Emerging Market Bonds: Part 3
248% Profits on the Best Asset Class Of the Last 10 Years
An Investment U White Paper Report: Part 3�
By the Investment U Research Team
Return to Part 1 or Part 2 of Emerging Market Bonds
6) A Mighty Fine Way to Diversify Your Exposure to the U.S. Dollar
And the final, but by no means least, critical reason involves diversification out of the U.S. dollar. The continued fall in the dollar proves this point in spades.
Of course, the argument that the U.S. dollar is overvalued has been promoted for some time now.
So what is the primary reason to expect the dollar to continue suffering a steady decline? Basically, the U.S. has depended entirely too much on the inflow of the world’s savings in the past several years to keep the U.S. motor humming along.
As risk appetite increases and global growth picks up, investors are actively seeking out higher yielding assets outside the U.S.
But the risk of a falling dollar can be mitigated. Investors in the U.S. should diversify not just among different asset classes, but among currencies as well. For most U.S. investors, their exposure to the U.S. dollar is significant. Investing in an emerging-market bond fund offers an easy way to reduce your exposure to the dollar by spreading your money among a multitude of foreign currencies.
In fact, being exposed to currencies that appreciate versus the U.S. dollar adds to any gains on your foreign assets. An article published each year in the The Economist has been consistently reporting a weakening dollar for years. (The Economist has a simple, yet sensible, way to value currencies: Compare the price of a McDonald’s Big Mac among countries worldwide. Were you expecting something more sophisticated from this prestigious financial magazine?)
As Always, This Asset Class is Not Without Its Risks
Emerging market bonds are prone to considerable volatility, which is why a long-term time horizon is recommended. Over the past several years, the spate of financial crises that have hit some high-profile emerging nations have led to significant market movements in the value of emerging market bonds.
The slower growth that has gripped the global economy in the past two years or so has also taken its toll on the economies of emerging nations. Often times, emerging markets are considered a leveraged play on developed nations, particularly the U.S., given the varying degrees of export dependence these countries have on the wealthier nations, which can make them more volatile.
Investors must also understand that investing globally involves multiple risks that are either not relevant to one’s domestic market, or are taken for granted. The risks include market, currency, economic, social, political and other factors, in addition to the heightened risks associated with the relatively smaller size and lesser liquidity of emerging markets.
Despite the disciplinary pressures applied by the world’s capital markets as outlined above, most emerging markets are viewed as still climbing the learning curve with respect to implementing prudent fiscal and monetary policies. As such, bouts of inflation, deflation or currency devaluation can occur, adding significantly to the risk and volatility of emerging market bonds. In fact, short-term volatility in these markets has been known to exceed 50%.
And we certainly can’t ignore the possible, and likely, flare-ups and backlashes that could occur in emerging market nations, particularly those in Asia, in light of the war on terrorism. Investors don’t look upon such fighting favorably, which leads to more skittishness.
The Preferred Vehicle: Templeton’s Aberdeen Asia-Pacific Income Fund
The above case for emerging market sovereign bonds is quite compelling. In a well-diversified fund and under the scrutiny of the world’s capital markets, government-guaranteed emerging market bonds turn out to be a conservative, high-return investment over the long term. Add to that the diversification these bonds give you outside of the U.S. dollar, and you’ve got a great addition to any portfolio.
The fund we recommend for capitalizing on this asset class spreads its sovereign bond exposure between developed nations – such as Australia and Europe – and emerging markets So risk is further mitigated. (For those looking for a pure play, try the Templeton Emerging Markets Income Fund (NYSE: TEI) which, as the name implies, invests exclusively in emerging market bonds.)
The Aberdeen Asia-Pacific Prime Income Fund, Inc. (NYSE: FAX) is a closed-end fund that invests in Australian and Asian debt securities. As of February 28, 2005, the fund was distributed, geographically, approximately 50% in Australia, 5.5% in the U.S. and the remainder in Europe and Asia (primarily South Korea).
By charter, FAX may invest up to 80% in Asian debt securities, with a minimum investment in Australian debt securities of 20%. It also must maintain at least 65% of its securities in
A-rated paper or better.
As of February 2005, 80% of the fund’s assets were invested in securities rated “A” or better (or the equivalent, if unrated) by Standard & Poor’s – more than 60% were rated “Aa” or better.
Although more than 48% of the funds are invested in Australian bonds, the remainder is spread far and wide: Geographically speaking, 49.6% are invested in Australia/New Zealand, 5.5% in the U.S., 0.3% in both Canada and Sweden, 2.7% in Switzerland and 39.5% in Asia.
Since Investment Director Alexander Green first began recommending Templeton’s Aberdeen Asia-Pacific Income Fund in September 2000 (under its previous name, First Australia Prime Income Fund), shares have risen from $4.12 to $6.24 – a nice, 10.4% annual growth rate.
That’s about what stocks return on average, historically, with much less risk.
It’s worth noting that FAX has sold off a bit over the past year, as the chart below indicates. And we consider this a great buying opportunity for investors who haven’t gotten in For those that already own FAX, adding to your position now would be a good idea.
As we write this, the value of the assets in the fund are $6.62 per share, and the per-share price is $6.24 – that means you can get these assets at a 6.09% discount to their real value. So if the market price of $6.24 moves toward the underlying value of $6.62, you’ll have a capital gain. The average maturity of the portfolio was 7.2 years as of February 2005.
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And the fund also pays 3.5 cents a month in income – that’s US$0.42 a year. Based on the underlying value of $6.62, that’s a yield of more than 6.34%. But you’re buying at a “discount,” getting numerous global funds but paying only $6.24 per share So your yield is 6.7% – nothing to scoff at, particularly now, when interest rates at the bank are hovering at 2%.
See the chart below for the fund’s top 10 holdings
Overall, Templeton’s Aberdeen Asia-Pacific Income Fund is a well-diversified, highly liquid fund mixing short-term emerging market sovereign bonds with longer-term developed market sovereign bonds. It enables investors to capitalize on the bright prospects of emerging market bonds and global funds – but in a conservative way – and it’s a well-balanced addition to the OC portfolio.
Recommended Action to Take: Buy Aberdeen Asia-Pacific Prime Income Fund, Inc. (NYSE: FAX) at market. As with other recommendations in our Oxford Income Portfolio, we won’t be using our customary trailing stop here. Learn more about The Oxford Club.
Good investing,
The Investment U Research Team
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View the complete Emerging Market Bonds report as a .pdf file.
Return to Part 1, Part 2
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