EDF: This Fund Has Fixed Some Of Its Problems, But The Price Remains An Issue

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The Virtus Stone Harbor Emerging Markets Income Fund offers a high level of income with a 12.88% yield, higher than its peers.The fund's share price performance over the past few years has been very ...

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It is uncertain whether recent reforms have improved the country's risk profile over the long term, though.The fund appears to be fully covering the distribution, and its net asset value per share has risen during the current fiscal year.The valuation remains extremely expensive, and the fund's performance does not really justify this.Wara1982 The Virtus Stone Harbor Emerging Markets Income Fund (NYSE:EDF) is a closed-end fund that provides an intriguing opportunity for investors who are looking to achieve a high level of income from the assets in their portfolios. The fund manages to do pretty well at this task, as its 12.88% yield is much higher than that of any other emerging market debt closed-end fund that is currently available:   Fund Name Morningstar Classification Current Yield   Virtus Stone Harbor Emerging Markets Income Fund Fixed Income-Taxable-Emerging Market Income 12.88%   Morgan Stanley Emerging Markets Debt Fund (MSD) Fixed Income-Taxable-Emerging Market Income 11.52%   Templeton Emerging Markets Income Fund (TEI) Fixed Income-Taxable-Emerging Market Income 10.58%   Western Asset Emerging Markets Debt Fund (EMD) Fixed Income-Taxable-Emerging Market Income 10.76%   Morgan Stanley Emerging Markets Domestic Debt Fund (EDD) Fixed Income-Taxable-Emerging Market Income 7.59%   Click to enlarge Regular readers can likely remember that I do not generally like to include two funds from the same sponsor in a peer comparison, but in this case, there are only five closed-end funds available in the market that invest in emerging market debt. Thus, it was necessary to either include both Morgan Stanley funds or only have four funds in the chart (I ordinarily prefer to include either five or six). The fact that the Virtus Stone Harbor Emerging Markets Income Fund has a higher yield than any of its peers is something that may prove to be very attractive to any investor who is looking to maximize the income that they receive from their portfolios. I can certainly appreciate that sentiment. In this case, though, the difference is very stark as this fund's yield is a full 136 basis points above that of the second highest-yielding fund on the list. This could be a sign that the fund is paying out too much money to its investors and as such, the market expects that it will be forced to reduce the payout in the near future. This is the same concern that I expressed in my previous article on this fund: While the yield is very attractive, that is an incredibly hefty price to pay given the risks of the large allocation to Argentina and the fact that the fund appears to be paying out a larger distribution than it can afford. My analysis at the time was correct, and the fund did end up cutting its distribution a month after that previous article was published. It has cut it again since that time, and the current distribution is 25% lower than it was the last time that we discussed this fund. However, the fund's outsized yield relative to its peers suggests that we should still take a close look at the fund's finances, as it still might be overpaying. My previous article on this fund was published on April 16, 2021. The fund's performance since that date has been very disappointing, as its shares have declined by 36.55% since that date: Seeking Alpha This is something that will almost certainly prove to be disappointing to most investors. After all, while all bonds underperformed during this particular three-year period due to rising interest rates, this fund did particularly poorly even against the J.P. Morgan EMBI Global Core Index (EMB) that tracks U.S. dollar-denominated bonds issued by emerging market nations. The Virtus Stone Harbor Emerging Markets Income Fund does have a much higher yield than either of the indices, but that loss of principal relative to the bond indices will be hard for most investors to stomach. However, it is important to keep in mind comments that I made about closed-end funds in a previous article: A simple look at a closed-end fund's share price performance does not necessarily provide an accurate picture of how investors in the fund did during a given period. This is because these funds tend to pay out all of their net investment profits to the shareholders, rather than relying on the capital appreciation of their share price to provide a return. This is the reason why the yields of these funds tend to be much higher than the yield of index funds or most other market assets. The above comment also applies to bond index funds because bonds themselves tend to deliver the bulk of their net investment return via their coupon payments as opposed to price appreciation. A bond index fund will pass these coupon payments through to its own shareholders. Thus, we should include all of the distributions paid out by the Virtus Stone Harbor Emerging Markets Income Fund as well as both index funds into our performance analysis. When we do this, we get the following chart: Seeking Alpha As we can see, despite the poor share price performance, investors in the Virtus Stone Harbor Emerging Markets Income Fund actually did better than investors in either of the two bond indices over the roughly three-year period that has passed since we previously discussed this fund. This is due to the fact that the closed-end fund has a substantially higher yield than the indices, and the yield provides a very real return that some investors have a tendency to overlook (especially those who have only participated in the market for the past decade or so). Unfortunately, we can also see that investors in the fund still suffered a loss over the period. It should be noted though that the Virtus Stone Harbor Emerging Markets Income Fund has delivered a pretty solid performance compared to its peers in recent years. This chart shows the total returns (including all distributions) paid out by each of the five emerging market debt closed-end funds over the past 36 months: Seeking Alpha We can see that the top performer was the Morgan Stanley Emerging Markets Debt Fund, but the Virtus Stone Harbor Emerging Markets Income Fund has come very close to matching it. All of the other funds trailed by several percentage points. The fact, then, that the Virtus Stone Harbor Emerging Markets Income Fund has the highest yield out of this group, thus could make it attractive compared to its peers given the performance and yield characteristics. However, we should still have a look at the fund and its finances to ensure that it can actually afford its distribution. After all, the share price of a fund such as this one does tend to get devastated if the distribution gets cut. About The Fund According to the fund's website, the Virtus Stone Harbor Emerging Markets Income Fund has the primary objective of providing its investors with a high level of total return. On the surface, this objective does not seem to make much sense given the fund's strategy. Here is how the website explains its strategy:  The Fund's investment objective is to maximize total return, which consists of income and capital appreciation from investments in emerging market securities. The Fund will normally invest at least 80% of its net assets (plus borrowings for investment purposes) in emerging markets securities. Flexibility - Managed portfolio of emerging markets fixed income securities structured to maximize total return potential and high current income with flexible asset allocation to currency sovereign debt, hard currency sovereign debt, and emerging markets corporate debt. Portfolio Diversification - Attractive total return and income potential with the possibility to diversify versus U.S. Dollar denominated assets. Depth of Experience in EMD - Stone Harbor's demonstrated ability in managing emerging markets debt is rooted in teamwork with a 30-year history, a disciplined research and investment process, and the experience to make what are believed to be sound investment judgments.  The first paragraph in this strategy description states that the Virtus Stone Harbor Emerging Markets Income Fund will invest in \"emerging market securities.\" That term means that this fund could invest in both common equities and debt issued by entities in emerging markets. However, later paragraphs imply that the fund invests solely in debt securities issued by entities that are located in these nations. The fund's first-quarter 2024 holdings report makes it very clear, though, that this fund is only investing in debt securities. According to the report, the fund was holding the following asset allocation on February 29, 2024:   Asset Type % of Net Assets   Foreign Government Securities 79.4%   Corporate Bonds and Notes 48.8%   Credit Linked Notes 4.0%   Click to enlarge We have government securities and corporate bonds comprising nearly all of the portfolio. Governments only issue debt securities; unlike companies, a government will never issue equity. A credit-linked note is a debt security that is similar to a collateralized loan obligation or other asset-backed security. It is basically a security backed by a pool of loans that has a credit default swap attached to it. Basically, the fund is accepting a larger default risk in exchange for a higher interest rate. This might be worrisome to the risk-averse investors who would ordinarily invest in a debt fund, but it is only 4.0% of the portfolio so hopefully, it will not have a noticeable impact on the fund should a default occur. The fact that this fund is entirely focused on investing in corporate debt is what makes its total return objective confusing. After all, bonds are an income vehicle for reasons that I discussed in an earlier article: Bonds by their very nature are income securities, as they do not deliver any net capital gains over their lifetimes. This makes sense, as an investor will purchase a bond at face value and receive face value back when the bond matures. This only investment return for a bond held over its entire lifetime is the coupon payments made to the bond's owner. Thus, bonds do not deliver capital appreciation over their lifetimes. Thus, ordinarily, we would expect that a bond fund would have current income as its primary objective as opposed to total return. However, the fact that this fund invests in foreign bonds does add a bit of a twist to the investment thesis here. Take a look at the fund's sector allocation chart provided on its website: Virtus Investment Management We can see two types of sovereign and corporate bonds here. Some of the bonds in the portfolio are designated as \"hard currency\" bonds and some of them are designated as \"local currency\" bonds. Hard currency is a foreign exchange term, which is explained on Investopedia: A hard currency is expected to remain relatively stable through a short period of time, and to be highly liquid in the forex or foreign exchange market. The most tradable currencies in the world are the U.S. dollar, European euro, Japanese yen, British pound, Swiss franc, Canadian dollar and the Australian dollar. All of these currencies have the confidence of international investors and businesses because they are not generally prone to dramatic depreciation or appreciation. A hard currency bond is a bond that is denominated in one of the seven currencies listed in the quote. These bonds pay their coupon in the denominated currency, not the currency of the emerging market. In most cases, the currency is the U.S. dollar, but some of these bonds might pay their coupons in euro if the bond was issued with the intent of attracting European investors. For example, the Czech Republic has been known to issue euro-denominated bonds due to its proximity to the European capital markets and investors in those nations. Other nations in Europe that were once behind the Iron Curtain have been known to do the same. As we can see, 83.17% of the fund's assets are invested in hard currency bonds. This fund also has 16.83% of its assets invested in local currency bonds. This suddenly makes the fund's total return objective make more sense, since it can potentially gain currency appreciation profits from these bonds. For example, if the U.S. dollar declines against the foreign currency, then the coupon payments that the fund receives from these bonds will actually increase over the life of the bond in U.S. dollar terms. In a few previous articles (such as this one), I made the case that the United States dollar will decline against several foreign currencies over the long term. This thesis is rooted in the fiscal problems of the United States Federal government that will ultimately force the Federal Reserve to keep interest rates lower than it really should over the coming decades. The lack of foreign currency bonds in the Western Asset Emerging Markets Debt Fund was my biggest complaint in last week's article about that peer fund, so it is very nice to see that the Virtus Stone Harbor Emerging Markets Income Fund has this exposure. It is still a bit less than I would really prefer, though, but risk-averse investors who do not really want to take on the currency exposure might be reasonably satisfied with the fund's mix of hard currency and local currency bonds. In my previous article on the Virtus Stone Harbor Emerging Markets Income Fund, I was not particularly pleased with the fund's outsized allocation to Argentinean debt. The reason for this was quite simple: Argentina first declared its independence from Spain in 1816 and since that time it has defaulted on its government debt nine times, most recently in 2020. While discussions with bondholders are still ongoing, it is uncertain how this will ultimately play out. Argentina has had two defaults in the past decade, including one in 2020 (the previous one was in 2014). The country has a history of defaulting on its debt. However, things have changed since that time. One notable change is that the fund's allocation to Argentine government debt has declined to 7.8% of its net assets. That is a substantial decrease from the 14.58% that it had in late 2020. Argentina's new President, Javier Milei, is very different from his predecessors, and the government this year has made significant strides in improving its finances. Inflation there still remains very high, but the government actually ran a surplus in the first two months of this year and the country's foreign reserves have increased by $7 billion. Thus, it is probably a bit safer for bond investors in that country now than it was at the time of our previous discussion. There is no guarantee that these reforms will be able to stick around, though, so there is still a risk, but overall, I am more comfortable now than I was previously. Leverage As is the case with most closed-end funds, the Virtus Stone Harbor Emerging Markets Income Fund employs leverage as a method of boosting the effective yield that it receives from the securities in its portfolio. I explained how this works in various previous articles. To paraphrase: In short, the fund borrows money and uses that borrowed money to purchase debt securities issued by governments and corporations in emerging market nations. As long as the yield that the fund receives from the purchased assets is higher than the interest rate that it needs to pay on the borrowed money, the strategy works pretty well to boost the effective interest rate of the fund's portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates. As such, this will usually be the case. The benchmark interest rates in most emerging markets are considerably higher than the 5.25% to 5.50% federal funds rate in the United States or the 4.500% marginal lending facility interest rate in the European Union. Here are the current benchmark interest rates in the countries whose securities comprise the largest weightings in the portfolio:   Country Benchmark Interest Rate   Mexico 11.00%   Argentina 40.00%   Nigeria 26.25%   Colombia 11.75%   Egypt 27.25%   Angola 19.50%   Iraq 7.50%   Indonesia 6.25%   Brazil 10.50%   Ecuador 10.87%   Click to enlarge The fund cannot borrow for the benchmark rate, but its borrowing rate is not usually going to be more than 50 to 100 basis points above the benchmark. Thus, we can very quickly see that the yield that the fund obtains from the purchased securities is going to be above the interest rate that it has to pay on its borrowings. While it is true that some of these countries have high interest rates because of their local currency declining in value very rapidly, the fact that the fund is mostly investing in hard currency bonds offsets that problem. Overall, it remains the case that the fund will usually be able to borrow money at an interest rate that is significantly less than the yield-to-maturity of the purchased bonds. The use of leverage creates risk for the fund's shareholders, though, which I have also explained in previous articles. To paraphrase myself: The use of debt in this manner is a double-edged sword. This is because leverage increases both gains and losses. Thus, we want to make sure that the fund is not employing too much leverage because that would expose us to an excessive level of risk. I would generally prefer that a fund's leverage remain under a third as a percentage of its assets for this reason. As of the time of writing, the Virtus Stone Harbor Emerging Markets Income Fund has leveraged assets comprising 24.70% of its portfolio. This is a bit less than the 25.51% leverage that the fund had the last time that we discussed it. It is also less than the one-third of assets maximum that we would ordinarily like to see a fund employ. However, that does not mean that it is a safe level of leverage for the fund's particular strategy. We should see how its leverage compares to its peers in order to make that determination:   Fund Name Leverage Ratio   Virtus Stone Harbor Emerging Markets Income Fund 24.70%   Morgan Stanley Emerging Markets Debt Fund 0.00%   Templeton Emerging Markets Income Fund 15.11%   Western Asset Emerging Markets Debt Fund 28.86%   Morgan Stanley Emerging Markets Domestic Debt Fund 12.15%   Click to enlarge (all figures from CEF Data) As we can see, the Virtus Stone Harbor Emerging Markets Income Fund is more leveraged than three of its four peers. The only fund that currently employs a higher level of leverage is the Western Asset Emerging Markets Debt Fund. This might suggest that the fund is using more leverage than it should, given its strategy. However, the fund's leverage is in line with what it has employed in the past and if it was able to be the second-best performing fund over the past three years (a very challenging environment for any bond fund) then its management probably has sufficient skill to handle a higher level of leverage than many peers. In short, we probably do not need to worry too much about the fund's leverage right now and should be able to enjoy the boost that it gives to the fund's yield. Distribution Analysis The primary objective of the Virtus Stone Harbor Emerging Markets Income Fund is to provide a high level of total return to its investors. As is the case with most closed-end funds, this fund pays out its investment profits to its shareholders, so we should expect that most of our total return will come from direct payments. To this end, the fund pays a monthly distribution of $0.06 per share ($0.72 per share annually). This gives the fund a very impressive 12.88% yield at the current share price. However, this fund has not been particularly consistent with respect to its distribution, as it has declined from $0.18 per share monthly back in 2011 to $0.06 per share monthly today. Despite what some sources claim, the fund has not raised its distribution since its inception in late 2010. All of the distribution changes have been cut. This is something that those investors who are looking to earn a safe and consistent income from their assets are probably not going to be too thrilled about, but it is not really surprising that this would be the case given the shock that the COVID-19 pandemic had on the finances of many emerging markets and the willingness of investors to take risks. As I mentioned in the introduction, the fact that the Virtus Stone Harbor Emerging Markets Income Fund has an outsized distribution yield relative to its peers could be a sign that the market expects a distribution cut. Let us have a look at the fund's finances and examine this. As of the time of writing, the fund's most recent financial report corresponds to the full-year period that ended on November 30, 2023. This is an older report than I would prefer, but it is the newest one that is available, and it should certainly work well to provide an update to the last article from early 2021. For the full-year period that ended on November 30, 2023, the Virtus Stone Harbor Emerging Markets Income Fund received $7.025 million in interest and $140,000 in dividends from the assets in its portfolio. From this, we subtract the money that the fund had to pay in foreign withholding taxes to arrive at a total investment income of $7.156 million for the period. The fund paid its expenses out of this amount, which left it with $5.491 million available for shareholders. That was not sufficient to cover the $8.411 million that the fund paid out in distributions over the period. The fund was, fortunately, able to make up the difference through capital gains. For the full-year period that ended on November 30, 2023, the Virtus Stone Harbor Emerging Markets Income Fund reported net realized losses of $15.476 million that were fully offset by $18.944 million in capital gains. The fund's net assets increased by $907,000 after accounting for all inflows and outflows during the period. Thus, the fund is fully covering its distributions, but it had to rely on unrealized capital gains in the most recent period in order to do it. There is no guarantee that these gains will remain as market turbulence can erase them before the fund manages to realize them. It does seem to be okay for the time being, however. This chart shows the fund's net asset value since November 30, 2023: Barchart The period of time in the chart therefore covers the entire period of time that has passed since the date of the fund's most recent financial report. As we can clearly see, the fund's net asset value has increased by 7.51% over the period. This tells us that the fund has fully covered all of the distributions that it paid during the current fiscal year and still has a lot of money left over. Therefore, there does not appear to be any reason to fear a distribution cut right now. Valuation Shares of the Virtus Stone Harbor Emerging Markets Debt Fund are currently trading at a 21.00% premium to net asset value. That is an enormous price to pay, and it is well above the 18.59% premium that the fund's shares have averaged over the past month. Overall, this fund looks extremely expensive right now. Conclusion  In conclusion, the Virtus Stone Harbor Emerging Markets Debt Fund is potentially a good way to add emerging market debt to your portfolio and earn a high yield while doing so. The fact that the fund's portfolio includes both local currency and hard currency bonds is very nice to see, although I will admit that I would not mind seeing more local currency bonds in the fund. After all, foreign currency exposure does provide a potential opportunity if the U.S. dollar is declining over the long term (as seems likely). The fund has apparently fixed the two complaints that we had about it the last time that we discussed the fund, although it did have to cut its distribution as expected. The only real problem here is that the fund seems extremely expensive for its performance as it was not the top performer in the sector, but it trades at a price that suggests outperformance.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.1","shortVersion":"4.29.1","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2442847417"}