2024-01-14 09:47:51 ET
Summary
- EMD offers a strong 11.0% distribution yield and a 12.5% discount to NAV, making it an attractive investment.
- EMD's distribution coverage ratio has improved, and the fund has outperformed relevant bond indexes since mid-2022.
- While EMD is a buy, it is still considered a relatively risky fund due to factors such as credit risk and leverage.
I last covered the Western Asset Emerging Markets Debt Fund (NYSE: EMD ) in mid-2022. In that article , I argued that EMD's unsustainable distributions, past underperformance, and significant risk outweighed its high yield and discount, making the fund a hold.
Since then, EMD's distribution coverage ratio has significantly improved, distributions and share prices have mostly stabilized, and the fund has outperformed relevant bond indexes since. Returns have been quite strong, higher than those of most bonds and bond sub-asset classes, slightly lower than those of the S&P 500.
As should be clear from the above, EMD significantly outperformed expectations. More importantly, distribution coverage ratios have improved, while the fund maintains a strong 11.0% yield and 12.5% discount. Forward returns look strong, and the fund does not look overbought or pricey.
EMD's strong 11.0% yield, 12.5% discount, improved distribution coverage ratios and performance make the fund a buy. It remains a relatively risky fund, however.
EMD - Basics
- Investment Manager: Franklin Templeton
- Expense Ratio: 1.85%
- Distribution Yield: 11.0%
- Discount to NAV: 12.5%
- Total Returns NAV 10Y: 2.24%
- Leverage: 30.36%
EMD - Overview
EMD is a leveraged, dollar-denominated, emerging markets bond CEF. It provides investors with diversified exposure to these securities, with investments in 242 securities from dozens of countries and several sectors. Largest countries are as follows. Investments in the United States correspond to cash and cash equivalents.
EMD is an actively-managed CEF, so returns could materially differ from those of its index. In practice, returns have closely tracked those of its index for most time periods, including the past five years.
EMD's leverage should increase portfolio risk and volatility, as well as realized capital gains and losses. Although this has been at least somewhat true, the impact seems quite muted, as can be clearly seen above.
As an example of the performance of a more typical leveraged fund, compare the BlackRock Core Bond Trust ( BHK ) with a simple bond index ETF.
BHK's leverage is readily apparent in the funds returns, EMD's leverage is not. For the past five years, at least.
Considering the above, EMD seems like a relatively simple, normal dollar-denominated emerging market bond fund. With this in mind, let's have a look at the fund's positives and negatives, starting with the positives.
EMD - Positives and Benefits
Strong 11.0% Distribution Yield
EMD invests in dollar-denominated emerging market bonds. These securities currently offer investors the second-highest yields in the entire fixed-income space. Security yields are high, and second only to senior loans.
EMD's underlying securities generate a lot of income, which results in a strong 11.0% distribution yield for the fund. It is a strong yield on an absolute basis, and quite a bit higher than that of most bonds and bond sub-asset classes.
On a more negative note, the fund's dividend growth track-record is quite mediocre, as the fund has seen consistent distribution cuts since inception. Cuts were due to a combination of past Federal Reserve cuts and unsustainable distributions / low coverage ratios.
On a more positive note, the conditions which led to prior distribution cuts have stopped. The Federal Reserve significantly hiked rates from early 2022 to late 2023, which should lead to higher distributions long-term (much will depend on future Fed policy, however). Distribution coverage ratios have also improved, from 71% in 2022, to 82% as of today. Return of capital distributions seem to be declining, so far at least.
Due to the above, EMD's distribution growth is much improved. There was a small cut earlier in the year, but a somewhat larger hike a few months ago. Distributions are up YTD, first time in the fund's history. With a bit of luck, the fund will be able to leverage current rates into further growth.
EMD's strong 11.0% distribution yield is a significant benefit for the fund and its shareholders. Although its growth track-record and coverage ratios have tended to be quite mediocre, both have improved in the recent past.
As an aside, I mostly changed my mind on EMD due to these improvements. The consistent distribution cuts made a bullish rating difficult, regardless of any other potential benefits.
Compelling Price and Discount
EMD currently trades with a 12.5% discount. It is a large discount on an absolute basis, about average for the past few years.
EMD's discount benefits investors in two key ways.
First, discounts can always narrow, leading to capital gains. For EMD, gains could be potentially quite large, as the fund's discount is quite high. On the other hand, I would say that significant capital gains are unlikely , as the fund generally trades with a discount, rarely at NAV or with a premium.
Second, higher discounts are equivalent to lower share prices, which mean higher distribution yields. As per management, EMD sports a 9.7% distribution yield on NAV . On price, which is what investors actually end up receiving, the fund's yield rises to 11.0%. In effect, investors are receiving 1.3% more in distributions from buying at a discount. These excess returns are generally sustainable long-term, and not dependent on market conditions, movements, sentiment, and the like.
EMD's sizable discount to NAV could lead to capital gains moving forward, and increases the fund's distribution yield, both important benefits for shareholders.
Favorable Asset Class
EMD focuses on dollar-denominated emerging market bonds which, as previously mentioned, sport particularly high yields right now.
The above is an important benefit for funds focusing on these securities, including EMD. As several asset classes offer roughly comparable yields, this is not a significant benefit, but is a benefit nonetheless.
EMD - Risks and Negatives
Credit Risk
EMD's underlying portfolio is more or less evenly balanced across credit ratings and quality. Around two thirds of the portfolio is comprised of BBB and BB-rated bonds, right in the middle of the pack. The fund tilts non-investment grade, but with sizable investment-grade holdings, and a bit of cash.
Considering the above, I think it would be fair to characterize EMD's credit risk as moderate.
Emerging Market Bonds
EMD focuses on emerging market bonds, which are much riskier than average. Emerging markets are significantly riskier than most, as their economies, corporations, and governance standards are weaker. Recessions and downturns are more common in emerging market, as are defaults. At the same time, emerging markets are perceived as riskier, and so tend to be much more volatile.
Due to the above, emerging market securities tend to see selling pressure during downturns and recessions, leading to losses and underperformance during the same.
Leverage
EMD is a leveraged fund. Leverage means more assets, which boosts risk, volatility, gains and losses . Leverage is particularly harmful during severe downturns, as leveraged funds are sometimes forced to sell assets at low prices during these.
On a more positive note, and as previously mentioned, EMD's use of leverage has only had a small impact on the fund's performance for the past few years. EMD performs in-line with unleveraged dollar-denominated emerging market bond indexes.
Discounts and Premiums
EMD is a CEF, and generally trades with a sizable discount. Discounts tend to widen during bear markets, leading to excess losses during the same. As an example, during 1Q2020 the fund's discount widened from 9.9% to 15.6%, leading 5.7% in excess losses. Most investments were down during that quarter too, but most ETFs and individual securities avoided losses from widening discounts. EMD did not.
Overall Risk
Overall, it seems that EMD is a relatively risky, volatile fund. I would expect quite a bit of share price volatility, and sizable losses during downturns and recessions. For reference, the fund performed in-line with high-yield bonds on a NAV basis during 1Q2020, the onset of the coronavirus pandemic. Price returns were lower, due to widening discounts.
Conclusion
EMD's strong 11.0% yield, 12.5% discount, improved distribution coverage ratios and performance make the fund a buy. It remains a relatively risky fund, however.
For further details see:
EMD: Strong Emerging Market Debt CEF, 11.0% Yield, 12.5% Discount