EMD: Double-Digit Historical Returns, Sovereign Bonds Focused, And Discounted (NYSE:EMD)

~ by Snehasish Chaudhuri, MBA (Finance)

In general, there is a pessimism over the emerging markets (EM) bond funds, despite the fact that most funds generated consistent strong yield over the past 10 years. Prices of most funds have dropped by more than 50 percent during these past 10 years. While that is a reason to be worried, this also means that those funds are available at a discount to their net asset values (NAV). I have sensed that investors suspect the sustainability of such high yields, and also assume there are some hidden elements behind boosting those yields. I don’t think it’s necessarily true in a majority of EM bond funds.

However, many funds are operating with a low asset under management (AUM), and investing in low-rated bonds, which surely is a factor worth considering. No doubt, there are certain risks involved with EM bond funds, but the future growth prospect of emerging economies and consistent high overall returns (mostly in close to double digit) cannot be ignored. Investors should be cautiously optimistic about these funds, and use their own filtering criteria while investing. In my opinion, Western Asset Emerging Markets Debt Fund (NYSE:EMD) is one such fund, investing in which makes sense.

Western Asset Emerging Markets Debt Fund Has a Well Diversified Portfolio

EMD is an actively managed, leveraged open ended fixed income mutual fund that invests in debt of sovereign and corporate issuers primarily in the emerging economies. However, 97 percent investments are made in US dollars. The fund was launched and is managed by Legg Mason Partners Fund Advisor, LLC. 55 percent of the entire fund is invested in sovereign debt, while almost 30 percent is invested in corporate bonds. The fund has a total of 232 holdings that are spread over almost 50 countries. Almost 40 percent investments are in the continent of North and South America. This way, the Western Asset Emerging Markets Debt Fund is geographically well diversified, as compared to a few other emerging market funds which have huge investments in Asian and African markets.

Western Asset Emerging Markets Debt Fund benchmarks its performance against the JPMorgan Emerging Markets Bond Index Global. It pays monthly dividends, and generated a yield in the range of 7 to 11 percent during the past 10 years. Average yield this year has been more than 11 percent, whereas the 5-year average yield comes to around 9.3 percent. The fund has a high expense ratio of 1.6 percent. However, that’s not unusual for an emerging market fund, as the fund employs fundamental analysis along with a top-down security picking approach focusing on a large pool of factors like tax structure, inflation, interest rate trends, currency, political ideology, growth rate forecasts, market liquidity of fixed income securities, etc., in order to create its portfolio. The fund also has a significant leverage component, which leads to interest expenses and thus enhancing the expense ratio.

Seven-Factor Model for Evaluating Emerging Market Bond Funds

While analyzing an emerging market bond fund, I use six criteria – stock price performance, AUM, annual average yield, level of portfolio diversification, average credit rating, current discount to NAV – in order to find out the investability of that fund. All these factors also enable me to assess the future sustainability of its yield (the 7th criteria), which in my opinion is the most critical factor while investing in an emerging market bond fund. As most funds are operating with a low price and low AUM, I generally pick up funds with prices higher than $5, and AUM of more than $400 million. Western Asset Emerging Markets Debt Fund has an AUM of $561.75 million, and is currently trading around $9. The fund has a leverage component of 30 percent, which is acceptable for fixed income funds.

76 percent of its assets are invested in bonds rated BB and above. However, the default risks are lower in the sovereign debts. Weighted average maturity of the portfolio is 13.7 years, while it has a weighted average coupon of 7.7 percent, which itself is strong enough to generate a strong yield for EMD’s shareholders. As discussed earlier, EMD’s portfolio is well diversified, and almost all investments are made in US dollars. The fund at present is available at a 10 percent discount to its NAV, which makes the fund attractive. The only major drawback of Western Asset Emerging Markets Debt Fund is its historical price performance – a fall of 57 percent over the past 10 years.

Risks Involved in Investing in Western Asset Emerging Markets Debt Fund

It’s true that EMD lost 57 percent of its market value over the past 10 years, but a 30+ percent loss was incurred only during the past 1 year. We all know how poorly the broader market performed during this period. Multiple factors such as Russia’s invasion of Ukraine, supply side shortages, record high inflation, rising level of unemployment, and multiple hikes in interest rates have led to a bearish market overall. If we consider the total return over the 5-year period between 2016 to 2020, the average annual return will be more than 10 percent. This was a period when the emerging economies were more stable, and the covid-19 pandemic started spreading at the fag end of this 5-year period. Overall pessimism in markets will obviously impact the returns of Western Asset Emerging Markets Debt Fund in the coming months. However, in the long run, a stable double-digit return is not impossible.

Investments in emerging markets are in general riskier than U.S. markets, as these countries have relatively weaker economies, governance standards and enterprises. Recessions and defaults are more common in emerging markets. EMD’s overall credit quality is relatively low, as almost two-thirds of its investments are rated either BBB or BB. An overall credit rating of BB+ is not that bad. Still, it lacks behind most broad-based bond indexes that focus on investment grade securities. Leverage component, though under control, makes Western Asset Emerging Markets Debt Fund a little riskier, especially when the market continues its downward movement for a longer period. Investors of fixed income securities are well aware of these facts, and so tend to sell emerging market funds during severe downturns.

Investment Thesis

Western Asset Emerging Markets Debt Fund is a reasonably good fund according to my “Seven-Factor Model for Evaluating Emerging Market Bond Funds.” It qualifies for the minimum requirements with respect to AUM, stock price, and yield. The portfolio is well diversified globally, has a manageable leverage component, and has an average credit rating of BB+. Although investments in EMs are in general riskier than U.S. markets, the default risks are lower in the sovereign debts. The fund generates strong yield, which I found to be sustainable. The fund is currently available at a good discount to its NAV. The only major drawback comes in the form of historical price performance. However, if we keep aside the performance of the past two years, the average total return between 2016 to 2020 was in the double digits. I am thus hopeful about EMD and would assign a buy recommendation.