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Finding Bargains Among Emerging Markets Bond CEFs

Summary The discounts associated with emerging markets CEFs are at historic highs, with many discounts over 2 standard deviations from the mean. Emerging markets CEFs have been significantly more volatile than their ETF counterparts. ESD, EMD and MSD had the best risk-adjusted performance among the CEFs analyzed. Over the past several weeks, I have been writing about potential bargains among Closed End Funds (CEFs). This week I will continue the series by analyzing the risks and returns associated with Emerging Markets (NYSE: EM ) Bond CEFs. Before jumping into the analysis, I will provide a quick review of some of the characteristics of this asset class. The term emerging market refers to securities domiciled in a country that is considered to be emerging from an under-developed economy to a more mainstream environment. These countries are typically in Africa, Eastern Europe, the Middle East, Latin America, and some Asian countries. Many of these economies depend on either exporting commodities or providing services to the more developed world. There are several subclasses of EM bonds. For example, EM bonds may trade in either the currency associated with their country or trade in U.S. dollars. In addition, EM bonds may be corporate bonds or government treasuries (which are usually referred to as sovereign debt). Some of the reasons for investing in the bonds of emerging markets include: EM bonds offer higher yields than comparable bonds from developed countries. As the credit worthiness of an emerging economy improves, the rating of the bonds may improve leading to capital gains. EM bonds rise and fall due to local conditions, which may not be in sync with the U.S. market, thus offering diversification. If the EM bond is denominated in local currency, there is a potential for additional appreciation due to currency fluctuations. Of course, depreciation is also a possibility (which has happened recently). Since many EM bonds are thinly traded and are available only on local exchanges, it is difficult for individual investors to purchase these bonds individually. The easiest way to invest in this asset class is to buy funds. Exchange Traded Funds (ETFs) are the most popular vehicle with some ETFs trading over 700,000 shares per day. However, Closed End Funds (CEFs) are an alternative choice. The closed nature of these CEFs makes it easier for the manager to invest and hold limited liquidity assets without having to worry about cash inflows and outflows. However, the downside of CEFs is that the price is based on market action, which can wreak havoc when the asset falls from favor. This has been demonstrated with a vengeance since the second quarter of 2013 when talk of the Fed increasing rates led to a collapse of prices of these CEFs. As prices deteriorated, the discounts of these CEFs widened to historical large levels, many over 18%. This is evidenced by a large negative Z-score, a statistic popularized by Morningstar to measure how far a discount (or premium) is from the average discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A Z-score lower (more negative) than minus 2 is a relatively rare event, occurring less than 2.25% of the time. However, in today’s environment, most of the EM CEFs have a one year Z-score of negative 2 or lower, which illustrates the current lack of demand for these CEFs. There are several reasons that investor lost confidence in emerging markets: The dollar has been in a bull market, which means that emerging markets currencies are becoming weaker versus the dollar. The Fed may finally begin to tighten in the near future, which will again strengthen the dollar. Commodities are in a bear market and many emerging market economies depend on the sale of commodities. When commodities swoon, so do these economies, putting pressure on their bonds. China is the largest emerging market and turmoil in China has crushed some of the lesser economies Has the rout in emerging markets gone too far? I believe in the wisdom of Warren Buffet when he opined: “Be greedy when others are fearful.” I am not clairvoyant and have no idea how long it will take the EM bonds to recover. Some bonds may default, but on a whole I believe a diversified basket of EM bonds will be a smart investment. If you decide to invest in this type of bond, the question is: what are the “best” funds to purchase? There are many ways to define “best.” Some investors may use total return as a metric but as a retiree, risk is as important to me as return. Therefore, I define “best” as the asset that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. This article will compare the risks and rewards of EM bond CEFs. I will use a 5-year time frame and require that the selected funds trade an average of 50,000 shares or more per day. Based on these criteria, I included the following CEFs for my analysis: MS Emerging Markets Domestic (NYSE: EDD ). This CEF invests in emerging market domestic debt and sells for a discount of 18%, which is a much larger discount than the 5 year average discount of 10.1%. The one year Z-score is minus 2. This is the only leveraged fund that invests exclusively in local currency debt. The fund has 46 securities, almost all in sovereign debt. Even though the bonds are from emerging markets, about 67% are actually investment grade (BBB or higher). The fund invests in a wide range of countries including Brazil (16%), Mexico (16%), South Africa (16%), Malaysia (15%), Poland (14%) and Turkey (14%). The fund utilizes 31% leverage and has an expense ratio of 2.2%. The distribution rate is 12.5 %, which is funded by income with some Return of Capital (NYSE: ROC ) in one quarter over the past year. The Undistributed Net Investment Income (UNII) is negative and is large when compared to the distribution, which is a concern. MS Emerging Markets Debt (NYSE: MSD ). This CEF sells for a discount of 18.5%, which is a larger discount than the 5 year average discount of 10.8%. The one year Z-score is minus 2.6. The fund has 115 holdings, with about 51% in sovereign debt and 46% in corporate bonds. Virtually all the bonds are denominated in U.S. dollars. Geographically, the holdings are distributed among a large number of countries including Mexico (13%), Indonesia (11%), Venezuela (7%), and Turkey (7%). About 41% of the bonds are investment grade. MSD uses 8% leverage and has an expense ratio of 1.2%. The distribution is 6.6% with no ROC. Western Asset Emerging Markets Debt (NYSE: ESD ). This CEF sells at a discount of 18.3%, which is a larger discount than the 5 year average discount of 8.6%. It has 240 holdings with 51% in sovereign debt and 42% in corporate bonds. The assets are distributed among several countries including Mexico (13%), Indonesia (11%), Turkey (7%), and Venezuela (7%). About 69% of the portfolio is investment grade. The fund uses 16% leverage and has an expense ratio of 1.2%. The distribution is 9.1%, consisting primarily of income and some ROC (about 10% of the distribution). UNII is negative but is less than one month distribution. Western Asset Emerging Markets Income (NYSE: EMD ). This CEF sells for a discount of 18.5%, which is a larger discount than the 5 year average discount of 8.6%. The one year Z-score is minus 2.2. The fund has 235 holdings with 53% in sovereign debt and 42% in corporate bonds. About 73% of the holdings are investment quality. The assets are distributed among several countries including Mexico (12%), Indonesia (9%), Turkey (9%), Netherlands (6%), and Peru (5%). The fund utilizes 14% leverage and has an expense ratio of 1.3%. The distribution is 8.5%, consisting primarily of income with about 30% ROC but the UNII is positive. Global High Income Fund (NYSE: GHI ). This CEF sells for a discount of 13.6%, which is a larger discount than the 5 year average discount of 7.3%. The one year Z-score is only minus 0.1. The fund has 308 holdings, with 66% in sovereign debt and 26% in corporate bonds. All the holdings are denominated in U.S. dollars. The holdings are distributed among a large number of countries including Brazil (11%), Turkey (7%), Indonesia (8%), Mexico (6%), and Russia (5%). About 38% of the holdings are investment grade. This fund does not use leverage and has an expense ratio of 1.4%. The distribution is 10.9%, consisting primarily of income and ROC. The ROC occurred in about 60% of the months over the last year and comprised about 30% of the distribution. The UNII is positive. Templeton Emerging Markets Income (NYSE: TEI ). This CEF sells at a discount of 17%, which is a larger discount than the 5 year average discount of 1.5%. The one year Z-score is minus 2.4. This fund has 119 holdings with 56% invested in sovereign debt, 24% in corporate bonds, and 13% in short term debt. The securities are distributed across many countries including Iraq (11%), Indonesia (11%), Zambia (10%), Hungary 990%), and UAE (8%). The fund does not utilize leverage and the expense ratio is 1.1%. The distribution is 8.1%, consisting of income with no ROC. For comparison, I will also include the following ETF: iShares J.P. Morgan USD Emerging Markets Bond (NYSEARCA: EMB ). This ETF is a passive fund that tracks an index made up of U.S. dollar denominated emerging market bonds. The country allocations are rebalanced monthly, based on the amount of outstanding debt. The fund has 287 holdings with 78% in sovereign debt and 21% in corporate bonds. About 62% of the portfolio is investment grade. The holdings are spread across a large range of countries including Russia (6%), Philippines (6%), Turkey (5%), Indonesia (5%) and Mexico (6%). Overall, 28 countries are represented. The fund has an expense ratio of 0.40% and yields 4.5%. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years. The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NYSE: NAV ). (click to enlarge) Figure 1. Risk versus reward over the past 5 years. The plot illustrates that the CEFs have booked a wide range of returns and volatilities over the past 5 years. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with EMB. If an asset is above the line, it has a higher Sharpe Ratio than EMB. Conversely, if an asset is below the line, the reward-to-risk is worse than EMB. Note also that Sharpe Ratios are not meaningful if a stock has a negative return. Some interesting observations are evident from Figure 1. The CEFs were substantially more volatile than the ETF. This was expected since CEFs are actively managed, may use leverage, and may sell at discounts or premiums. All of these attributes tend to increase volatility. The EM CEFs did not have great performance over the period. EM bonds have been in a bear market since 2013 and the prices associated with CEFs decreased faster than Net Asset Value . Since EMB is an ETF that does not sell at a discount, EMB has much better risk-adjusted performance than any of the CEFs. Looking only at the CEFs, MSD had the best performance followed by ESD and EMD. The other three CEFs were underwater for the period. Next I wanted to see if the diversification promised by these emerging markets bonds lived up to expectation. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the selected funds. The results are provided in Figure 2. As is evident from the figure, these CEFs provided relatively good diversification with correlations in the 50% to 60% range. Thus, these CEFs did provide good portfolio diversification. (click to enlarge) Figure 2. Correlation over past 5 years. The 5 year look-back data shows how these funds have performed in the past. However, the real question is how they will perform in the future when the bull market in EM debt returns. Of course, no one knows, but we can obtain some insight by looking at the most recent bull market period from March 2009 to January, 2013. Figure 3 plots the risk-versus-reward for the funds over this bull market time frame. (click to enlarge) Figure 3. Risk versus reward during a bull market As expected, all the funds had excellent performance over this bull market period. The CEFs all had higher absolute returns than EMB but were also significantly more volatile. When volatility was taken into account, EMB was still a leader in risk-adjusted performance. However, during the bull market, EMD matched EMB in risk-adjusted performance and ESD, TEI, and MSD were not far behind. EDD and GHI continued to lag the other funds. Bottom Line If you are a risk-adverse investor who wants to diversify into emerging market bonds, EMB would be your best bet. However, if you want to take advantage of the wide discounts associated with CEFs, I would recommend ESD, EMD and MSD. These three CEFs had good performance over the entire 5 year period plus will likely excel if the bull returns. When this asset class returns to favor, I would expect the discounts to revert back to the mean and this would provide some capital gains to go along with attractive distributions. But beware, emerging markets CEFs are not for the faint hearted. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ESD,EMD, MSD over the next 72 hours. (More…) 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.

Capturing Alpha: Scouring Social Media To Gain An Edge

Company news posted via social media can precede press releases. Social media can be used as a tool to establish company relationships. In rare cases, it can even provide tools for uncovering hard financial data. Gaining an edge in the market is hard, especially for an individual investor. There are people making good money and working long hours analyzing economic data and crunching numbers based off of 10ks , so how are you supposed to compete? Maybe by looking at different information altogether. For small and micro cap companies, it seems that more and more opportunities are presenting themselves via social media. This medium can break news that might never show up in a PR, yet it may fall outside the scope of the professionals. I observed this phenomena first hand with a holding in Digimarc (NASDAQ: DMRC ), a tech company looking to partner with major retailers. One Monday, the CEO of Walmart, Doug McMillon, posted a picture to his Instagram account acknowledging that the company was experimenting with Digimarc technology. At the time, the account didn’t even have one thousand followers, and Digimarc wasn’t mentioned directly in the posting. For these reasons, people paying attention found themselves with a great opportunity. Instead of blasting off, the stock seemed to climb as the news spread, eventually peaking at $49 (click to enlarge) Ultimately, events like those will probably be exceedingly rare. There has to be a small company, involved with a large company, where information comes from a verifiable source with a small following. With a little more legwork though, there are still opportunities to uncover information that may be significant to company developments. What follows are two examples of the type of this type of research. The first deals with determining relationships, while the second is the holy grail of this sort of research and yields hard data on company financials. The first instance involves Digimarc again. The company held an online seminar where they explained the capabilities of their technology and took technical questions from potential users of their products. In the chat box, many participants identified themselves and the city from which they were logging in. The benefit of having this information is that the names could then be cross referenced against LinkedIn profiles to get a sense of potential customers for Digimarc. Included in the chat were the following people. Person Company Notes Jeff Rosenzweig Zaptivity Managing Director Klaudia Campos Peel Plastic Products “For over 30 years, Peel Plastics Products Ltd. has been a recognized leader in flexible packaging solutions and process innovation.” Brian Novotny Schwan Food Company Represents lots of brands besides Schwan’s® including Red Baron® , Tony’s® , Freschetta® , Pagoda® , Edwards® , Mrs. Smith’s® Shasta Blaustein Dollar Shave Club Bill Belias Ergonix Company President Ultimately, this information is neat, but it is neither breaking news nor hard data. Digimarc has said that it is basically in discussions with everyone in the industry, and discussions aren’t dollars. Still, that this type of information can be gleaned at all is something to constantly be thinking about. What if this had been a smaller company and the chat had been full of people working for FritoLay? If you turn over enough stones, eventually you’ll find something. The grail of any analysis goes beyond uncovering relationships and into ferreting out actual revenues and expenses. These opportunities are rare, but I came upon one recently. Wizard World ( OTCQB:WIZD ), an events company that holds comic cons all over the country, has recently begun attempting to diversify its revenue stream. One of its new products is the Comic Con Box. A thirty dollar subscription service similar to Birch Box, but which delivers nerdy t-shirts and toys to people on a monthly basis. Massive competitors in the space exist, most notably LootCrate, but Wizard World’s celebrity and artist relationships as well as its brick and mortar conventions give it advantages which could allow it to catch up and emerge as a contender. At the LD Micro Conference in June, CEO John Macaluso mentioned that some day in the distant future the box business could be the company’s leading revenue generator. Since the company’s comic cons are generating more than twenty million dollars annually, this certainly made it sound like early results were promising. The most recently released quarter, however, only captured a fleeting look at Comic Con Box data. Its figures comprised the initial small launch plus one month. Investors following the company were informed that the company had made $132 thousand on sales of the Comic Con Box. A slightly deeper dive into the 10Q, however, showed that the unearned revenue from the sale of future boxes was $124 thousand. Regarding what goes into that number, Wizard World states that, “Unearned ConBox revenue is non-refundable up-front payments for services. These payments are initially deferred and subsequently recognized over the subscription period, typically three months, and upon shipment of the product.” In other words, the $124 thousand represented essentially all July sales plus the remainder of funds garnered from long term subscriptions. Single month recurring subscriptions were not included nor were, obviously, purchases from new buyers occurring after the period closed. At the time three months was the longest possible subscription so it was a guarantee that all of that $124 thousand would be recognized during the next quarter. Additionally, the bottom line prospects were good a well as the p ress release for second quarter results states, “We are now planning to ramp up the volume of boxes shipped monthly, and anticipate this recurring, higher margin revenue stream to continue to grow.” Growth was clearly ramping, and every single box was selling out, but how much was Wizard World increasing the supply by each month? If there was a way to acquire early data points a person could hold a major advantage. At $30 a box, if they had grown to 5,000 units by the end of the quarter, that would represent an annualized figure of close to two million and growing fast. Then I saw this photo posted to Instagram. A celebrity had signed 1,200 items to be placed in future boxes. This certainly wasn’t going to be enough for everyone to get one based solely on the initial revenue figures, but it created a chance for analysis. All that had to be known was whether the 1,200 would be distributed in a single box or across several and the rate at which they were distributed. Luckily, a later post confirmed that the 1,200 would be placed during a single months mailing. From there, all that was left was to determine the percentage of boxes that held the autograph. Uncovering this figure was tedious, but in no way actually difficult. The key to figuring things out was that Comic Con Box encourages people to post videos to YouTube of themselves reacting in real time to the items they’ve received. Watch enough of these, and you have a random sample. (I actually believe that, including prior months where I was simply watching to see people’s reviews of the items, I most likely have watched more of these than anyone else in the world) It’s the same as sneaking into the Comic Con Box warehouse, opening a bunch of boxes, and extrapolating data directly. The only thing to be careful about is that the boxes are truly unopened. Anyone posting a review with the box already open is biased by its content: They may only be posting to show off their autographed memorabilia. The results were as follows: Videos 56 Autographs 22 Percentage 39.29% Projected Boxes Sold 3055 Monthly Revenue $91,636.36 Annualized Revenue $1,099,636.36 Elements that could have skewed that data were if people were more likely to post their videos if they received the autograph (or more likely to post them sooner as I went with the very first uploads) or if this was a particularly popular or unpopular box. It did get supported by a DC Comics tweet which is an account with around a million and a half followers. Ultimately, the fact that around three thousand people received the most recent Comic Con Box isn’t terribly actionable information. It’s slightly below my expectations, but since boxes are selling out this is more a sign of cautious management rather than limited demand. Additionally, this is the sort of exercise that it is useful to make a habit. The idea isn’t that you will be able to make great investments off of every social media investigation. It’s that, as the Digimarc-Walmart event proved, the opportunities are out there, and if you don’t put in this sort of work, you’re guaranteeing you’ll miss out. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long DMRC, WIZD. (More…) 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.

Is The Fed’s Policy Meeting Important For GLD?

Summary This week the highly anticipated FOMC meeting will take place. The market still places a low chance of a rate hike. But the meeting isn’t just about will they raise rates this time? Will the FOMC move the price of GLD? This week the highly anticipated FOMC meeting will take place, in which the Fed will decide whether to raise rates or not. Currently, the implied probabilities for a September rate hike are slim – the market gives this possibility a 23% chance. For investors of the SPDR Gold Trust ETF (NYSEARCA: GLD ) will this rate decision move the price of GLD? How important is a rate hike at this stage for precious metals? It should matter, shouldn’t it? A rate hike should have some implications of the price of GLD: after all higher rates should translate to an increase in long term treasury yields, which should adversely impact gold prices. I talked about the relation between GLD and long term yields at great lengthen in previous posts . (click to enlarge) Source: U.S Department of Treasury and Bloomberg But as you can see, the medium term treasury yields, and the same goes for long term yields, after yields started to pick up at the beginning of the year, they have resumed their slow descent. Currently, yields aren’t far off their levels from the beginning of the year. The correlation between GLD and 5-year yields isn’t too strong at -0.24. This relation used to be much stronger in the past. It seems, for now, the relation may have weakened. Usually, the rise in the risk factor and economic uncertainty tends to pressure down long term yields and pull up GLD price. But this wasn’t the case for GLD this year. And if the FOMC raises rates, it could slightly raise interest rates, which should also lead to a modest decline in GLD. The U.S. dollar should also strengthen, a move that could also bring down GLD prices. Finally, as the Fed changes its policy, which in effect it has already heavily prepared us for, the “fear factor” of some bullion investors over a possible rate hike is likely to subside – a shift that could also reduce the demand for bullion investments including GLD. This FOMC meeting, however, isn’t likely to make long term waves. Yes, it could lead to some short term volatility, because some people still think a rate hike is still on the table. And if the Fed does push the button, it could raise market volatility in the following days. In such outcome, the price of GLD is likely to suffer even if it’s only for a few days. But for the more likely scenario – no rate hike, only a promise for hikes in the near term – the price of GLD could actually slightly rise, even if for a short term. More than just the statement This meeting also includes an update to economic data, a press conference – if we don’t get a rate hike, Chair Yellen will promise us a rate hike is right around the corner and is “data dependent” – and the dot plot. (click to enlarge) Source: FOMC As you can see, the Fed’s medium cash rate has declined over the past year, while the rates for 2016-2017 increased in the past meeting. If we don’t see a rate hike this time, the dot plot will likely show a decline in the medium rate for this year, a perhaps a rise for 2016. This shifts in the dot plots could also impact the markets as it will provide the outlook of FOMC members’ vis-à-vis the direction of the cash fund. I think, as I pointed out in the past , the current market conditions are less in favor for a rate hike at this point in time. If the Fed doesn’t raises rates, we could see a short term bounce in the price of GLD. But as long as the Fed is on course to raise rates in the coming months, GLD is still likely to suffer. For more please see: ” Gold and Inflation – Is there is relation? ” Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.