The Enduring Woes of First Australia Prime Income

Thank you for your articles (Dec. 3, 1999, Feb. 12, 1999) on First Australia Prime Income (FAX). Can you explain what's been going on with it more recently?

--Henry Yee

Henry,

The recent story of First Australia Prime Income is an unfortunate tale.

The closed-end fund, which invests primarily in Australian government bonds and at $1.5 billion is the ninth-largest closed-end bond fund (including loan-participation funds), appeared to have a promising future a year ago.

It was underearning its dividend, in the parlance of closed-end fund analysts, meaning that the bonds in the fund weren't throwing off enough income to cover what the fund was paying out to investors in dividends. That had been true for years, however. Because it had purchased its stock of Australian government bonds, and its much smaller stock of Asian government bonds, at times when interest rates on those securities were high compared to today, the fund had substantial unrealized capital gains from which it could draw to supplement its earnings.

More importantly, the Australian dollar looked painfully undervalued. First Australia Prime Income, which earns income mainly in Australian dollars, is joined at the hip with the Australian dollar. If the Australian dollar strengthens, the income the fund collects from its Australian government bonds will convert into larger U.S. dollar amounts, enabling the fund to pay out higher dividends. At the same time, a strengthening Australian dollar would boost the U.S. dollar value of the securities in the fund, and thus the fund's net asset value .

The Australian dollar was widely expected to strengthen last year. It had gotten trashed during the fall 1998 meltdowns, dropping as low as 58 cents. Currency analysts figured that the combination of a strong Australian economy, economic recovery in the Pacific Rim, and recovering commodity prices -- with which the Australian dollar has a high correlation -- would return the Aussie dollar to its pre-Asian financial crisis level of about 75 cents.

Sadly for holders of First Australia Prime Income, that forecast fell on its face. The Australian dollar, after trading as high as 67 cents in the past year, is back down around 58 cents, as this chart shows.

What went wrong? Commodity prices have certainly moved higher. As measured by the Bridge Commodity Research Bureau Index, commodity prices have rebounded to May 1998 levels.

Part of the problem is that the commodities most closely associated with Australia -- gold, coal, iron ore, to name a few -- haven't participated in the commodity rally to a great extent, says James Shugg, economist at Westpac Banking Corp. in London.

Equally important, Shugg says, is that the Aussie dollar simply hasn't been able to compete with the U.S. dollar where investments are concerned. "There have been more attractive assets you can buy in the U.S. economy than in the Australian economy," he says. "The Australian share market didn't participate in the rally we saw in late 1999 and early 2000, particularly in the Nasdaq."

At the same time, U.S. short-term interest rates have remained higher than Australian short-term rates. That also makes it more lucrative to hold U.S. dollars than Australian dollars.

With the weakening of the Australian dollar, the value of everything First Australia Prime Income owns and earns has been marked down in U.S. dollar terms. The fund, which in March 1999 said it would hold its dividend constant at 6 cents over the next year, had to draw more deeply from its capital gains in order to supplement its shrinking (in dollar terms) earnings. Meanwhile, the value of those capital gains was also shrinking in dollar terms. Mariana Bush, closed-end fund analyst at First Union Securities, recently calculated that from October 1999 to April 2000, the fund went from having unrealized gains of 12 cents a share to unrealized losses of 17.5 cents a share. (It had realized gains of three cents a share in April, Bush says.)

"The Australian dollar overpowered the portfolio despite its strong performance in the Asian markets," says Michael McGrath, closed-end fund analyst at Gruntal.

Adds Prudential Securities closed-end fund analyst Kristoph Rollenhagen: "The Australian dollar has not done what it was supposed to do, and the longer it stays down, the more financial compression [First Australia Prime Income] is going to experience."

Compounding its woes, the fund, which like many closed-end funds employs leverage -- borrowing money at short-term rates and investing in higher-yielding long-term bonds -- saw its cost of leverage climb as U.S. short-term rates rose in response to interest-rate hikes by the Fed .

Predictably, as the fund's net asset value dropped, and as investors anticipated that the fund would be unable to maintain its dividend at 6 cents, they sold it, driving its price down to levels it had never seen before, as this chart shows.

Even Further Down Under Net asset value and market price for First Australia Prime Income

Source: Lipper

Indeed, in March, the fund cut its dividend to 4.5 cents and pledged to keep it constant for a year. But First Union's Bush thinks that barring a sudden, sharp recovery by the Aussie dollar or a big rally in the Australian government bond market, First Australia Prime Income will either have to renege on that pledge and cut the dividend again, or return capital in order to make up the difference between its earnings and its dividend. The unrealized capital gains won't last the whole year, she thinks.

Again, it all comes down to the Australian dollar. The currency's tumble back to crisis lows took First Australia Prime Income down, and lack of faith that the currency is going anywhere any time soon is what's keeping the fund there.

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