EDI: High Yield, Higher Risk
Summary
- EDI invests in sovereign and corporate debt in emerging markets. At current market prices it offers a tempting double digit yield.
- However, the IMF has warned about fragility due to the rapid increase in emerging markets debt.
- The risks of emerging market debt are amplified by the fund's use of leverage.
- EDI has traded at a double digit premium since 2018, but this is unsustainable.
Stone Harbor Emerging Markets Total Income Fund (NYSE:EDI) offers a tempting 16.9% yield at the current market price. Although emerging markets represent a long term growth opportunity, low interest rates have driven excessive borrowing in recent years. Since EDI uses a significant amount of leverage, and trades at a hefty NAV premium, even a minor disruption to emerging markets could be painful for EDI investors.
Portfolio
EDI invests in both sovereign debt and corporate debt in emerging markets. Approximately 50% of EDI’s portfolio is in sovereign debt owed to external creditors, and approximately 34% is in sovereign debt denominated in the local currency. The rest of the portfolio is in emerging market corporate debt, with a small amount of equity. EDI’s largest currency exposures are in Indonesian Rupiah (4.85%) Russian Rouble(5.3%), and Brazilian Real (4.5%). The average yield on EDI’s portfolio is 7.73%.
The following chart shows EDI’s portfolio by sector.
Source Fact Sheet
Regionally, EDI’s largest exposure is in Latin America (~42%), and Africa (~33%). The following chart shows EDI’s portfolio by region:
Source Fact Sheet
EDI is taking significant duration risk. The effective duration on the whole portfolio is 7 years. Approximately Just over 40% of the portfolio has maturity greater than 10 years. Another 38% has maturity of between 5 and 10 years. The following chart shows the maturity profile of EDI’s portfolio.
Source: CEF Connect
The ability of emerging market countries to issue such long maturity bonds reflects how favorable the market is for issuers. Yet, this is also a key risk for EDI investors.
Emerging Market Debt Risk
Easy money in the US has driven a friendly borrowing environment for emerging markets. With developed market debt yielding less than zero for much of the year, investors seeking income have had to take more risk than they are accustomed to.
For example, Ghana, which was dependent on the IMF and the World Bank for loans prior to 2009, issued bonds in 2019 that were 7x oversubscribed. EDI owns three different issues of USD denominated government bonds from the republic of Ghana, with maturities ranging from 2026 to 2051, and yields ranging from 8.13% to 8.95%. Many examples of surprisingly low yields and long maturities for the sovereign debt in relatively unstable political environments abound in EDI’s portfolio.
The IMF has warned that the low interest rate environment is encouraging an excessive buildup of debt. High debt levels will limit countries' ability to respond to a crisis, and assist their populations with adapting to technological shifts.
According to the IMF:
A sudden change in external conditions or other shocks could trigger large price adjustments that could tighten domestic financial conditions, especially in countries with significant vulnerabilities
A larger price adjustment to sovereign debt could be doubly painful for EDI, because of its use of leverage.
Leverage
Leverage makes it possible for EDI to pay out double digit distributions, but its also a key concern factor amplifying risks for investors. The average yield on EDI’s portfolio is less than 8%, but through reverse repurchase agreements it was able to borrow at an implied rate of 2.68% per year, thus allowing it to pay out double digit distributions. Yet, if any of its portfolio holdings default, the effect on EDI’s ability to pay distributions, and on its NAV would be amplified to the downside. Even if its holdings don’t default, major capital outflows from emerging markets sovereign debt could force them to mark assets down, forcing them to sell assets to avoid breaching regulatory leverage limits.
EDI varies leverage depending on its confidence in the market. According to the EDI’s annual report, it ranged between 33.3%, and zero during the last fiscal year. Leverage is currently 24%. EDI’s manager is highly experienced in emerging markets fixed income, but there is no guarantee they would be able to lower leverage in time if a crisis hits.
Leverage could have an even worse impact on EDI’s market price, because it isn’t exactly cheap right now.
Price and Performance
EDI has been trading at a significant premium since late 2018. Currently, the market price is about 12% above NAV. Yet, as the chart below shows, its traded at double digit discounts in the past.
Source : CEF Connect
A premium to NAV doesn’t automatically make a closed end fund a bad investment. If the fund was able to increase distributions or grow NAV it would be justified. However, EDI pays out most of its cash flow as distributions, which it has kept at the same level since 2013, and has barely grown NAV since inception. Its investment objective is total return, but clearly EDI is something investors buy for income.
This table shows EDI’s long term performance:
Source Fact Sheet
Its notable how much the market price has outpaced NAV. This is likely unsustainable in the long term.
Conclusion
If emerging market debt continues its bull run, EDI will continue paying high distributions. However the slightest disruption could cause a painful reversal. If a wave of defaults starts in emerging markets, the drop in NAV would be amplified by leverage. With half its portfolio in sovereign external Debt, EDI is also vulnerable to outflows from emerging markets. As sentiment reversed, the NAV premium could easily reverse to a discount, compounding investors losses. We’ll be on the sidelines.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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