The Allianz Global International & Premium Strategy fund (NYSE:NAI) is a very small and volatile International stock fund that offers investors an extremely generous 14.5% market price yield as of the closing price on June 6, 2012. NAI, like many equity CEFs that have cut distributions over the past year, uses an option-income strategy to generate income which it passes on to investors in the form of high distributions and yields. NAI has already cut its distribution twice in its history, from $0.5375/share to $0.46/share in December of 2008 and from $0.46/share to $0.40/share in September 2010. I think Allianz may have to do it again.

NAI is in a similar situation as the BlackRock International Growth and Income Trust (NYSE:BGY), one of the BlackRock funds I highlighted last year which had a large distribution cut in March. Both funds have international stock portfolios with exposure mostly to European and Asian markets. Not exactly the place to be over the past year or so. Both funds sell index and individual stock options against their portfolios to generate income. BGY sells about 52% coverage on its large cap portfolio while NAI sells about 70%.

Before BGY cut its distribution in March of this year, BGY had a 15.4% Net Asset Value yield, which was one of the highest NAV yields among equity CEFs. Funds that have a 12% or higher NAV yield I've identified as being in the danger zone of a potential distribution cut so you can see BGY was well into the danger zone. NAI currently has a 16.3% NAV yield so it is even higher than BGY's when it cut. To make matters worse, investors have bid up NAI's market price this week so even though the fund is paying a whopping 16.3% annualized NAV yield, new investors are only getting a 14.5% market yield as of the close June 6, 2012. In other words, an investor chasing a high yielding fund at a premium isn't even getting the yield the fund is actually paying. Here is NAI's year-to-date premium/discount chart in which NAI started the year at a 7% discount and now has jumped to an 12.1% premium, essentially matching the highest in its history.

(click to enlarge)

Now I'm not saying Allianz is going to cut the distribution on NAI next week, only that they should. The reason is because the fund's NAV has become so depressed that Allianz needs to try and build back up the fund's NAV before they can even start thinking about raising the distribution back. Allianz has been known to do this before and it paid off handsomely for the NFJ Dividend, Interest & Premium Strategy fund (NYSE:NFJ) which cut its distribution dramatically back in March of 2009 when its NAV was around $13. Today, NFJ's NAV has recovered to around $17 and a more normalized $0.45/share distribution was reinstated in December of 2010.

Allianz may or may not take the same approach with NAI, but considering the fund started with a $23.88 inception NAV back in April of 2005 and now has the lowest NAV of all the Allianz equity funds at $9.83, I wouldn't be surprised if Allianz addresses this issue, particularly with the overseas markets so unsettled. NAI was one of the high fliers when it came public back in April of 2005 showing large gains for the first two years and even offering large capital gain distributions to go along with its regular quarterly distributions back in 2006 and 2007. All of that has changed, however, and the fund has dropped an enormous amount of Net Asset Value since 2007, as have most purely international CEFs. In fact, the parallels with BGY are a bit uncanny. Here is NAI's and BGY's total return NAV performances from the market high around the third quarter of 2007. All distributions are added back to give a running total return performance. Red represents down quarters and green represents up quarters.

(click to enlarge)

What's interesting to note is that both NAI and BGY have significantly lower NAVs today than they did even during the worst period of the bear market back in March 2009. This is shown in the NAV Actual column of the table. Though both funds show positive total return performance since the lows of the market, the high distributions over the past years have still taken a large toll on both funds' NAVs.

BlackRock has taken the necessary step to better align its fund's distributions with its income and I believe Allianz will need to take the same step. We should find out next week when Allianz is due to declare distributions, and if I were an investor, I would not want to hold NAI at a premium valuation going into the declaration.

Source: Equity CEFs: The High Cost Of High Distributions

Additional disclosure: Short NAI.