With inflation easing and cracks appearing in US labor markets, the days of Fed-induced rate hike pressures are likely to be over. However, the main risk is that the US yield curve remains inverted and until term premiums normalize, emerging market central banks can be protected. Notice surprise rate hike by Indonesia’s central bank to protect its currency – despite a well-controlled backdrop of domestic inflation. The rest of emerging Asia is also experiencing similar currency pressures, and should they implement defensive tightening measures (eg, rate hikes or liquidity withdrawals) to stabilize their currencies, bonds may have even less performance.
Also of concern is the surprisingly tight emerging market (‘EM’) to US yield spreads, especially of late. While there is merit to a narrower spread, writing off US Treasuries as ‘risk-free’ assets seems premature. Thus, EM investors may be vulnerable as a a growing wave of new emissions come to market and when the premium term returns to the Treasury yield curve, pushing EM yields higher together.
However, the income benefits offered in the high yield emerging market/Asian bond universe are attractive, as evidenced by the Asia-Pacific Emerging Market Income Fund with a focus on Asia (NYSE:FAX) stable yield >10% of distribution. However, the catch is that FAX achieves this yield through a generous amount of leverage, which feeds not only higher volatility and downside risks, but also into its expenses (2.6% net expense ratio, including costs of debt). Current discount > 10% NAV (in line with historical levels) seems fair for an expensive high-risk fund with a dismal total return track record over the past decade.
Fund overview – A multi-leverage (mainly) Emerging Asia debt fund
The abrdn Asia-Pacific Income Fund is an income-oriented closed-end fund focused primarily on the emerging Asia fixed income universe, although the manager has also ventured into developed Asia and, to a greater extent, small, in non-Asian emerging market bonds. The fund aims to outperform a composite benchmark comprising the following indices – JP Morgan Asia Diversified Credit Index (40%), Bloomberg Ausbond Composite Index (35%), Asia USD Unsecured Government Index (15%) , iBoxx India Asia Index (5%), and iBoxx Indonesia Asia Index (5%).
The main differentiator lies in FAX’s capital structure – the fund typically has leverage levels below 33% of its total asset base, although it is allowed to use even higher leverage depending on the circumstances. As of the third quarter, the fund managed $726 million in net assets ($1.1 billion in gross assets, including borrowings) and charged a hefty expense ratio of 2.6%.
Most of the expense is due to leverage costs (1.4%), however, as FAX has been able to issue debt at below-market rates – specifically, the debt comes from $250 million of senior notes A-rated secured with low fixed rates between 3.7% and 3.9%, a higher 5.7% on a $65 million revolving line of credit, as well as 4.1% on $50 million of preferred stock. Depending on the terms FAX gets when it goes back to market or refinances (note ~$115 million matures this year), expect some volatility around the leverage portion of the expense ratio. The management fee portion of 77 bps, on the other hand, is competitive (by active manager standards), with the remaining 39 bps going to other operating costs.
There aren’t many comparable US-listed active funds to FAX, although emerging market bond ETFs typically come with much lower expense ratios. For example, ~0.4% for non-dollar-linked EM bond funds like the iShares JP Morgan USD Emerging Markets Bond ETF (EMB) and the JPMorgan USD Emerging Markets Sovereign Bond ETF (JPMB)), with Vanguard’s Emerging Markets Government Bond ETF (VOB) charging an industry low ~0.2%. These ETFs also offer lower income and upside potential because they are undervalued, so investors should carefully evaluate the type of risk/reward they are comfortable with.
From a single-issue perspective, FAX holds a fairly diversified bond portfolio with a focus on Asia, with no single holdings exceeding the 3% threshold. The two largest holdings are notably non-Asian (Mexican and Brazilian government bonds yielding 8.5% and 10%, respectively), although the rest of the top ten list is heavy on Asia’s high single-digit share of debt. development. Since the modified duration stands at 6.9 years (excluding interest rate swaps), the portfolio is skewed toward the longer end of the curve. More specifically, the five-ten-year segment is in focus at 53.0%, followed by <5-year (23.0%) and ten-fifteen-year maturities (11.0%).
Because of its underlying leverage, the fund is not as diversified in other key metrics. For example, the two largest geographic exposures, India and Indonesia, contribute 51.1% of the portfolio. Including the rest of the top five geographies (China, Australia and South Korea), this rises to 86.1%, so FAX’s performance is very much tied to their fortunes. The credit quality breakdown is also heavily skewed towards BBB (ie, borderline investment grade) at 88.3%, with BB (ie, one grade below investment grade) contributing 21.1%.
Fund Performance – Attractive >10% Return but Be aware of the risks
Against a rising rate backdrop, FAX has performed well over the past year, posting a +2.8% YTD return and a +10.0% one-year return in NAV terms. However, that doesn’t change the fact that the fund hasn’t returned enough over the past decade to justify its high fees or its higher-risk portfolio. Total annualized NAV returns over the past five and ten years stand at -0.2% and 0.5% respectively, although the widening NAV discount means market price returns were consistently negative at -1.0% and -0.2% , respectively.
Where the fund shines is in its well-hedged distribution (paid monthly), currently at 12.6% NAV (11.0% market) – well above the high-single-digit yields of comparable market ETFs development. However, it’s worth noting that the fund takes a lot of leverage to achieve this yield and passes through debt costs through a higher expense ratio. Furthermore, there is a fairly significant return on equity component of yield; the yield portion is closer to the high single digits, in line with lower-cost EM ETFs and peers. Given the risks associated with FAX’s loan portfolio, as well as the high expense ratio, the current >10% NAV discount is probably justified.
A risky game for emerging Asian bonds
Emerging market bonds have been surprisingly resilient this year relative to US Treasuries, driving a historically narrow yield spread between the two regions. To some extent, lower emerging market yields are warranted, given their comparative lack of inflationary pressures and stronger fiscal positions. That said, keeping rates low in the face of a strong US dollar remains a challenge, with the recent hike in protective rates (Indonesia) and tightening (India) being cases in point. And as longer-dated US Treasuries regain their long-dated premiums, emerging market/Asian bond yields may still be under pressure, especially at the bottom end.
In any case, there are probably better ways to get exposure to emerging Asia bonds than the rather steeply oriented Asia-Pacific Income Fund.FAX) portfolio. Yes, the fund’s 10%+ total allocation yield is attractive, but it comes at a high price (2.6% net expense ratio) that has also weighed on overall returns over the past decade. Also of concern is the leverage that FAX uses to deliver its returns, leaving little downside protection if key components of its concentrated bond portfolio underperform. The >10% NAV discount helps, but is not enough to skew the risk/reward favorably, in my opinion.