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Top Picks for Emerging-Markets Bond CEFs

Here are two emerging-markets debt CEFs we like. 

Cara Esser, 12/13/2013

Of course, emerging markets are not without risk. Investments can be affected by a host of issues over which investors have no control, including political and economic policy, environmental challenges, and changes in foreign currency exchange rates. On top of those risks, many emerging-markets securities are often thinly traded and local exchanges are off-limits to most foreign investors, making it difficult for individuals to invest directly. Traditional open-end mutual funds are often a top choice for exposure to emerging markets, but it can be difficult for a large mutual fund to manage fund inflows and outflows without pushing prices in adverse directions due to limited liquidity. What's more, retail flows tend to be particularly unpredictable in the emerging-markets space. Flows into the $75 billion emerging-markets bond category, for example, have been volatile over the last year, even as the category gathered a net $4.2 billion in assets over the trailing 12 months ended Oct. 31.

The CEF wrapper mitigates some of these liquidity risks because managers do not have to make allowances for sudden inflows and outflows of cash. But investors are beholden to the whims of the market, which can wreak havoc in the short term on share prices. Investors experienced this firsthand during the so-called taper tantrum in May and June: The average share price for emerging-markets bond closed-end funds dropped nearly 11% in the second quarter of 2013; most of the drop occurred during the latter half of May. In June, the average share price continued to fall another 8%. Net asset value declines were more moderate during May and June but still stung. The typical fund's NAV fell 4.6% in May and 5.6% in June. This illustrates a significant benefit of CEFs, as share prices do not always track NAV movements and investors can snap up deeply discounted shares in times of market stress.

Funds We Like
Options abound in the CEF space for investors to access both emerging-markets equity and debt (sovereign and corporate), though many of the equity funds are single country focused and are often very small and thinly traded. Two of our favorites are large and well-diversified funds run by experienced management teams who also oversee open-end funds with similar strategies. Both funds generally avoid leverage (only five emerging-markets-focused CEFs use a significant amount of leverage). By choosing a CEF over a similarly managed open-end fund, investors often collect higher distribution rates and have the ability to purchase shares at a significant (absolute and relative) discount.

Western Asset Emerging Markets Debt ESD
Despite a recent downgrade to a Morningstar Analyst Rating of Bronze from Silver mostly due to an increasing expense ratio, we still like Western Asset Emerging Markets Debt ESD for its superior risk-adjusted results over the long term. Further, because of its international presence, we believe Western Asset is more than equipped to run this fund (and its open-end sister Western Asset Emerging Markets Debt SEMDX), which it acquired from Citigroup in 2005. The firm's emerging-markets team has offices in four countries and meets at least every two weeks to discuss potential investments in their respective regions. With a large portion of the fund's portfolio invested in Latin America, the team's Sao Paulo office is particularly useful. Head portfolio manager Keith Gardner has been managing assets for the firm since 1994 and was named manager of this fund in September 2008. His investment career has focused specifically on international investments for more than two decades.

The fund splits its allocation among emerging-markets corporate debt, local-currency sovereign debt, and U.S. dollar-denominated sovereign debt, though holdings tend to be concentrated in Latin America and Eastern Europe. Gardner overweights or underweights countries and regions relative to the JPMorgan Emerging Markets Bond Global Index based on valuation metrics and outlook. While the fund can use leverage, it has not since October 2008 (between 2005 and October 2008, portfolio leverage was usually lower than 5%). Derivatives are often used to manage duration and currency exposure and occasionally to gain access to local currency markets.

During Gardner's tenure, the fund beat its emerging-markets bond CEF, ETF, and open-end peer group average in 89% of rolling three-year periods ended November 2013. On a total return basis, the fund gained 7.2% between September 2008 and November 2013, compared with the peer average return of 7.3%. Overall, the fund hasn't delivered chart-topping returns, but managers have been thoughtful risk-takers and have avoided some of the riskier emerging-markets countries. The fund's 12% discount as of Dec. 3 boosted its distribution at share price to more than 8.5%, higher than most of its CEF peers. While the current discount is not overly attractive on a relative basis (the one-year z-score is negative 1.4), it is more undervalued than most of its CEF peers.

Templeton Emerging Markets Income TEI
Star manager Michael Hasenstab runs this (and other emerging-markets CEFs) alongside a few better-known open-end funds including Gold-rated Templeton Global Bond TPINX. Templeton Emerging Markets Income TEI invests in global fixed-income securities, both government and corporate, with a focus on emerging-markets economies. Hasenstab manages currency exposure through currency forward contracts but leaves some currency exposure unhedged. As of Aug. 31, 83% of the fund's currency exposure was to the U.S. dollar with small exposures to the real, peso, Ghanaian deci, and Serbian dinar.

Templeton's well-resourced team is spread across continents, and on-the-ground-research is an important part of the process. Hasenstab doesn't construct portfolios with traditional issuance-weighted global-bond benchmarks in mind, which are skewed toward the world's most-indebted developed markets. Instead, he and his team aim to identify value among currencies, credits, and interest rates in countries with healthy or improving fundamentals that they think the market doesn't appreciate. Hasenstab is known for his slow (often glacial) portfolio turnover, and this fund is no different. The latest fiscal year's turnover was 14.5%, lower than nearly all of its peers.

Over the trailing five- and 10-year periods ended Dec. 3, the fund's NAV gains beat 95% of CEF, ETF, and open-end emerging-markets bond peers. These chart-topping returns have not come with excessive volatility. The fund's Sharpe ratios have been significantly higher than peers over the same periods and its standard deviations lower.

While the fund's 2.6% discount as of Dec. 3 is less enticing than some CEF peers on an absolute basis, the fund's one-year z-statistic was negative 0.80, indicating the valuation is fair. The small discount boosts the distribution rate at share price to nearly 7%, which is slightly lower than the peer average. Investors should note that the fund generally pays $0.25 per share each quarter for the first three quarters of the year and generally pays a year-end capital gains and income distribution that can be significant; these year-end distributions are not included in the calculation of the aforementioned distribution rate. For 2013, the special distribution was recently announced at $0.2245 per share in long-term capital gains and $0.1996 per share in income.

Home-country bias is often blamed for the lack of non-U.S. holdings in the average investor's portfolio. But many investors are simply unfamiliar with the available options and the benefits of going beyond their borders. Emerging markets took a hit this summer, no doubt scaring off some investors, but this should not be cause for exclusion from a portfolio entirely. A well-diversified portfolio can benefit from a small allocation to emerging markets (whether CEF, ETF, or open-end fund), and individuals can benefit by investing in funds run by well-staffed and knowledgeable investment teams offering these strategies.


Cara Esser is a closed-end fund analyst at Morningstar.

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