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Risk and Return for Emerging-Markets Income

We look at two facets for analyzing emerging-markets bond CEF distributions.

Steven Pikelny, 05/28/2013

Though closed-end funds, or CEFs, are known for being excellent income-generating vehicles, many income investors are confused by the distribution payments and subsequently avoid CEFs altogether. This is not entirely unwarranted, as CEF distributions can be quite complex. After accounting for discounts, leverage, return of capital, and return of UNII, a 6% distribution rate might not be all that it appears. Nevertheless, it is worth taking the time to understand two of the dimensions in which investors should view distribution rates: how much risk the fund takes to maintain its distribution and whether the fund is actually earning enough income to meet distribution payments.

But still, even after taking into account these two factors, it is difficult to make any kind of meaningful assessment in a vacuum. With this in mind, let's take a closer look at the distribution profile of the emerging-markets bond CEF category, which includes 11 funds in total.

Leverage and Other Risk Factors

In the above table, we show distribution rates at net asset value and at share price. While the former gives a good indication of how much the fund is paying out from an operational standpoint, the latter takes into account the fund's premium or discount to show what shareholders actually receive. The third column presents the fund's leverage ratio (total assets/net assets), while columns four and five provide "core" distribution rates (back-of-the-envelope adjustments for the leverage, calculated by dividing the distribution rate by the current leverage ratio). This can be interpreted as the fund's estimated distribution rate in the absence of leverage. At first glance it looks like Stone Harbor Emerging Markets Total Income EDF is the best bet, as it pays the highest distribution rate at NAV and share price. However, it is also one of the most leveraged funds in the category, with a leverage ratio of 1.37. After adjusting for this, its core distribution rate of 6.4% at share price, while still above average for the category, is notably less impressive. After adjusting for leverage, it appears that Global High Income Fund GHI and Stone Harbor Emerging Markets Total Income EDI are the most attractive. However, it is also important to look at the risk profile of the individual holdings. While some of the lower-yielding funds, such as Templeton Global Income GIM, focus on higher-quality sovereign debt, GHI focuses on corporate debt with about 40% of its portfolio unrated.

Taking our analysis one step further, the next chart looks at whether the underlying portfolio of each fund is currently generating enough income to cover their distributions.

Earnings Coverage


 

Steven Pikelny is a closed-end fund analyst at Morningstar.
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