EDF - MSD: 11% Yield From An Outperforming EM Bond Fund

2023-10-25 09:05:27 ET

Summary

• The Morgan Stanley Emerging Markets Debt Fund invests in sovereign bonds and corporate debt in emerging markets.
• The fund has outperformed EM benchmarks this year, highlighting the attraction of the actively managed CEF strategy.
• We see EM debt as well-positioned to continue delivering positive returns with the fund also offering a compelling 11% yield.

The Morgan Stanley Emerging Markets Debt Fund ( MSD ) invests across sovereign bonds and corporate debt in emerging markets. The closed-end fund ((CEF)) structure makes MSD relatively unique compared to several indexed ETFs and alternative funds in this category.

Indeed, the fund's actively managed strategy has paid off with the fund outperforming historically, delivering positive returns this year in contrast to most fixed-income benchmarks. We like the MSD given its distinct profile with a sense that the current exposure is well-positioned to climb higher through 2024.

A scenario where global yields pull back should work as a tailwind for EM debt. Finally, the fund's quarterly distribution which currently yields 11% makes it compelling for income investors.

What is the MSD Fund?

According to Morgan Stanley, MSD combines a top-down country allocation with a bottom-up security selection investment process . Ultimately, the objective here is to produce high current income alongside long-term capital appreciation.

Going through the current MSD portfolio, 66% of the holdings are in "sovereign" bonds. These are the debts issued by foreign governments that fund fiscal budgets. Countries often issue bonds in currencies like the Dollar to tap international markets as a way to attract global investments.

The remainder of the portfolio is in corporate bonds at 30% of the fund, with a smaller amount in "quasi-sovereign" names representing state-controlled enterprises.

We find an eclectic group covered with the largest exposure being bonds from the Republic of Suriname representing 6% of the portfolio, this is followed by Romania at 5% and debt from the "Emirate of Sharjah" which is the region in the United Arab Emirates covering Dubai.

On the corporate side, some high-profile names down the line of complete holdings include small positions in bonds from Mexico-based CEMEX, S.A.B. de C.V. ( CX ) and South Africa's Sasol Ltd. ( SSL ), for example.

Overall, the theme we find here is a tilt towards commodity exporters, and oil states in particular. The backdrop of elevated energy prices is typically positive in terms of sovereign credit. Keep in mind that the holdings here are subject to change and have shifted compared to the position even at the start of the year. Notably, the exposure to China represents less than 1% of the fund, which is at the discretion of the fund manager.

While MSD can invest in local-currency debt, the bulk of the exposure is in dollar-denominated bonds and some small Euro issuances. By this measure, even as the direct FX risk is limited, the understanding is that trends in the Dollar affect broader macroeconomic conditions that can drive credit spreads.

In terms of credit exposure, the majority of the fund at around 75% is classified as non-investment grade with a BB rating or lower. At the same time recognize there is otherwise good diversification across the portfolio with more than 50 countries represented. Outside of a global contagion event or historical financial crisis, the credit profile here is more of a measure of volatility and relative sovereign positioning than the actual default potential.

MSD Performance

Technically, MSD uses the J.P. Morgan Emerging Markets Bond Index as a performance benchmark. We can proxy that index through the iShares J.P. Morgan USD Emerging Markets Bond ETF ( EMB ). At the share price level, MSD has favorably outperformed EMB over the past decade with a 23% cumulative total return compared to 15% by EMB.

Keep in mind that EMB only invests across sovereign bonds while the MSD fund has exposure to corporates. By this measure, it's not an apples-to-apples comparison with the understanding that corporates can offer a higher return potential based on their credit spreads relative to the corresponding sovereign.

While EM debt is a relatively specialized or "niche" segment of global bonds overall, investors have several alternatives to choose from among passively managed exchange-traded funds and a handful of other similar CEFs.

Some of these focus on a particular segment being "sovereign bonds" like the Invesco Emerging Markets Sovereign Debt ETF ( PCY ) or local-currency debt such as the VanEck J.P. Morgan EM Local Currency Bond ETF ( EMLC ).

From CEFs, we can point to the Western Asset Emerging Markets Debt Fund Inc ( EMD ) as well as the Stone Harbor Emerging Markets Income Fund ( EDF ), which have a similar profile to the Morgan Stanley fund.

Notably, MSD has outperformed this group over the past decade which we attribute to the valued added dynamic of the portfolio team security selection process.

While it's difficult to claim one EM category or fund is "better" than another, we like MSD for its overall balance of strong points between the flexible investing mandate compared to ETS, solid long-term performance history, and the attractive yield at 11%. Over the past year, MSD has distributed $0.68 from net investment income.

While a portion of this amount may be classified as a return of capital in the future, the otherwise steady underlying returns as stable net asset value suggest the distribution is sustainable for the foreseeable future.

What's Next for MSD?

The attraction of emerging markets is the potential for above-average risk-adjusted returns. The idea here is that compared to weak growth and stubbornly high inflation persistent in developed economies including Europe and the United States, emerging markets maintain some structural benefits as positive long-term economic tailwinds.

According to the International Monetary Fund, emerging markets are expected to lead to global GDP growth in 2024 while advanced economies slow down. Outside of China, the good news is that regions including Latin America and the rest of Asia-Pacific have seen declining inflation which is a good signal for lower bond yields as a catalyst for bond prices.

We expect MSD to continue to perform well in this environment, particularly if there is a broader move of lower rates going forward, propelled by an improving outlook on that front from advanced economies.

A scenario where U.S. inflation data evolves more favorably than expected pushing back on any further rate hiking actions by the Fed could drive some tightening of global credit spreads as financial conditions improve.

Final Thoughts

MSD is a high-quality fund offering exposure to an important but often overlooked market segment of EM debt. Investors can consider adding an allocation to the fund across a more diversified portfolio for both the income component and total turn potential.

In terms of risks, let's recognize that MSD remains exposed to broader financial market volatility. The potential for a deeper deterioration of global macro conditions or deeper recession would likely result in risk aversion and open the door for wider credit spreads in a broader EM bond selloff. A sharply stronger U.S. Dollar would likely also pressure the fund with the underlying sovereigns facing tighter debt servicing requirements.

Overall, we believe the risks are worth it at the current level with a better chance MSD is trading higher over the next year. Finally, we can mention that the fund's 1.21% net expense ratio is reasonable within this category of fixed-income CEFs.

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