Western Asset EM Debt Fund: Fade The Rally (NYSE:EMD)

Thesis

Western Asset Emerging Markets Debt Fund (NYSE:EMD) is a fixed income CEF. The fund focuses on EM debt, both sovereign and corporate. The fund mostly invests in USD bonds from those issuers, hence exposes minute currency risk. The main drivers for its performance here are credit spreads and U.S. rates.

The CEF has seen an explosive rally of over 30% since the lows in October, and represents a high beta duration play. The fund’s performance has also been helped by a 7% narrowing in its discount to NAV.

The main risk drivers for this CEF are U.S. rates and EM credit spreads. From a credit spread standpoint an investor would be shocked to find out we are back to the 2021 lows in spreads:

We can see spreads having widened substantially to 4% during 2022, only to come back enormously since October, now sitting at 2.59%. This is a level consistent with the lows seen in 2021! Do you think we are out of the woods and set for an accelerated growth environment or are we walking into a mild recession? If accelerated growth is in front of us then these levels are justifiable, for a recession though, we are going to re-visit the wide levels in spreads.

The CEF has a 7.4-year duration, hence let us look at the 10-year Treasury rate for a second:

U.S. 10-year rates peaked at 4.2% before retracing. We are of the opinion that as the market realizes rates could go much higher, U.S. 10-year rates are going to revisit the 4.2% to 4.5% range. Even if inflation continues to come down, it is going to be stickier than expected, and with a strong labor market prices will stay higher for longer.

The pressure from both spreads and rates widening will put downward pressure on EMD’s price. Fade this rally, and reduce risk exposure here.

Holdings

The fund holds EM Sovereign and EM Corporate debt:

We can see from the above table extracted from the fund’s fact sheet that the CEF is overweight sovereign names. From a currency risk standpoint, the fund holds mostly hard currency bonds, namely USD paper:

We like that since it eliminates currency risk, or the basis risk associated with FX hedging – i.e. some funds lose value given the implied cost associated with the hedging.

From a credit ratings standpoint, the fund is reflective of its collateral, namely mostly below investment grade risk:

Many EM issuers, although sovereign, have below investment grade ratings. The fund is well balanced however, with few highly risky issuers (i.e. CCC credits).

Performance

The CEF is up very substantially since the start of the current bear market rally in October:

I am comparing the fund with the iShares JPMorgan USD Emerging Markets Bond ETF (EMB) and with a CCC U.S. HY CEF, namely KIO. KIO is in this comparison graph purely because it is a high beta name, its collateral is obviously very different. We can see EMD blowing out of the water the other two names. The CEF is up an astounding +30% since the start of the bear market rally. EMB is an ETF, hence not leveraged, therefore it lags. U.S. HY by comparison did not do as well either.

Longer term though, the CEF lags:

EMD has a performance which lags the simple unleveraged JPM ETF on a 5-year basis. This speaks very poorly to EMD. Please keep in mind we are looking at total return here, i.e. dividends are included. EMD is more of a cyclical fund rather than a buy and hold, therefore it should be traded as such.

Premium/Discount to NAV

The fund usually trades at a discount to net asset value:

We can see from the above graph, courtesy of YCharts, how the fund’s performance has been helped by the narrowing of its discount to NAV. During risk-off environments we see this CEF bottoming at discounts of -16% to net asset value, discounts which revert to highs of -8% during normalized times. That is a wide range that can be traded.

Conclusion

EMD is a fixed income CEF. The fund focuses on EM sovereign and corporate debt. The fund has a 30% leverage ratio and a 7.4 years duration, and represents a high beta duration play in the EM space. Up over 30% since its October lows, the vehicle looks overstretched. With EM corporate spreads now back at their 2021 low levels, and U.S. rates set to rise again after retracing, EMD is best to be reduced in an investor’s portfolio. The fund’s performance has also been helped with the tightening of its discount, which moved from -16% to -9% now. EMD is more of a cyclical fund rather than a true buy and hold, with a simple ETF in the space (namely EMB) performing much better long term. Trade EMD for what it is, and take some risk off the table here.