Despite a torrid few months, frontier bond markets still have an important role to play in investors' portfolios.

Frontier market bonds have not escaped a torrid few months for emerging markets, with yields spiking and prices falling. These bonds still have an important role to play in investors’ portfolios – but selectivity and active management are vital.

Investors must be discerning if they are to take advantage of opportunities in frontier market debt

The first half of 2018 has given investors in emerging market bonds pause for thought, with turbulence in larger countries such as Argentina and Turkey causing a reassessment of risk across the EM universe.

So-called frontier markets have been caught in the storm, perhaps unsurprisingly given their idiosyncratic nature and often misunderstood stories, resulting in exaggerated price action – yields on government bonds from Ecuador, Iraq, Tajikistan and Ukraine have all widened between 100 and 200 basis points in recent months amid concerns over rising fiscal deficits. However, frontier markets are not homogenous and the recent volatility could present significant opportunities.

Within the broad emerging market universe, frontier markets are typically smaller, sub-investment grade and less accessible than larger emerging markets. To be eligible for inclusion in NEXGEM – a subset of JP Morgan’s Emerging Markets Bond Index Global (EMBIG) – the country must have a rating of Ba1/BB+ or lower from Moody’s and S&P, and cannot be a European Union member or be in the process of seeking EU membership.

Frontier market issuers tend to be among the fastest growing economies in the world, and many are also making strides in improving their governance standards. These favourable characteristics have been reflected in the total returns of the NEXGEM – as of June 4, 2018, the index had returned 22.2 per cent over three years; 47.6 per cent over five years; and 122.9 per cent over 10 years.1 By contrast, EMBIG delivered 14 per cent, 22 per cent and 87 per cent over the same periods.

Still, investors must be discerning if they are to take advantage of the opportunities. Argentina is clearly a very different economy from Iraq or Tajikistan. And external forces – including the shifting nature of institutional financing, the rise of China, and fluctuating commodity prices – are causing frontier markets to become differentiated as never before. Understanding the impact of these forces will be crucial for debt investors hoping to successfully navigate the frontier.

IMF support: this time it’s different

Take the role of the International Monetary Fund (IMF). When Argentina’s President Mauricio Macri announced in May that he was seeking support from the IMF,2 credit investors could be forgiven for feeling a sense of déjà vu; after all, the country has sought IMF help more than 20 times over the last 60 years. But where an application for IMF support would once have been a warning sign, it is now increasingly taken as an indication that a country is willing to get its fiscal affairs in order.

Credit rating agency Fitch has undertaken extensive analysis of how IMF support affects the creditworthiness of frontier markets. In a report from February 2018, it noted there has been a sharp increase in the number of sub-Saharan African countries receiving money from the IMF in recent years.By the end of 2017, nine out of the 21 countries in the region rated by Fitch were in active IMF programmes, up from just three in 2014.

The increase in IMF activity is a sign of the economic shocks these countries have faced in recent years, but it also points to a growing willingness among African governments to implement the kind of painful yet beneficial macroeconomic adjustments the IMF advocates. The nuance for credit investors, as Fitch notes, lies in the details of the individual programmes each country has with the IMF.

“The ability of IMF arrangements to support sovereign creditworthiness ultimately depends on each country’s characteristics, including macroeconomic fundamentals; the quality of institutions and governance; political set-up; and, above all, the strength of commitment to the implementation of the required adjustment,” wrote Fitch in its report.

IMF programmes are now seen as an advantage by many investors, as long as the governments involved prove their commitment to making the necessary adjustments. “From our perspective, when countries approach the IMF, they are potentially moving to more proactive economic policies. Now they don’t have to wait until there is a balance of payments crisis,” says Aaron Grehan, emerging market debt fund manager at Aviva Investors in London. “IMF involvement is very important as it limits potential losses for bondholders. But it is more than just financial assistance; it is the policy, reporting and other support that helps.”

China: the new creditor

Another significant change to the frontier market universe is that the IMF is no longer the only game in town. China’s rise as an exporter of capital has added a fascinating new dimension to the credit analysis of frontier markets.

“China is now providing a lot of money to frontier markets, especially those in Central Asia and Africa,” says Ed Parker, head of EMEA Sovereign Ratings at Fitch in London. “But there is not a lot of transparency over the total amount of financing Chinese development banks provide to these countries.”

China’s economic assistance to frontier markets differs markedly from IMF or World Bank support. Firstly, the money tends to be  project finance, as opposed to government finance; sourced from institutions such as the China Development Bank and the China Export Import Bank (neither of which disclose many details about their activity). Lending tends to be conditional on projects being carried out using Chinese material and labour.

According to Carmen Altenkirch, emerging market sovereign analyst at Aviva Investors in London, the scale of Chinese involvement in many frontier economies is huge. For instance, 28 per cent of all of Zambia’s external debt is held by China. “Countries such as Angola, Ecuador, Pakistan and Zambia have seen significant lending from China,” she says. “But many of these countries are now asking to renegotiate the loans either through lower coupons or longer maturities because they are struggling to repay.”

An example of this dynamic was recently revealed in parliamentary proceedings in Kenya. In May 2014, China lent Kenya Sh324 billion ($3.2 billion) to build a new railway line from Nairobi to Mombasa.4 The 15-year debt had a grace period of five years. Proceedings at the Kenyan National Assembly showed that annual repayments on this debt will increase from Sh6 billion to Sh35 billion over the next year. Over the same period, total debt payments to Chinese lenders will increase from Sh26 billion to Sh82 billion. Other African countries face similar increases in debt repayments to China.

This raises several questions: how will China behave as a creditor; will it allow accommodation on debt repayments in order to secure good bilateral relations with strategically-important countries or will it play hardball? China is not part of the Paris Club of creditor nations, so there is little visibility on how it will proceed. As with the IMF, it is likely each country will be treated differently, adding a further element of specificity to the credit drivers of each frontier market for investors to consider.

Figure 1: Total returns NEXGEM vs EMBIG

The frontier expands

Investors in frontier markets need to do their homework and commit to the long term

A further shift in the frontier-market environment is that there are many more international issuers than were present in the previous cycle. Furthermore, a number of countries have multiple international debt issues outstanding.

According to Parker at Fitch, many debut sovereign issuers have accessed the international debt markets with varying degrees of success over the last decade, including Ghana, Mongolia, Senegal and Tajikistan. “This reflects the hunt for yield among investors, but also the fact these countries have been growing quickly, which allows them to borrow more,” he says.

Ghana is a good case study of a country that has borrowed successfully. In mid-May, the country issued $1 billion of 10-year bonds, carrying a coupon of 7.625 per cent, and $1 billion of 30-year bonds,5 which have an 8.625 per cent coupon. The combined issuance generated $7.5 billion of demand, and added to four other outstanding bonds, one of which came with a 10.75 per cent coupon and a World Bank guarantee. The country now has the trappings of a solid sovereign issuance programme with a yield curve and a debt management office – all of this undertaken while it is in an IMF programme.

Ghana has joined other countries such as Ivory Coast, Kenya and Senegal in tapping the 30-year end of the curve. Ivory Coast and Senegal (as well as Egypt) have added further diversification to the market by completing debut issues denominated in euros. Such a plethora of bonds compels investors to be selective – especially as many of the debut Eurobonds will need to be either refinanced or redeemed over the next few years. Not all issuers will be able to complete this process smoothly.

“Zambia in 2012 was able to issue a Eurobond with a coupon of just 5.375 per cent, but since then there has been a significant increase in the price it has had to pay,” says Altenkirch. “You have to differentiate between frontier markets now, especially in terms of their capacity to refinance their existing issues, because many of these countries will have to redeem their first Eurobonds in the early 2020s.”

Commodity prices and credit ratings

Countries’ capacity to redeem these debts will be dictated to a large extent by the availability of foreign currency, which will depend on export revenues – often derived from natural resources – or the presence of internal buffers such as dedicated reserves or a sovereign wealth fund.

Frontier market economies tend to be tethered to commodity prices in a way that diminishes further up the development curve. For nations such as Mongolia (copper) and Ivory Coast (cocoa), this dependence can seem almost umbilical. Many frontier market economies suffered badly during the 2015-2016 commodity-price slump. Now that prices are recovering, their prospects are brighter, but there is still a high level of dependence on commodity exports for both growth and the foreign exchange necessary to repay their debts.

According to Parker at Fitch, many frontier markets were downgraded between 2015 and 2017 due to the collapse in commodity prices. In Fitch’s overall sovereign rating model, commodity prices only account for two per cent of the total inputs. But the dependence of these economies on commodities feeds through into many other metrics that influence their rating.

A fall in commodity prices leads to a fall in reserves, an increase in overall government debt and a fall in the value of the currency. Cumulatively, these dynamics can quickly and severely impact the external credit of frontier economies. “Commodity price slumps can lead to big macro impacts for these countries,” says Parker. “This dependence makes them more vulnerable to shocks.”

Credit ratings are another key factor. An upwards ratings trajectory can transform a country’s prospects and provide a tailwind for their bonds. An exercise undertaken by Aviva Investors involves looking at the macro inputs that could lead to an upgrade – such as the per-capita income of a frontier market, its total government debt, and the rate of improvements in its governance metrics – and then using GDP growth as a proxy to gauge how long it would take for it to achieve parity with established EM economies.

Being selective

With these factors in mind, it would seem investors need to find credits that have good support from the IMF or China; sufficient external buffers to withstand commodity shocks; and a manageable debt burden that is administered in an institutional way. This actively reduces the potential number of issuers that are investable.

What is certain is that it pays to be rigorously selective when investing in frontier market bonds, as in any other asset class. Most of the returns will be derived from actively finding the best credits while avoiding cyclical losses. What is often considered a ‘high-beta’ play on the wider emerging market asset class is actually more of an uncorrelated alpha generator. Above all, investors need to do their homework, commit to the long term and – perhaps most crucially – have the stomach to brave the kind of volatility that has roiled emerging markets over the past few months.

References

1 JP Morgan NEXGEM index, June 2018

2 ‘Argentina begins talks with IMF over financial aid’, Financial Times, May 2018

3 ‘IMF programmes in Africa and the implications for creditworthiness’, Fitch Ratings, February 2018

4 ‘Kenya inaugurates Chinese-built railway linking port to capital’, Reuters, May 2017

5 ‘Ghana sells $2bln Eurobonds at issuer-favoured yield’, Reuters, May 2018

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