Frontier markets are a subset of the emerging markets universe, offering high yields in exchange for liquidity and informational constraints. Idiosyncrasies between frontier economies drives diversification, limiting risk and underpinning a key advantage to an active investment approach.
Regardless of whether recent financial sector instability is contained, or western economies experience a “hard landing”, one thing should be clear to investors: the days of easy money and returns are over. This is the outcome of three years of consistent macroeconomic shocks that have laid waste to government finances, elevated geopolitical tensions to Cold War levels and forced an ongoing restructuring of global trade policies and supply chains. However, more challenging environments such as these create the perfect opportunity for active asset managers to sift through the universe of risky investments to find pockets of value and deliver outsized returns. Frontier markets are a particularly appropriate asset class for an active manager: highly attractive current valuations and idiosyncratic risk profiles have created the perfect opportunity to “find diamonds in the rough”.
Frontier markets are a subset of the emerging markets universe, loosely defined by low credit ratings – almost exclusively single B or below – and illiquid, homogenous securities markets, with government bonds generally the only investable asset class. As a result, few are included in emerging market indices, reinforcing the need for an active approach. The upside is extremely high returns, with USD or EUR denominated frontier market bonds often yielding more than 10%, and their local currency equivalents sometimes double that. Beyond these similarities the frontier market space is extremely heterogenous, spanning all continents and with member economies of all sizes and types, ranging from troubled behemoths such as Nigeria or Pakistan to tiny, tourism-driven Bahamas and emerging hydrocarbon titan Mozambique. The diversification these idiosyncrasies provide helps limit the risk of the asset class and drives another advantage of an active approach, remembering that traditional indices hold only a fraction of the entire emerging markets universe.
In order to navigate this asset class, dedicated research and a comprehensive ESG methodology are crucial. The ability to generate alpha rests on the lack of broad analytical coverage, which results in many names trading at similar distressed levels despite possessing wildly different credit and currency risks. It is also important to note that credit ratings denote capacity to borrow rather than outright risk of default and are thus not an appropriate guide for bond valuations: Ghana – now undergoing a sovereign debt restructuring – possessed the same S&P credit rating as Papua New Guinea until August of last year, despite Papua New Guinea having only limited debt servicing needs and a single Eurobond outstanding, not due to mature until 2028. Reflecting these points, an in-depth analytical approach is required to both unlock pockets of value and avoid names where pricing does not compensate for the – sometimes extreme – level of risk. This analysis should take advantage of a mosaic of sources, ranging from formal data providers to local banks, the IMF and government contacts, supplemented by regular on the ground visits to investee countries.
The first priority when looking to invest in frontier markets is to identify downside risks, such as the possibility of a sovereign default or balance of payments crisis, which broadly involves identifying financing needs and sources over a medium-term horizon and assessing these against available foreign reserves. Sometimes this highlights sovereigns with otherwise weak fundamentals; Nigeria, for example, has a low level of outstanding debt and a forgiving repayment profile, making the high yields offered by its Eurobonds worth considering despite its deep economic and political issues.
Second, it is key to perform an assessment of a sovereign’s politics and institutional strengths, the qualitative nature of which draws heavily from on the ground assessments. These can identify critical weaknesses in fundamentally strong economic profiles; for example while Ecuador – an oil exporter with a Dollarized economy – is well poised to take advantage of high commodity prices while containing inflation, its politically radical population frustrates even basic reform efforts and drives instability and uncertainty. In contrast Benin, one of Africa’s least developed nations, sports a credible development trajectory underpinned by a highly technocratic administration.
It is important to note that these strategies can realize value from highly distressed and even defaulted sovereigns such as El Salvador, Sri Lanka and Zambia, taking advantage of the fact that the pricing of these bonds sometimes overestimates restructuring needs and thus underestimates their intrinsic value.
Investing in frontier markets is a critical element of our emerging markets strategies, providing alpha and diversification while utilising the core strengths of an active approach.
