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Don't look now, but high yielding Closed-End funds that specialize in Return-of-Capital (NYSE:ROC) in their distributions could become a lot more valuable if the tax status of qualified dividends or municipal bonds are changed, something that is becoming more and more likely in the case of qualified dividends that are currently taxed at 15% and may revert back to being taxed at ordinary income tax levels.

Then consider all the talk circulating about reducing or even eliminating the Federal tax-free status of municipal bonds. This may be less likely, but even a small shift in risk assessment against municipal bonds could have a dramatic affect in favor of the much smaller market Return-of-Capital investments. MarketWatch was the latest to cite this risk over muni bonds in this article released on November 1st.

This growing concern over the past few months was part of my motivation for writing an article just last week which included a recent white paper report from Eaton Vance (NYSE:EV) that outlined some of the misconceptions and even advantages of Return-of-Capital in high yielding Closed-End fund (NYSEMKT:CEF) distributions. I also tried to add some color to the report comparing ROC distributions with that of tax-free municipal bond distributions. You can read the article here.

ROC Distributions vs. Tax-Free Bond Distributions

The advantages of tax-free municipal bonds are well known, certainly much better known than the advantages of Return-of-Capital. But are the distributions essentially the same? Because the Internal Revenue Service (NYSE:IRS) looks at Return-of-Capital as the equivalent of returning an investor's capital investment, that portion of any distribution that an investor receives during the year identified as ROC will show up in Box 3 of their 1099's for taxable accounts as non-dividend distributions and thus, are not taxable.* Now the IRS requires that an investor would need to reduce their cost basis by the ROC amount, which would increase the amount of capital gains (or decrease the capital loss) to be recognized when a shareholder sells his or her shares of the fund, but if an investor does not sell their shares then this becomes a non-issue.

I will tell you right now, there are some very smart institutional investors who do just that for their clients. Re-investing the distributions of high ROC funds at significant discounts with no intention of selling the shares since there are ways to hedge your downside risk without selling. This is frankly one of the best long term financial planning strategies I know of and it may become even more advantageous if these other investment classes have their tax-advantaged status changed.

Municipal Bonds vs. Municipal Bond Funds

Now I don't want to give the impression that conservative muni bond investors would convert en masse to equity based high ROC yielding CEFs since the risk levels of municipal bonds are not even close to the same risk level as high ROC stock based CEFs. Here I am referring to individual tax-free municipal bonds, which are one of the most conservative asset classes available to investors, particularly the AAA-rated insured bonds. These are, by far, the investment of choice of conservative high net worth clients looking for tax-advantaged income because they have guaranteed payments and maturities. I should know about their popularity, I had many million dollar+ clients when I was a Vice-President/Financial Advisor at Smith Barney and Morgan Stanley who bought nothing but municipal bonds.

However, when you start comparing municipal bond mutual funds and municipal bond ETFs, the risk level may still be much lower compared to high ROC stock based CEFs, but at least now we're talking about perpetual investments that don't mature, can adjust their distributions, are reduced by their distributions each ex-dividend period and can lose value, i.e. are not guaranteed. However, it's when you start comparing leveraged municipal bond CEFs with high ROC equity CEFs, that the risk level becomes more balanced. This is because leverage, even in bonds, is going to substantially raise the risk profile. Then consider that most leveraged municipal bond CEFs trade at all-time high market prices and premium price levels and I believe the risk level in these funds has increased substantially in light of any possible tax status changes.

Referring back to my article from last week, there is a graph of the total return market price performances of the 4 largest leveraged muni bond CEFs ($1 billion+ in net asset market cap) sponsored by Nuveen, BlackRock (NYSE:BLK), INVESCO (NYSE:IVZ) and PIMCO compared with that of two high ROC equity CEFs that mirror the S&P 500. Here you'll see that during the 2008 financial crisis, the high ROC stock based CEFs held up as well if not better than leveraged muni bond CEFs and held up much better than the S&P 500, which dropped -38.5% for 2008.

Now I'm not saying we're going to see a repeat of 2008 but I did want to point out the downside risk for an asset class that invests in securities that are at all time high market prices and all time low yields. Individual municipal bonds currently average about 1.8% for a 10-year AAA-rated municipal bond and about 3.2% for a 30-year bond, but because of 30%-40% leverage that most muni bond CEFs use, their current yields are a higher 4.5%-5.5%, obviously very attractive to investors looking for tax-advantaged income. But even that yield is not even close to the average yield of high Return-of-Capital equity CEFs that are more in the 8%-11% range currently, though not all of that yield would be classified as ROC. Of course, you have to buy into my thesis that the tax-advantages of these two asset classes and the risks are essentially equivalent.

In all my articles written on Seeking Alpha, I have never compared fixed-income bond CEFs with stock based CEFs because I felt the two asset classes were apples and oranges. But the difference in valuations of the leveraged muni bond CEF market with the high ROC equity CEF market combined with some striking similarities, I believe warrants such a comparison. I've compared the tax-advantaged distribution status and risk associated with such funds but let me address a more subtle similarity.

Why Option Income & Bond Income Is Better Than Dividend Income

High ROC stock based CEFs are overwhelmingly represented by the option-income funds. Option-income funds use a sell call option strategy against their stock portfolios (index or individual stock options) to generate income the fund passes on to investors in the form of high distributions and yields. This is a defensive strategy because in essence the funds are short options and being short options will lower the volatility of the funds in up or down market environments. This is why these funds tend to have Net Asset Values (NAVs) that hold up better in down market environments while still offering tax-advantaged ROC distributions along the way.

Here is the subtle similarity with municipal bonds. Like interest payments from bonds, options do NOT affect the value of the fund's portfolio when the income is generated. When you receive a bond interest payment, the bond itself does not go down in price by the value of the payment. Neither does an option when put into place against a stock or an index. Yes, you may limit the appreciation potential of the asset tied to the option, but the asset does not go down in value. Contrast that to funds that rely on dividend payments from stocks to generate income and you realize that each stock holding is reduced by the dividend amount when it goes ex-dividend. This is a subtle but very important factor to understand when comparing income strategies.

This similarity of income generated from options and bonds (never mind the source of that income) vs. income generated from stock dividends can have a dramatic affect on fund values over time. One has only to look at CEFs that use a "dividend harvest" income strategy to see what the cost of overweighting stocks going ex-dividend has been to their NAVs. The lowering of portfolio value each time a stock position goes ex-dividend has been nothing short of a ball and chain on these fund's NAVs. Then consider that the distributions of "dividend harvest" funds may not be as tax-advantaged if the 15% tax-qualified status goes away and...anyway, that's a discussion left for another day since this problem does not affect leveraged equity CEFs nearly as much.

Most Investors Misunderstand High Return-of-Capital CEFs

The fact of the matter is that the vast majority of investors completely disregard one of the most tax-advantageous investments I can think of because they completely misunderstand the risks of funds that include high Return-of-Capital in their distributions. What most investors don't realize is that during down market periods, when many investors would think that ROC distributions would just add to the poor performance of these funds, many of these fund's Net Asset Values (NAVs) are actually holding up better and outperforming their benchmarks.

Now investors DO have to be careful since there are CEFs that have high Return-of-Capital in their distributions and are truly returning a fund's capital to investors. This is called 'destructive' ROC and you have to watch out for funds that continually use it. Then there are fund's that can mask distributions as non-Return of Capital but yet are in essence, returning an investors capital investment nonetheless. I even wrote an article early in 2011 identifying such funds, which you can read here. Please do yourselves a favor and compare total return performances of the fund's mentioned in the article. You can do that here, and then go to Chart Creator and then use the "Total Return Price" metric. Be sure to check "Display chart as percent change."

To summarize, high ROC distributions in option-income equity CEFs are not a liability during poor market periods and in fact, most of these funds offer lower volatility NAVs compared to their benchmark averages (typically the S&P 500, NASDAQ or global indices). In addition, high ROC stock based CEFs, many of which offer 8% to 11% current market price yields, can be less risky than leveraged tax-free municipal bond CEFs that offer 4.5% to 5.5% current market yields while still offering much of the same tax-free characteristics in their distributions.

Well, if that doesn't get you interested, then how about this. Because of negative investor perceptions of high ROC funds, many are market priced at heavy discounts to their NAVs. Think Apple (NASDAQ:AAPL) has taken a big hit, down over 18% from its high? Well, imagine buying Apple at a further -10% price reduction? This is indirectly what you can receive in some of the best Return-of-Capital stock based Closed-End funds I follow, and I would like to go over them now.

NOTE: Because of the length of this article, I will be writing a part II segment which covers the high ROC funds I am recommending. I am not an accountant and investors should discuss with a tax-professional their tax situation before making any investment decisions based on this article.

Source: Equity CEFs: The Best Return-Of-Capital Funds