The Fading of First Australia Prime Income
By Elizabeth Roy
Senior Writer
12/3/99 12:01 PM ET
Your February heads-up on First Australia Prime Income (FAX:Amex) was one of the many ways in which TheStreet.com has helped me become a more informed investor. I did a lot of further research on FAX and a couple of profitable trades. But more recently, it has tanked. What's going on?
-- Gitanshu Buch
Gitanshu,
First Australia Prime Income has indeed experienced a painful reversal of fortune.
The fund had a great quarter after that February story. Its price went from 6 to 6 3/4 and hung out around there for much of the summer. Its decline started at the end of August. By October, it was back at 6. In mid-November, it collapsed anew, closing yesterday at 5 5/16. Ouch!
Back Down Under
First Australia Prime Income has given back
most of its first-half gains.
Source: Lipper
What happened to the $1.7 billion fund -- the second-largest closed-end bond fund, according to Lipper -- is a combination of bad luck and bad timing.
To review, FAX invests primarily in Australian government bonds. For its first 12 years, that was all it invested in. Then, in the fall of 1998, when emerging-market bond yields went through the roof and into the clouds after Russia defaulted on its debt, the fund changed its strategy to allow investment of up to 35% of its assets in Asian debt securities.
The managers invested roughly 13% of the fund's assets in Asian debt, which has performed extraordinarily well. The Bear Stearns Asia Pacific index, a good proxy for the Asian portion of the fund, returned 31.7% from Oct. 31, 1998 to Nov. 30, 1999.
Australian Portion Lags
If only the Australian component of the fund had done half as well.
The Australian portion has suffered for two reasons. First, as this chart shows, Australian government bond yields have followed U.S. Treasury bond yields higher this year, eroding their prices.
Sinking Bond Prices
The Australian 10-year government bond yield
Source: Reuters
Second, Australian government bond yields obviously earn interest in Australian dollars. And FAX doesn't hedge its currency risk, meaning that if the Australian dollar appreciates against the U.S. dollar, the interest payments on the bonds will convert into larger dollar amounts. (Like any foreign bond fund that doesn't hedge its currency risk, FAX is more a currency investment than an income investment.)
That was precisely why many analysts and investors liked FAX last winter: The Australian dollar looked cheap to them. The Australian dollar has a high correlation with commodity prices, and commodity prices were in the tank. But with the global economy starting to recover, commodity prices seemed poised to rally, and indeed they have.
Unfortunately, the commodity that correlates most closely with the Australian dollar -- gold -- hasn't fully participated. Gold rallied massively in late September and early October, rising from about $255 to $325 an ounce, but it has since retreated to about $285.
As this chart shows, while the Australian dollar is still higher on the year, it's only barely so.
A Stagnant Currency
Value of the Australian dollar,
in U.S. dollars
Source: Reuters
Those two factors are behind the fund's initial leg down, from August to October. The second leg down is another story.
Dividend Dilemma
In April, the fund decided to fix its monthly dividend at 6 cents a share for the 12-month period ending March 31, 2000, subject to market conditions. That's an unusual decision for a fund whose earnings are mostly in another currency, since weakness in the currency could make it difficult to honor that intention.
Deteriorating bond prices made it even more difficult. For years, FAX has been "underearning its dividend," in the parlance of bond closed-end funds. In other words, the income generated by the fund's assets has not been enough to cover its stated dividend. Rather than cutting the dividend, FAX has been distributing capital gains to make up the balance. It had loads of those, mainly because it bought Australian government bonds years ago, when their yields were much higher than they are now.
When I wrote about FAX in February -- indeed, when the fund adopted its level-dividend policy in April -- it still had enough unrealized capital gains to give analysts confidence that the fund would be able to maintain its dividend for the foreseeable future. But that was before the worst of the bond-market rout.
On Nov. 12, FAX sent a letter to shareholders informing them that their October dividend, the last one of the fund's fiscal year, included a partial return of capital. The directors estimated that of the 6-cent dividend, 2 cents represented a return of capital. They didn't say the fund was out of capital gains to realize -- and that won't be clear until the fund files its annual report in January -- but that's the implication, says Paul Mazzilli, director of closed-end fund research at Morgan Stanley Dean Witter. He figures the fund will return another 2 cents of capital a month through the end of March, at which point it will cut its dividend.
Some Analysts Upbeat
Other analysts are more optimistic. Michael McGrath of Gruntal and Kristoph Rollenhagen of Prudential Securities (which has underwritten rights offerings for FAX) say their conversations with the fund's managers indicate that the return of capital was done, Rollenhagen says, "so they could keep the gain component in reserve in order to satisfy the level distribution policy through March." Rollenhagen also says that while the bond-market rout eroded the fund's unrealized gains, it didn't wipe them out.
FAX's managers at Equitilink in Sydney were unavailable for comment. But Richard Strickler, managing director at Equitilink USA in New York, cautioned that the return-of-capital estimate was merely an estimate. Along with the fund's overall fiscal position, the precise amount won't become known until the annual report is released.
In any case, the decision to return capital clearly wasn't popular with investors.
The selling has been aggravated, analysts say, by tax-loss selling. Before last year, FAX traded in a range between 7 1/4 and 11 1/4, making it an excellent candidate for investors who bought it at those lofty levels. Tax-loss selling continues to weigh on all kinds of bond closed-end funds this year.
What to do? Mazzilli has an underperform rating on the fund and recommends substituting either Debt Strategies I (DBS:NYSE) or Debt Strategies II (DSU:NYSE), two Merrill Lynch Asset Management funds that invest in a combination of U.S. high-yield bonds and bank loans -- a very different type of investment, to be sure. No foreign currency exposure, but a much lower average credit quality.
Others feel it's worth sticking with the fund on the assumption that its directors' expectation for improvement in the Australian bond and currency markets will pan out in the new year. Even a 20% dividend cut would leave the fund with a yield over 10%, a rare find for a fund whose assets have an average rating of double-A, they note. "This is an attractive entry point, with the caveat that currency and dividend volatility might be expected," McGrath says.
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