EDF - EDF: Weakness Reorganized Into Weakness

Summary

• Virtus Stone Harbor Emerging Markets is a small emerging markets fixed income CEF.
• The fund is set to absorb a sister CEF from Stone Harbor, namely EDI.
• Both funds have seen substantial NAV erosion in the past decade.
• The contemplated corporate action is beneficial for both sets of shareholders.

Thesis

We have written a couple of articles regarding Virtus Stone Harbor Emerging Markets (EDF) closed end fund. The vehicle is a small emerging markets fixed income CEF that has seen a tremendous NAV erosion in the past decade due to overdistribution. The Stone Harbor CEFs have the propensity to post eye-popping yields to attract AUM, yields which are unsupported. What ends up happening in this type of set-up is NAV erosion and an eventual fund merger or closing. In our case it is a merger:

HARTFORD, Conn.-The Boards of Trustees of the Virtus Stone Harbor Emerging Markets Income Fund (EDF) and Virtus Stone Harbor Emerging Markets Total Income Fund (EDI) have approved the reorganization of EDI with and into EDF. The surviving fund will continue to be known as Virtus Stone Harbor Emerging Markets Income Fund and will retain the EDF ticker symbol.

At the annual meeting of shareholders of EDF scheduled for May 22, 2023, EDF shareholders will be asked to approve the fund's issuance of additional shares of common stock to affect the reorganization. No action is needed by shareholders of EDI in connection with the reorganization. The transaction is expected to qualify as a tax-free reorganization for federal income tax purposes and will be effected at each fund's respective net asset value ((NAV)) at the time of the reorganization.

The boards of EDI and EDF have approved this reorganization as a result of a comprehensive assessment of the two funds, which have substantially similar investment objectives and strategies, and are managed by the same investment adviser, Virtus Alternative Investment Advisers, Inc., and sub-adviser, Stone Harbor Investment Partners. The boards believe this reorganization will benefit shareholders of both funds through the creation of a larger fund that may offer economies of scale, including lower portfolio trading costs and a lower total annual operating expense ratio, as the fixed expenses of the combined fund would be spread over a larger asset base. The boards also believe shareholders may benefit from enhanced market liquidity for the combined fund's common stock, which could positively impact trading in the combined fund's shares.

The two funds are a good match since they contain similar collateral pools. Let us have a quick look at the characteristics for the two names:

We can see EDF is the larger and more successful fund as measured by the investor interest embedded in its premium to NAV. We expect EDI shareholders to reap some benefits here from the convergence of the two premiums to NAV:

The two funds have had fairly well correlated premiums/discounts to NAV, with only a recent divergence.

The issue with these two names is the very high distribution yield, which is unsupported. Unsupported distributions usually result in an ever deteriorating NAV:

If we have a look at the above graph we can see the fund's NAV has moved in the past decade from $24/share to $4.31/share now! Shocking. We do not like these types of funds that overdistribute because they hide the fact that you are virtually just getting money back via the distribution.

The end result of such a NAV destructive set-up is the eventual merger or dissolution of a fund. And this is exactly what is happening here. The current corporate action is more beneficial to EDI shareholders, but both funds are to benefit from the consolidation and increase in asset pool.

We expect next the premiums to NAV for the two funds to converge, and from a market risk standpoint the names to continue to trade weak as spreads widen in EM credits.

Conclusion

EDF is an emerging market fixed income CEF. The fund has suffered from a tremendous NAV destruction in the past decade, with the net asset value having moved from $24/share to $4.31/share. EDI is a sister fund with a much smaller AUM that has seen a similar dynamic in its NAV performance. The two funds are now set to merge, with EDF incorporating EDI. This is beneficial for both funds given the increase in AUM, and more so for EDI shareholders given their lower premium to NAV. Ultimately for a fund such as EDF which overdistributes, a merger or dissolution are the only normalized results of the modus operandi via the dividend policy. Both names are weak funds that a retail investor should steer away from. Weakness is merged into weakness here.

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