Merger Of 2 Global Bond Closed-End Funds Provides A Good Opportunity

| About: Western Asset (GDF)
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Summary

GDF trades at a 17% discount and has a distribution yield over 12%.

GDF will be merging with EHI which will lead to a lower expense ratio and better market liquidity.

Provides exposure to beaten down emerging market and global high-yield bonds.

Western Asset Global Partners Income Fund (NYSE:GDF) is a leveraged closed-end bond fund that provides exposure to emerging market sovereign and corporate debt, U.S. high yield corporate debt and foreign high-yield sovereign debt securities.

The fund seeks a high level of current income along with some capital appreciation. They use a team management approach. The fund managers try to use extensive credit research to identify attractively priced securities.

(Data below is sourced from the Legg Mason Global Asset Management website unless otherwise stated.)

GDF is currently selling at a discount to NAV of -17.23% compared to the 52-week average discount of -14.45%. Over the last year, the highest discount has been -18.53% which is only slightly higher than the current discount.

Source: cefconnect

The three month, six month, one year and two year Z-scores are all in negative territory, which means that GDF trading over a 17% discount to net asset value is well below the mean over various time periods.

3 month Z-score= -0.87 (3-month average discount= -16.43%)

6 month Z-score= -0.82 (6-month average discount= -16.40%)

1 year Z-score = -1.16 (1-year average discount = -14.47%)

2 year Z-score = -1.55 (2 year average discount = -11.38%)

Source: cefanalyzer

GDF- Five Year Discount History

Upcoming Fund Merger

In November, 2015, the fund board announced approval of a plan to merge GDF with EHI, subject to approval of the shareholders of each fund. If approved, the merger is anticipated to occur during the second quarter of 2016. Based on past experience, I expect the merger to go through. The surviving fund will be EHI.

Right now, I prefer GDF over EHI because its discount to NAV is a little higher. GDF shareholders should benefit from the merger because the combined fund will benefit from economies of scale, greater asset diversification, a lower expense ratio and enhanced market liquidity.

Here are a sample of three-month correlations for the NAV of GDF compared to various benchmarks. The correlations are scaled between -100% to +100%:

GDF NAV 3-Month Correlation Data versus Benchmarks

GDF versus High Yield Bonds = +83.65%

GDF versus Emerging Market Bonds = +87.60%

GDF versus Bank Loans = +51.79%

GDF versus International Treasury Bonds = +54.13%

GDF versus Total Bonds = +18.77%

GDF versus 7-10 Year Treasury Bond = + 1.04%

GDF versus 10-20 Year Treasury Bond = - 8.50%

GDF versus EHI = +98.87%

Source: cefanalyzer

Note that the correlation with longer term Treasuries is close to zero or negative. This is likely true because Treasuries have recently become a "risk-off" investment, while GDF is more of a "risk-on" investment because of its high yield and emerging market exposure.

The NAV of GDF has been very highly correlated (almost 99%) with the "sister" closed-end fund EHI. The two funds are expected to merge in the second quarter of this year.

Distributions

GDF has been paying $0.0725 per month. They reported average monthly earnings per share of $0.0682 the last six months, so a small portion of the recent distributions have been return of capital. I don't have any problem with this since when the discount is -17%, any distributions returned to shareholders generate significant "discount capture" alpha.

Asset Allocation

Credit Quality

Top 10 Emerging Market Countries

Limited Foreign Currency Exposure

Given the mix of countries that GDF holds in its portfolio, one would expect the fund to have a lot of foreign currency exposure. But that is not the case and they are overweighted toward the US dollar.

Market Performance

GDF has had good long-term NAV performance, but negative NAV performance over the last three years. But it may be a good swing trade candidate now (if you believe high yield and emerging market bonds are close to forming a bottom) because of the high discount to net asset value. Since inception, it had one big losing year in 2008 when the net asset value fell -35.63%, and it also struggled in 2015 with a -7.26% loss. Here is the total return NAV performance record for the last 10 years along with its percentile rank compared to Morningstar's World Bond category:

GDF

NAV Performance

World Bond

NAV Perf.

Percentile Rank in Category

2006

+11.06%

+10.51%

38

2007

+1.07%

+6.13%

100

2008

-35.63%

-12.35%

94

2009

+73.62%

+31.91%

6

2010

+18.72%

+13.85%

25

2011

+2.52%

+1.55%

60

2012

+23.66%

+16.43%

29

2013

+1.82%

-2.62%

85

2014

+0.75%

+2.76%

78

2015

-7.26%

-6.41%

55

YTD

-2.76%

-1.88%

82

Source: Morningstar

Discount Capture Opportunity

Closed-end fund discount capture is primarily used by active swing traders with a shorter term trading time horizon. This occurs when you buy a closed-end fund at a discount which later narrows.

Here is a simple example of discount capture. You buy a closed-end fund at a discount of 20%. For simplicity, assume no distributions. The net asset value is $100, and you buy the fund for $80. Suppose the net asset value goes up 10%, and the discount narrows from 20% down to 15%.

The new net asset value is now $110, and the new market price at a 15% discount would be 0.85*110= 93.5. You have earned a return of 93.5/80= 16.9%. So the "alpha" earned from discount capture in this example is 6.9%. Note that the "alpha" earned is more than the 5% change in the discount.

Using GDF as an example, if the discount were to fall 5% from -17% to -12%, you would pick up about 6.9% worth of "alpha" which would be added to the NAV return.

Dividend Yield Enhancement Opportunity

With dividend yield enhancement, you don't need a change in the discount to net asset value, so this method for capturing "alpha" is useful for longer term buy and hold investors.

Suppose you own a closed-end fund which distributes 10% of net asset value each year and sells at a 20% discount. When the fund pays a distribution at NAV, you actually earn 25% extra. Assume a net asset value of $100 and a market price of $80. The $10 annual distribution is 12.5% of market price, so you are earning an extra 2.5% in dividend yield enhancement because of the discount.

Another useful metric to look at is the adjusted expense ratio which takes into account how much alpha you earn from recovering net asset value from the annual distributions. In some cases, this results in a negative adjusted expense ratio.

Let's compute the dividend yield enhancement and adjusted expense ratio for GDF.

Baseline expense ratio= 1.35% (Source: cefanalyzer)

Distribution yield (market) = 12.15%

When you recover NAV from a fund selling at a 17.23% discount, the percentage return is 1.00/ 0.8277 or about 20.8%.

Dividend yield enhancement alpha= 12.15% * 20.8%= +2.50%

Adjusted Expense Ratio= 1.35% - 2.50%= -1.15%

The adjusted expense ratio is negative, so you are effectively getting the fund management services for free.

Ticker: GDF Western Asset Global Partners Income Fund

  • Total Net Assets= 189.4 MM
  • Total Common Assets= 134.8 MM
  • Annual Distribution Rate= 12.15%
  • Dividend Frequency= Monthly
  • Current Monthly Distribution= $0.0725 ($0.87 per year)
  • Baseline Expense ratio= 1.35%
  • Adjusted Expense Ratio= -1.15%
  • Discount to NAV= -17.23%
  • 52 week Average Discount= -14.45%
  • Effective Duration(years)= 6.20
  • Number of Holdings= 492
  • Effective Leverage: 25.83%
  • Average 3 Mos. Daily Trading Volume= 48,447 shares (about $350,000)

Sources: cefconnect, yahoo finance, Legg Mason, cefanalyzer

GDF looks attractive now for a discount capture swing trade. It does have fairly high expenses, but you recover that and more because of the high distributions and discount to NAV. It is a good diversifier for other fixed income holdings in a tax deferred retirement account.

The discounts for many of the global and emerging market closed-end funds are the highest they have been since 2008. For example, the five-year average discount for GDF is only -4.46%. This appears to be a good entry point for a contrarian investor.

GDF has moderate liquidity and usually trades around 50,000 shares a day. The bid-ask spread is usually one or two cents, but care must be taken for larger orders. After the fund merger with EHI, the trading liquidity should improve considerably.

Disclosure: I am/we are long GDF.

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.