Using CEFs To Diversity Currency Exposure

Includes: BWG, EDD, FAM, FAX, GIM
by: Alan Young

Despite all the warnings about diversifying one's exposure to various asset classes, most investors in the US are overwhelmingly exposed toward a single currency, the US dollar.

This is a particularly opportune time to hedge that risk. Technically, the $USD has formed a long-term head-and-shoulders pattern, so traders expect it to drop sharply, sooner rather than later, relative to other currencies. (This is not necessarily a reflection on the domestic buying power of the dollar, or inflation; that would be a different article altogether).

A cheaper dollar generally implies higher-priced stocks, so stock investors should be happy with this. But bond investors are getting paid back in cheaper dollars. What's worse, as investors find other assets growing in value, they tend to abandon the bond markets, letting prices fall.

The solution to this is to buy bonds that are priced in other currencies. But this is easier said than done. Retail investors trying to buy individual bonds are up against many disadvantages, such as transparency, liquidity and spread. That's why bond funds are preferred. And closed-end funds are better in specialized markets like this, because open-ended mutual funds often have to sell at the worst time, when the market is weakest, because fearful investors are redeeming shares. The same phenomenon affects ETFs.

One can also buy foreign currencies directly, or through Wisdom Tree ETFs, but the yield on these are minimal or nil, and you'd have to be an expert trader to guess which currencies would be best. International bond managers are worth hiring to manage the exposures.

Note that not all "global bond" funds provide significant exposure to foreign currencies, as many small countries issue bonds denominated in US dollars, and managers often hedge away the currency difference.

Here are my favorite funds for gaining directly from foreign currencies.

1. First Trust/Aberdeen Global Opportunity Income Fund (NYSE:FAM)

FAM holds investment-grade bonds, mostly from government issuers, from all over the world (except the Eurozone). As of 6/30/2012, it had 60.5% in $USD, 13.6% in Australian dollars (AUD), 3-4% each in currencies of Mexico, Russia, South Africa, Brazil, Turkey, and small amounts of other countries.

Over its 7-year life, FAM has returned an average of 9.5% on NAV (13% in the last 3 years), and currently yields above 8%. This is an amazing yield for such high-quality bonds. I believe investors are shy of the fund because a substantial portion of the distribution is described as "return of capital." I have been unable to find out why this is the case; perhaps it has to do with how the currency hedges are accounted for. But the steady growth of NAV proves that this is not destructive ROC.

2. Legg Mason BW Global Income Opportunities Fund (NYSE:BWG)

This is a relatively new fund, without much track record to judge. But it has all the characteristics I look for in a good diversified bond fund: good yield (7%), good quality (BBB), good diversification:

35% $USD, 13% Mexico, 13% South Africa, 8% Turkey, 8% Brazil, 7% Poland, etc. (Note: these are currency exposures. Use of hedging and currency contracts makes this different from country-of-issuer exposure).

3. Aberdeen Asia-Pacific Income (NYSEMKT:FAX)

FAX is a popular, liquid fund with many years of steady performance. With a strong focus on Australia, 70% of the portfolio is rated A or higher; 36% is AAA. This includes 47% sovereigns, 18% other governments, 33% corporate. Currency exposure as of 9/30/2012 is 45% AUD, 37% USD, and 18% various Asian countries.

As would be expected for a well-established, high-quality fund, the yield is a modest 5.3%, and the shares trade at a premium. I would buy on a price dip.

4. Morgan Stanley Emerging Markets Domestic Debt (NYSE:EDD)

This is perhaps the only fund that avoids US dollars altogether, by investing exclusively in bonds issued in domestic currencies of Emerging Market governments. Although the portfolio is mainly investment-grade, it is more volatile than most bond funds. Last September, the distribution was dropped from .30 per quarter to .25. Whether this is the result of narrowing spreads, or trading losses, is not yet known; the forthcoming annual report may tell us more.

With that background, the current yield of 6% is not a compelling bargain, so I don't consider this a buy-and-hold investment. I use it for cyclical exposure to currencies of Brazil (16%), Mexico (16%), Turkey (11%), South Africa (10%), Poland, Indonesia, and Hungary.

5. Templeton Global Income Fund (NYSE:GIM)

Like FAX, this is a highy-respected fund that has done well in all market conditions since its 1995 inception. Accordingly, it trades at a premium, and currently yields only 4.4%. This is a go-to fund for currency risk protection when markets get volatile. While it holds $1.2 billion in mostly investment-grade bonds, it has an even more extensive and varied portfolio of currency-exchange contracts.

Currency breakdown as of 8/31/2012 includes 31% USD, 17% South Korea, 15% Malaysia, 13% Sweden, 11% Poland, and big short positions of -32% Euro and -21% Yen.

Despite the low yield on the bond part of the portfolio, the currency contracts are likely to ensure good results, so I believe this is worth a place in one's portfolio.

Disclosure: I am long FAM, BWG, FAX, EDD, GIM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.