Is a falling Aussie dollar enough to avoid Aberdeen Asia-Pacific Income?
Earlier this week we highlighted Nuveen's lineup of municipal bond closed-end funds. Although the fundamental characteristics of their portfolios leave much to be desired, a recent sell-off in the CEF universe has left them undervalued, in our opinion. To be sure, the sell-off is not confined to muni CEFs, with several emerging-markets and global CEFs seeing their share prices drop much faster than their net asset values. In a recent article we noted that Gold-rated Aberdeen Asia-Pacific Income FAX was trading at a statistically unusual discount, but today we take a closer look at whether it is fundamentally undervalued.
Pros and Cons
Aberdeen Asia-Pacific Income tends to split its portfolio between debt issued in Australia and debt issued in various Asian countries. There are plenty of things we like about the fund: an extensive management team located in the Asia-Pacific, good performance against a hard-to-replicate benchmark, and reasonable fees. However, we do have some concerns that don't necessarily factor into the rating. The most pressing issue is the portfolio's exposure to the Australian dollar. As of March 2013, about 43% of the fund's assets were denominated in Australian dollars. The fund's 1.33 leverage ratio (total assets/net assets) amplifies this exposure. With the Australian dollar depreciating 8.6% since mid-April against the U.S. dollar, the fund's net asset value took a hit of 7.7%. Evidently, shareholders expect the Australian dollar to depreciate further, as the fund's share price fell 15.6% over the same period. Moreover, a slowdown in Asian economies could negatively affect the credit quality of the Asian bond half of the portfolio. Income investors should also note that the fund typically underearns its distribution (now 6.5% at share price), making up the difference with either return of capital or realized currency gains. The fund's earnings rate at share price is closer to 4.8%. Provided that investors reinvest the difference, however, the current discount allows the practice to be accretive to shareholders.
Considering that our ratings eschew market calls and are based on NAV total return performance (which assumes reinvestment of distributions), neither point factors into Aberdeen Asia-Pacific Income's Gold rating.
Hedging Macro Exposure
For investors looking to buy into the fund, now may be a good time. The current 9.1% discount is close to its three-year low of 9.6%, with shares having traded at an average discount of 2.2% over the period. As recently as September 2012, shares were trading at a premium of 3.5%. Not only is this attractive on a relative basis, but it is also attractive on an absolute basis: Given the fund's 57% net exposure to the Australian dollar (leverage ratio of 1.33 x 43% total exposure), the currency could depreciate roughly 16% relative to the U.S. dollar before the NAV would be in line with the current share price (holding all else equal). Though one would expect such a scenario to be priced into current foreign exchange rates, such a drop is still completely feasible.
With this in mind, buying the fund outright would hardly be a free lunch. The current discount potentially provides some cushion against a fall in NAV, but it's unlikely that share prices will be completely insulated from any future detriments to the portfolio. However, one can still take advantage of the large discount by buying the fund and hedging some of its macroeconomic exposure.
Considering the allocation of Aberdeen Asia-Pacific Income's portfolio, there is no single instrument to sell short that would act as an adequate hedge against both Australian and Asian bonds. However, investors can sell short separate ETFs for each component of the portfolio. WisdomTree Australia & New Zealand Debt AUNZ and PIMCO Australia Bond Index AUD both focus primarily on Australian debt. Considering the small size of both funds (AUNZ has $60 million in assets under management, while AUD has $41 million), practicality becomes an issue. Alternatively, larger investors can look toward foreign exchange contracts to hedge exposure to the Aussie dollar, though this would not account for any changes in Australian interest rates. Surprisingly, the Asian bond portion of the portfolio might be easier to hedge, as the eminent Asian bond ETF WisdomTree Asia Local Debt ALD has roughly $540 million in assets under management.