The next frontier in EM debt
A combination of favourable demographics and positive growth prospects make frontier bond markets among the more exciting opportunities in a fixed income market starved of yield. But selective asset allocation will be critical in a sector where there will be winners and losers.
With yields and growth remaining supressed in developed bond markets, it is hardly surprising that investors are scouring far and wide for opportunities to secure higher returns. Frontier markets, with an alluring mix of rising populations and economic growth, are obvious candidates to benefit from investors’ hunt for yield.
Within the broad emerging market universe, frontier markets are characterised by being smaller, sub-investment grade and less accessible than larger emerging markets. To be eligible for inclusion in JP Morgan’s Next Generation Markets Index (NEXGEM) – a subset of its 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.
Currently, 32 countries have NEXGEM status, with Latin America accounting for 45 per cent of the market and Africa 30 per cent. By rating, single-B credits represent almost 79 per cent of investible assets and double-B credits just under 20 per cent.
The market has grown substantially in the past five years, with the weighting of NEXGEM bonds in the EMBIG more than doubling from just fewer than five per cent in 2011 to around 12 per cent now; equating to total outstanding debt of around $87 billion.
It is easy to see why investors are looking closely at this nascent asset class. On the surface, the growth outlook in many frontier markets is encouraging in a world where growth opportunities are becoming increasingly scarce. There is also the prospect of higher returns, with the 32 NEXGEM issuers offering an average yield of 6.5 per cent versus 5.15 per cent for the EMBIG. The growing relevance of these markets in the index is also set to increase as the universe opens up to new countries.
However, whereas frontier market returns were once driven by idiosyncratic factors, the correlation between NEXGEM and EMBIG is at its highest level since 2011. This suggests NEXGEM has increasingly become a high beta sector, with performance driven largely by overall investor sentiment towards emerging and global markets rather than more fundamental, credit-specific factors.
Perhaps this should not be a surprise in the context of a global fixed income market that has become over-reliant on supportive central banks. The hunt for yield has intensified in 2016, leading to indiscriminate buying and higher correlations. But it would be unwise for investors to believe this will be permanent. Over time, we expect the correlation between NEXGEM and EMBIG to reduce, with idiosyncratic factors once again becoming the main driver of performance.
Long-term returns will therefore depend on allocating to the right countries, as there will be clear winners and losers within the sector. Mozambique is a good example of a loser this year as political uncertainty and the lack of information regarding a potential restructure has led to the country significantly underperforming its peer group. Zambia, conversely, has returned over 30 per cent; more than double the returns of Mozambique. Despite a fiercely contested general election in August, which saw the ruling Patriotic Front party re-elected, the government has committed to an economic reform programme and is in talks with the International Monetary Front regarding a potential deal.
The diverging fortunes of Mozambique and Zambia illustrate how Sub-Saharan Africa simultaneously offers opportunities and challenges for investors. The demographics are certainly favourable. Africa is the second largest continent and home to over 1.2 billion people, with a median age in 2012 of 19.7; making Africa’s population the youngest of any continent. Meanwhile, life expectancy is growing, as is its urban population.
Sub-Saharan Africa has a variety of strengths that should position it for a sustained period of economic growth and rising prosperity. While most domestic markets remain small, regional trade agreements and other economic unions provide greater opportunities for investment. Many international retailers and consumer goods firms have high hopes for the region given its rapidly urbanising population and the proliferation of the internet and mobile phones.
However, investors would be unwise to ignore the challenges it faces. Poor infrastructure, relatively low economic diversification, political risk and security challenges are not insignificant concerns. The countries that make the most progress in addressing those are likely to be the winners in attracting international investment, and potentially graduating to full emerging market status.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 7 October 2016. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
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