Navigating Morgan Stanley Closed-End Funds' 2025 Dividends: Sustainability and Tax Considerations

As investors navigate the evolving landscape of income-generating investments, the quarterly dividend distributions from Morgan Stanley's Closed-End Funds (CEFs) for 2025 offer both opportunities and complexities. With the Morgan Stanley Emerging Markets Debt Fund, Inc. (MSD) and the Morgan Stanley Emerging Markets Domestic Debt Fund, Inc. (EDD) declaring dividends of $0.19 and $0.12 per share respectively, the focus shifts to assessing whether these payouts are sustainable—and how their tax implications could impact investor returns.

The Sustainability of Dividends: A Delicate Balance

The declared dividends for MSD and EDD, payable on July 15, 2025, align with their net investment income per share for the quarter. This suggests current coverage of the distributions by operational earnings. However, the funds' ability to sustain these levels hinges on broader market conditions and their investment strategies.

Key Sustainability Factors:
1. Net Investment Income (NII) Reliance: Both funds derive dividends primarily from interest income on emerging markets debt. While NII appears sufficient for now, risks such as currency fluctuations, geopolitical instability, and rising global interest rates could compress future income.
2. Leverage and Risk Exposure: The Funds' portfolios face inherent risks tied to emerging markets, including credit downgrades and liquidity challenges. For instance, the Morgan Stanley Direct Lending Fund (MSDL)—though structured as a business development company—highlighted a debt-to-equity ratio of 1.11x in Q1 2025, underscoring the importance of prudent leverage management.
3. Expense Dynamics: Subsidized expense ratios, supported by fee waivers, may temporarily boost returns. Should these subsidies end, expenses could rise, squeezing NII and threatening dividend stability.

Tax Implications: The Return of Capital Conundrum

A critical caveat for investors: the final tax characterization of 2025 dividends remains uncertain. While the declared amounts are based on federal tax regulations, Morgan Stanley warns that all or part of the payout could qualify as a “return of capital”—a term that reduces shareholders' cost basis and may trigger capital gains taxes in future years.

Tax Considerations to Monitor:
- Return of Capital (ROC) Impact: If a portion of the dividend is classified as ROC, investors must adjust their cost basis. For example, an initial $20 cost basis could drop to $19.81 per share if the $0.19 MSD dividend is fully ROC. This erodes the principal and could create taxable capital gains if shares are sold at a higher price.
- Final Determination Lag: The tax classification will not be finalized until after year-end, leaving investors in a holding pattern. This uncertainty complicates tax planning and requires meticulous record-keeping.
- Straddle Risks: For funds like the Parametric Equity Plus ETF (though not a CEF), overlapping holdings with indices could inadvertently trigger straddles, further complicating tax treatment.

Investment Implications: Proceed with Caution and Strategy

While the dividends offer compelling income potential, investors must weigh risks against rewards.

Recommendations:
1. Focus on Diversification: Emerging markets debt is inherently volatile. Pair these CEFs with other income assets (e.g., U.S. Treasuries or REITs) to mitigate concentration risk.
2. Tax-Aware Allocation: Consider holding these funds in tax-advantaged accounts (e.g., IRAs) to defer ROC-related complications. For taxable accounts, prioritize funds with lower likelihood of ROC.
3. Monitor Leverage and Expenses: Track the Funds' debt levels and fee structures. Rising expenses or leverage ratios could signal sustainability pressures.

Conclusion: A High-Reward, High-Risk Opportunity

Morgan Stanley's Closed-End Funds deliver attractive dividends in a low-yield world, but their exposure to emerging markets and uncertain tax treatment demands vigilance. Investors should treat these funds as strategic, rather than core, holdings—pairing them with robust diversification and proactive tax planning. As always, consult a tax professional to navigate the nuances of ROC and final tax classifications.

In 2025, the path to sustainable income from these funds remains navigable, but only for those willing to chart it carefully.