Frontier markets – a subset of emerging markets (EMs) – offer debt investors value both on a standalone basis or as part of a diversified portfolio. Here are five reasons why.
Diversification potential
Frontier markets debt offers a highly diverse and growing range of investable countries, currencies and corporate issuers – which historically, have had low correlation to other core markets and asset classes.
This is mainly because investment opportunities are analysed from a country perspective rather than a global macro perspective and this typically makes the movements of asset prices less correlated to the price of other assets.
Appealing risk-return characteristics
We believe this asset class has strong risk/return characteristics – valuations, fundamentals and technicals. We look at frontier markets through these three lenses and we’ve seen a lot of improvement over the last two years.
Frontier markets typically offer high carry, meaning investors can potentially earn a substantial yield relative to the risk of holding the asset. And while frontier markets often offer low volatility, we believe the risk premia in these markets may overcompensate for any volatility as well as default risks and losses.
From a valuation perspective, many of these countries have devalued their currency, so now these currencies appear to be fair or cheap in valuation; raised monetary policy, so that you're getting a much higher carry; and implemented liquidity reform, to make access to these markets that much easier.
From a fundamental perspective, a lot of work has been done by governments in frontier markets to reduce the debt burden and to implement reforms that are positive for these countries’ long-term economic goals. This raises the potential growth of these countries and makes them a more attractive investment destination for foreign capital.
On the technical front, there are isolated local markets that international investors are already familiar with such as Egypt where foreign buyers own a large and rising share of domestic issuance. However, we believe that due to higher operational and informational barriers we are at the nascent stage of overseas demand of many local frontier markets that is likely to result in greater demand as liquidity improves and investors become more comfortable with them.
Inefficiency
Frontier markets are fairly unique in the sense that there is still a large amount of inefficiency. A lack of research coverage, coupled with less transparency and disclosure, contributes to frontier markets being under-represented and under-owned.
Additionally, investors’ home country biases and information asymmetries can result in an overestimation of the risks associated with frontier markets, further compounding the inefficiency.
Risk Premium
Frontier markets debt offers a higher risk premium. This is reflected in the high bond yields per unit of duration risk and the attractive risk-adjusted carry embedded in currency forwards. Additionally, we believe that default risks in these markets are often over-estimated, while recovery values are under-estimated, providing further opportunities for investors to benefit from the higher yields.
This excess risk premium is something that we feel can be uncovered through the bottom-up work that we do from a credit analyst perspective as well as a sound understanding of how these markets technically operate, and we feel the valuations are easy to assess by looking at them from a bottom-up perspective. And it’s about making sure that we manage the risks and potential drawdowns from an individual holding.
Sponsorship
Significant work has been done by governments in frontier markets to implement reforms that are positive for these countries’ long-term economic goals. These markets also garner strong sponsorship support from multilateral and bilateral organisations (such as the International Monetary Fund, (IMF)), which raises the growth potential of these countries, making them an attractive destination for foreign capital.
Pakistan and Sri Lanka stand out as two countries benefitting from this support and, thus in our view, we believe these frontier markets are positioned for further growth.
Pakistan: Investment sentiment in Pakistan turned upbeat on decisive steps taken by the prime minister’s administration to push through a revenue-generating reform agenda and the IMF approving Pakistan a 37-month, $7bn extended fund facility (EFF) loan in September. Pakistan’s 25th IMF reform programme has received widespread support from government officials, members of ruling and opposition parties, local political advisers, investors and banks, many of whom agree that this is the last chance for the country to turn its economy around.
Sri Lanka: Despite political challenges due to a new president lacking governing experience, and the delayed prospect for debt restructuring and IMF funding, the economic situation in Sri Lanka is positive. Economic growth is robust, with GDP projected to rise by 4-5% in 2024-2025. Headline inflation has dropped below 1% and technical deflation is anticipated in the coming months. Moreover, the country has already surpassed the IMF’s primary surplus targets for this fiscal year and is making significant strides in rebuilding foreign-exchange reserves, aiming for $7bn next year.
These countries among many others are exhibiting strong growth. We expect the growth gap between emerging markets and developed markets will widen to over 2% in the coming years, which is likely to drive capital inflows into emerging market economies.
Within the 70 plus countries within the frontier markets universe, you need to do your homework, visit these countries, immerse yourself in the culture and really understand the fundamentals of the economics of these particular countries.
This under-researched, under-reported universe creates opportunities for rigorous research to unlock alpha. We believe that there is value in investing in frontier markets and, in both hard currency and local currency, we are finding very strong, bottom-up opportunities.
We believe the breadth and depth of the frontier markets debt universe presents unique alpha-generating opportunities.
Marcelo Assalin is head of emerging markets debt at William Blair Investment Management. The views expressed above should not be taken as investment advice.