Setups should be considered in the context of risk and reward. This in turn is weighed by the likelihood of your success. Of course, gauging this isn’t always easy, but sometimes you get a real big pitch to swing on. We had a big pitch on Aberdeen Global Income Fund (FCO), a fund where we had no likelihood of even positive returns about a year ago. Let’s recap what happened and see if the thesis still has legs.
FCO is a modestly sized fund with just $70 million in assets. As we will see later in the article, this tiny size creates unusual complications for the fund.
Source: CEF Connect
Its primary investment objective is to provide high current income by investing primarily in fixed income securities. Of course, there is a big difference between what he “earns” and what he pays.
The high distribution yield, which was close to 10% a year ago, is what created this bubble in the first place. Unfortunately, today it is still likely to attract new beginners who are lured by the 12.75% payout.
Fixed income securities, which average in the BBB range, do not produce returns of 12.75%.
This is easily evident by a quick glance at bond yields and coupon prices.
While that 5.98% may seem high, note that the fund has increased its exposure to emerging markets to achieve this.
So we have lower credit quality and higher exposure to emerging markets. What else can make the situation worse? Well, two things actually. The first is the portfolio’s duration, which is close to 5.5 years. Rising interest rates have already lowered NAV and will continue to do so in our view. The second factor is of course that the extremely small size increases the expense ratios. At the last check, these were quite high.
This is of course the snapshot from last year. Other than investment management fees, we expect all other expenses to remain constant or increase (interest costs).
On the other hand, total investment income is expected to decrease. Why would total investment income decrease? Simply because the fund continues to pay out extraordinarily high levels of capital repayments, which heavily deplete the net asset value. As we estimated when we first covered this fund, the best-case scenario for total net asset value returns was nearly 3% per year. Paying way beyond that obviously depletes the NAV and forces the higher fees for the remaining units. Now, it turns out that even we were a little bullish on the total NAV returns. NAV has gone from $6.85 to $5.50 in the last 12 months.
If you count the generous distributions, you still have a negative 10% return on net asset value.
This was all pretty concerning, but we had this excruciating setup alongside the funniest 23% NAV bonus when we first covered it. Thanks to a slight drop in the NAV premium, total returns have been negative by 12% since this first article.
The opportunity today
Despite the sharp drop in net asset value and despite the sharp drop in prices since then, the fund is actually in a more dangerous position than before. For starters, it always trades at a premium of 20%.
Because the net asset value per share has fallen so much, distributions deplete the net asset value even faster. This is a depletion of at least 1% per month, as distributions of 16% on NAV are not even 25% covered. Even using capital return information which we believe lags behind a real-time look, we find that only a third of the distribution is earned.
The fund is 31% leveraged and its leverage costs are expected to increase significantly with any future rate hikes. As the net asset value falls, the fund’s expenses begin to increase at an increasingly rapid rate. Cast reduction will come at some point and this will quickly restore gravity and a strong discount to NAV.
Why hasn’t the cast already been cut?
One of the main reasons we believe is that the fund used the net asset value premium to issue new shares. Approximately 9.17 million shares are outstanding based on most recent report. This is an increase of approximately 400,000 from pre-ATM days. The fund obtained $400,000 of cash in addition to its net asset value thanks to this issue. As long as this window is open, it has an incentive to continue issuing shares. Of course, if he cuts the distribution, the NAV bonus will evaporate.
The price of the fund has a date with its net asset value. We just don’t know when that will happen. Our best guess here is that it will happen within the next 12 months. Even reputable PIMCO funds trade at discounts to NAV. We see no reason why this one, with a negative 9.38% YTD total return, should be trading at a 20% premium. Get out while you can.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.