EMB - TEI: EM Bond Fund With Poor Performance But Improving Asset Class Prospects

Summary

• At the start of 2023, emerging market equities are becoming an increasingly popular asset class. Emerging market bond valuations appear even cheaper in the context of the last two decades.
• Templeton Emerging Markets Income Fund has a poor track record over the last decade. Potential investors need to actively make sure they are comfortable with the fund’s current bets.
• Currently, the fund’s larger exposures to Thailand, South Korea, Indonesia and Malaysia are appealing. The historical discount to NAV suggests closer to 15% can generally be an opportunistic entry point.
• If “risk-off” sentiment prevails again similar to like we witnessed last October, such a discount level might present us with a short-term buying opportunity.

Introduction

The Templeton Emerging Markets Income Fund ((TEI)) is a closed-ended fixed income fund focused on emerging markets. It has a mandate to invest at least 80% of its net assets in income-producing securities of sovereign entities and private sector companies in emerging market countries. In terms of corporate bonds, there is currently less than a 5% weight. More than 90% of net assets are made up of foreign government and agency securities.

If the high government bond exposures give you comfort, beware that more than half the portfolio is either unrated or non-investment grade. The fund has a yield to maturity of almost 14%, which should tell you that they are invested in the sovereign debt of relatively high-risk countries.

Another important feature to note, is that the fund is quite flexible when managing its exposures. They can be very active taking on currency risk and altering duration. They prefer the higher yields available in select local-currency bonds.

In recent times such as the first 9 months of 2022, the strong USD therefore hurt their performance. On the positive side last year with inflation emerging as a key trend, their bias for lower duration risk was prudent.

On balance though, there is no escaping the fact that historical performance of the fund over the last decade has been poor.

Other key fund facts for TEI

• Portfolio Managers: Michael Hasenstab (managed fund since 2006), Calvin Ho (managed fund since 2018).
• Portfolio size: Net Assets $272 million as at Dec 31, 2022.
• Fees: Expense Ratio 1.23%.
• Monthly distribution plan: minimum annual fixed rate of 10% of average monthly NAV.
• Inception date: September 1993.
• Current discount to NAV: Approximately 7%.

Are emerging market bonds a buy in 2023?

In the last few months of 2022, some of the emerging market equity valuations stood out as cheap. I covered a couple of equity closed end fund opportunities on Seeking Alpha back then that at least have begun relatively well. They felt like quite contrarian calls at the time, are emerging market bonds even more of a contrarian bet?

At the start of 2023 I came across the below chart.

Here is another chart below of emerging market debt yields from 2003 to December last year.

One more chart to ponder below, granted these are simply forecasts from GMO. They probably offer limited value on what will happen in 2023, but I still find it interesting to get perspective on long term value. Emerging market debt is amongst the more attractive asset classes.

TEI performance

In terms of the performance of TEI, over any reasonable period it is clear investors would not be pleased.

To some extent though, the investors that have gone into this over the last decade must accept some responsibility for choosing a poor performing asset class. (As shown by the performance of the JP Morgan EMBI Global Index). The portfolio manager however has done even worse from their active management and larger fees.

In terms of some other potential options for emerging market bonds exposure, the below chart examines relative total returns over the last year.

• Templeton Emerging Markets Income Fund: As touched on earlier, can be very flexible and active with currency bets so expect more volatility. Last year until October the rising USD trend was hurting them more.
• iShares J.P. Morgan USD Emerging Markets Bond ETF ( NASDAQ:EMB ): This ETF is what TEI considers as a benchmark. As the name suggests is made up of emerging market bonds denominated in USD currency. Far more diversified and lower fees than TEI.
• Western Asset Emerging Markets Debt Fund ( NYSE:EMD ): Does use more leverage and is a lot larger fund than TEI. Has been a better active manager in this area than TEI over the last decade.
• Morgan Stanley Emerging Markets Debt Fund ( NYSE:MSD ): Over the last 5 to 10 years this CEF appears to have done better than TEI & EMD. Still however performed worse than the EMB ETF I highlighted above in the long run. Activist investors Saba Capital and Bulldog Investors are key shareholders of this.
• Stone Harbor Investment Partners also has some CEFs, but they are very small in size.

I am somewhat wary of simply basing current views on past long-term performance. The ETF has been the safer choice in the past, but the past includes a terrible last decade for the asset class. Presumably one examining this space is expecting much better returns going forward.

Theoretically at least, one may also say that active management fees could be worth it in less efficient markets such as emerging market bonds. Another point is that replicating fixed income benchmarks too closely doesn't always make logical sense. This is due to the underlying trouble with fixed income indices. It can compel investors to perversely pour even more money towards the bond issuers that are in more desperate need to raise debt. Or one may need to suddenly sell a bond that has been removed from an index.

TEI country and currency exposures

One should be mindful of your own current views on the prospects of the USD as TEI are positioned for weakness.

After the rising USD surprised many investors in 2022, I am looking towards a change in sentiment sometime in 2023. We may already be at the beginning of such a trend.

Not a CEF to set and forget, but comfortable with current Asian exposures

Throughout the history of TEI they have demonstrated they can be very active with their portfolio but have generally failed to add value. I do get some comfort however with their current positions. One of the overweight positions that stands out versus the benchmark is in Asia.

I note the larger weights to Asian economies such as India, South Korea, Thailand and Malaysia. In these Asian economies I observed inflation being less of a worry last year relatively compared to the likes of the US and Europe. Overall, these Asian central banks tended to go into 2022 with more conventional monetary policy settings and higher rates.

Apart from inflation surprising to the upside in 2022, another major theme for last year was increasing geopolitical tensions. In such an environment, I can see the attraction that TEI might have by favoring such Asian countries that keep a lower profile on such matters. This article discusses such various Asian countries and the degree of neutrality they show in terms of China-Taiwan relations.

I would also regard the chance of inflation expectations spiraling out of control in the future to be relatively low with India, South Korea, Thailand and Malaysia.

The below chart shows the cumulative inflation reads over of a few years across Asia. The latter three countries mentioned above have seen inflation behave relatively well compared to other countries in the world. India has recorded the higher inflation reads out of this four but is an attractive investment destination in terms of GDP prospects and political leadership.

High yielding portfolio and diversification can compensate for high risk

I would concede that some portfolio exposures may not be intuitively comfortable investments to hold. We must balance this out however with the high yields on offer. That is the nature of investing in emerging markets debt.

In general, I would say emerging markets investing works better adopting a contrarian mindset. Another more recent reminder of this was the fact that Turkish stocks were surging in 2022 . For those just casually glancing at headlines in that part of the world at the start of 2022, that may come as a surprise. Sometimes markets have terrible news flows, but valuations get so cheap that "less terrible" news can see a bull market.

Some emerging market bond yields certainly give us the impression the asset class could be very cheap.

For instance, the average yield to maturity on the TEI portfolio as at December 31 last year was almost 14%. There is no such thing as a free lunch, so investors must place close attention to some of the other fund characteristics which I shall now explore.

This high reported yield is even after emerging market debt has seen quite a big rally from the October low.

TEI yield to maturity, duration, and credit rating exposures

Over the last year or so they have kept duration risk considerably less than the benchmark. In terms of credit risk however, this is where the fund particularly dials up risk to produce the large yield on offer.

In comparison to the iShares J.P. Morgan USD Emerging Markets Bond ETF, TEI have a lot more exposure to securities rated B or worse.

TEI distribution yield and leverage

TEI targets a monthly payment plan worth a minimum annual fixed rate of 10% of the average monthly NAV.

The fund is currently using leverage of around 10%.

The history of the fund suggests they need to regularly return capital to sustain such a high distribution yield. Although they hold some very high yielding securities, they are very active in trading and the evidence suggests ultimately this fails to add value.

The distribution policy may well continue to see further pressure on the NAV to decline, eventually leaving a less than optimal fund size. If the discount may widen again, this can make it tricky to use tools such as share buybacks or tender offers to solve such a problem.

TEI discount to NAV history

The chart below suggests the 15% discount to NAV level offers some support for TEI. As "risk on" sentiment has generally prevailed since the last quarter of 2022, the discount has tightened lately to circa 7%.

Cautious that we may have already seen a bear market rally in "risk-on" markets

Another factor that would make me cautious about stepping in to buy TEI at current levels is whether we have already witnessed a bear market rally in "risk-on" assets. This has seen some sharp gains already for any investors brave enough to buy TEI around October last year.

The time lag of globally tighter monetary policy effects could still lead to a worsening global economy for at least the first half of 2023. In that context, I wouldn't consider TEI in the buy range at the present time.

Conclusion

I was however open minded in considering whether TEI might be worth revisiting as a long idea later in 2023. This would be in the event markets become risk averse again like we witnessed in October last year.

As I discussed earlier, I don't mind some of their current active bets such as being overweight parts of Asia. Their history suggests however these bets could easily change substantially if I go to examine TEI again in the months ahead.

Their poor performance history looks less like a rough patch, and more like what to regularly expect in comparison with their benchmark.

The asset class still interests me for a potential contrarian opportunity if markets retrace again. For that reason, I have labelled this as a hold. Emerging market bonds look well placed to present much better returns in the next decade compared with the last. I am just not sure this is necessarily the right vehicle to use to play this theme.

Perhaps it is one for shorter term traders if such a decline pushes the discount back out to 15%. I do not see TEI though as a CEF for those who try to keep risks low whilst seeking reliable and relatively high distributions.

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