The Reserve Bank of Australia (RBA) is finally seeing greater evidence of strength from some of the country’s non-mining sectors, which could bode well for economic growth now that investment in the resource space is on the decline.

On Wednesday, March 26, RBA Governor Glenn Stevens delivered an upbeat speech in Hong Kong before the 17th Annual Credit Suisse Asian Investment Conference.

Following his remarks, the Australian dollar extend its recent rally and currently trades near USD$0.923, up about 6.3 percent from its three-year low in late January, near USD0.868. At this level, the aussie is down about 16.2 percent from this cycle’s high in mid-2011.

For 2014, Mr. Stevens predicts growth will be led by the developed world, a rebalancing of sorts after the many years in which the emerging markets drove the global economy.

As for Australia’s regional peers, the RBA chief sees growth continuing at a pace in line with the recent trend. He noted that China, which grew slightly faster than the central government’s official target last year, could slow down somewhat during the first half of this year.

Recent indicators, including slowing industrial production, moderation in retail sales and passenger vehicle sales, and lower investment in fixed assets, all suggest a near-term slackening. China is Australia’s single largest trading partner, and its demand for the country’s resources, particularly iron ore, have helped drive export growth in recent months.

On the more positive side, Mr. Stevens believes Chinese policymakers’ efforts to rein in the country’s shadow-banking system should prove successful and, therefore, remove a key source of risk to its economy. Additionally, he also noted that the Middle Kingdom continues to make strides toward greater liberalization of its economy, including a widening of the range in which the renminbi is allowed to trade.

Turning toward the home front, Mr. Stevens observed that a number of domestic analysts and pundits tend to take a pessimistic view of the country’s growth prospects, a sharp contrast to the more optimistic tone he hears from their peers in Asia.

His own take is more measured: The Australian economy is doing a bit better than many in the country believe, but not nearly as well as foreign investors might assume.

Australia emerged from the Global Financial Crisis in far better shape than most of its developed-world peers. And the resource boom, which Mr. Stevens characterized as being of “truly epic proportions,” was a significant boost to the economy, with gross domestic product (GDP) now 13 percent higher than it was at the beginning of 2009.

However, over the past 18 months, Australia’s economy has been growing at a pace below the country’s long-term trend of 3 percent annualized.

While Mr. Stevens says Australia’s resource exports should continue to grow, helped along by new projects finally coming on line as well as a lower exchange rate, that alone won’t be enough to get the economy back on track.

To that end, the country’s consumers will have to eschew their recent conservatism and start opening their wallets, while businesses will have to invest in future growth. Though business confidence has improved in recent months, companies tend to be cautious in committing to higher capital spending until they see greater evidence that the economy’s on the rebound.

As we’ve noted recently, the retail space could be one source of non-mining sector strength, though the RBA believes consumer spending will grow only slightly faster than incomes, at best.

And the housing sector has been a major beneficiary of historically low interest rates. Although a number of analysts and economists have been concerned that the country could be in the midst of a real estate bubble, as it didn’t experience a housing crash anywhere near what the US suffered, Mr. Stevens said that the rise in dwelling construction is a welcome development. At the same time, the central bank is closely monitoring the sector for any signs of speculative excess.

Overall, the RBA thinks the early evidence suggests that the so-called handover from mining-led demand growth to broader private demand growth is finally underway. The central bank predicts economic growth could strengthen later this year and accelerate further during 2015.

Last year, the country’s economy grew 2.4 percent year over year. For full-year 2014, the consensus among private-sector economists is that GDP will grow 2.8 percent, with a fairly consistent pace of growth in each of the four quarters.

Portfolio Update

While Australian Edge is primarily a stock-picking service, there is one closed-end fund (CEF) that’s a constituent of our Portfolios: Aberdeen Asia-Pacific Income Fund (NYSE: FAX).

The CEF’s mandate is to produce current income, along with incidental capital appreciation, from investments in Australian and Asian debt securities. In addition to its sizable distribution, FAX is also a currency play, and investors’ willingness to take a position in the fund likely depends on whether they believe the Australian dollar is trading near its ultimate bottom, though the fund has exposure to other regional currencies as well. 

Until recently, the fund had been a major beneficiary of fast-growing emerging Asia as well as Australia’s resource boom and the attendant appreciation in the country’s currency. From the beginning of 2002 through the end of February 2014, FAX gained 11.4 percent annualized on a distribution-reinvested basis, returns that far outpaced the US stock market, even though the CEF invests in fixed-income securities.

Of course, this long-term tailwind lost considerable power last year, as Asian economies slowed and the Australian dollar weakened. The aussie ended the year down about 15.8 percent from its earlier high.

As such, FAX, which had traded at varying points at a premium to net asset value (NAV), fell out of favor with investors, ending the year down 20.7 percent on a price basis, or nearly double the 10.5 percent drop in its NAV.

So those who held the CEF through the selloff should feel reassured that the fund’s underlying portfolio did a far better job of holding its value than the price decline suggests. And since the beginning of the year, the fund has regained some momentum, climbing 6.3 percent on a price basis compared to a 1.4 percent increase in the value of its underlying portfolio.

The CEF currently trades at a 9.6 percent discount to its NAV, which is lower than the fund’s average discount over both the trailing one- and three-year time periods. During the latter time period, FAX’s discount has been as low as 12.9 percent below NAV, while its premium has been as high as 4.5 percent above NAV.

That last paragraph means it’s probably time for a brief overview of closed-end funds, before things get too confusing for those who’ve never encountered them before.

Closed-end funds, like open-ended mutual funds, actively manage pools of assets. But they trade on the open market, like exchange-traded funds (ETF).

Unlike mutual funds, CEFs have a fixed number of shares. This enables them to avoid the negative impact that mutual funds can suffer as the result of mass redemptions during downturns. And this stable asset base also affords the flexibility to invest in less liquid securities.

However, many CEFs periodically raise additional capital through secondary issuances or via rights offerings to existing shareholders, though FAX does not appear to have ever done so.

Many closed-end funds have historically traded at modest discounts to their NAV, though some periodically trade at premiums, as FAX did until recently.

In general, it’s best to avoid CEFs that trade at premiums to NAV. And it’s important to compare a fund’s current discount with its longer-term discount, such as over the last three years, to determine if it’s truly undervalued. As noted earlier, FAX has traded at steeper discounts to NAV during this period, though its current discount is still lower than average.

Meanwhile, income investors must be mindful of the source of a CEF’s distribution, as well as the fact that many funds use leverage to boost their payouts. FAX currently has a leverage ratio of 23.6 percent, a level that’s not uncommon among CEFs.

Many funds, including FAX, also have a managed distribution policy, which means management attempts to smooth the payout rather than let it fluctuate according to the actual income and capital gains produced by the portfolio.

FAX pays a monthly distribution of USD0.035 per share, or USD0.42 annualized, and the CEF has a current distribution rate of nearly 7 percent. While this predictability is important for income investors, it can also lead to a return of capital, which we’ll discuss in detail below.

A fund’s distribution can consist of net investment income, short- and long-term capital gains, and return of capital. The latter detail is particularly important because many CEFs entice investors with high distributions that can only be maintained via regular returns of capital, a Ponzi-like scenario where investors are basically getting their own money back, net of management fees.

However, not all returns of capital are bad. For instance, when a return of capital is based on unrealized capital gains and is, therefore, paid out from a fund’s cash balance, that typically means management is attempting to let its winners run, rather than liquidate them to meet short-term obligations.

But the occasional destructive return of capital is permissible. For instance, management may have erred in projecting payouts, or the market may have suffered a short-term dislocation that eroded a portion of the distribution.

In addition, if the fund trades at a discount to NAV, then even a destructive return of capital can enhance returns if investors reinvest distributions. In any event, returns of capital aren’t taxable and reduce an investor’s cost basis.

The challenging market FAX navigated last year meant that return of capital comprised about a quarter of the fund’s total annual distribution. However, the CEF did not return capital to shareholders in any of the three preceding years. So for now, it should be fine to give management the benefit of the doubt as far as its intentions with regard to return of capital are concerned.

Management’s investment process starts with a top-down macroeconomic analysis to determine regional and currency exposure. Then the team’s fundamental analysis includes meeting with the leadership of the companies and countries in whose debt they’re considering investing. Aberdeen has a number of offices situated throughout Asia which helps facilitate this personalized approach.

As of the end of January (the most recent period for which we have data), 40.3 percent of FAX’s portfolio was invested in corporate bonds, while 36.3 percent was invested in government debt, 15 percent in state debt, and 5 percent in supranationals, with most of the balance in cash.

The currency exposure of the fund’s holdings tilted toward the Australian dollar, at 44.9 percent of assets, with dollar-denominated debt at 36.7 percent of assets. The balance was split among 10 Asian countries, with the Chinese renminbi the largest allocation among this subgroup, at 4 percent of assets.

In terms of geography, 37.1 percent of the portfolio was allocated to Australian bonds and 54.7 percent was invested in debt from Asian countries, including South Korea and China at 11.1 percent and 10.1 percent of assets, respectively.

As for credit quality, the vast majority of the fund’s holdings were investment grade, with 68.7 percent rated “A” or higher, while 12.6 percent were speculative grade. The average maturity of the portfolio was 6.5 years.

Management believes China’s efforts to curtail risk in its financial sector and the broader economy, as well as upcoming elections in India and Indonesia, mean that Asian bonds and currencies could see higher volatility in the months ahead. However, they also note that this volatility could provide opportunities to add exposure to Asian currencies.

In January, Victor Rodriguez took over as lead manager. While we might normally be leery of recent management changes, Mr. Rodriguez has about 20 years of investment experience, most recently as head of Aberdeen’s Australian fixed-income team, a position he had held since 2009. Additionally, Morningstar notes that the fund manager is supported by a deep bench of regional analysts.

FAX charges an adjusted annual expense ratio (i.e., net of interest expense) of 1.03 percent, which is about average for its peers.

Aberdeen Asia-Pacific Income Fund is a buy below USD9 in the Conservative Portfolio.