What is the deal with Frontier Markets’ bonds?
Yields are persistently low across Western Europe and North America. Even with a significant steepening of the yield curve over the past six months, bonds still provide asymmetric risk if you are not holding them to maturity for the foreseeable future. They no longer remain the conservative assets in a portfolio. Investors searching for yield have bid up values of every fixed income asset they can find; first it was high yield (HY) debt, then it was emerging markets (EM) debt, and more recently it has been Frontier Markets (FM) debt.
Fixed income, as an asset class is undergoing a significant maturation. Pension plans are focused now on asset-liability matching (ALM), using only duration to match liabilities, in the same way as insurance companies have acted for decades. At the same time, many institutional investors and retail investors are looking to diversify their portfolio with assets that have low levels of correlation. Growth is concentrated in EM and FM for the foreseeable future. The market continues to grow, and these countries on average, have a significantly lower debt-to-GDP ratio than developed countries. Of course, you have probably heard all of this. This is the case for EM, but the problem with the major EM markets, is they are in peril. India’s currency and current account deficit is a basket case, Brazil has anemic growth, Russia is a black box that is unpredictable, given the credit growth, and China’s real challenge is will it grow old before it grows rich?
The yields for EM debt have already compressed, and yet growth projections are the worst they have been in a long time. EMI’s EM debt fund has returned 4.0% in the last 12 months (as at Sept 2013) and Templeton’s EM debt fund has returned 4.1%. Hardly attractive numbers, given the risk inherent in these markets. In fact, the same risks present in developed sovereigns are now rampant in EM debt. Investors need to be selective and patient.
For investors seeking diversification, low correlation, and the potential for attractive returns, FM debt is now attracting all the attention. Reuters has a great chart here, which shows the expected pipeline of FM debt for the fourth quarter. Sovereigns are cashing in on the demand. Countries like Zambia are able to have offerings 15x oversubscribed. Each issue needs to be considered on its own merits. Jumping headfirst into FM debt, is likely to end in disaster for your portfolio.
The big guns are aiming at Frontier Markets in their hunger for yield, Aberdeen launched a Frontier Markets’ debt fund last month, and it has grown from a launch of $75mm to $250mm today, in less than a month. Fidelity, Franklin Templeton, and AXA all have their own funds, which are seeing significant growth.
There are three kinds of FM debt; hard currency sovereign debt, hard currency corporate debt and local currency sovereign debt. The market, by and large has been focused on hard-currency issues. Local currency issuance however, is the far more interesting one. It is the least attractive to investors domiciled in developed countries. It bears significant currency risk, and is subject to significantly more uncertainties than hard currency. However, it provides local exposure which should be more stable over the long-term (major purchases in local currency are principally domestic pension funds in most frontier markets).
We do not recommend local currency issues as a first foray into FM debt, but it is something to keep on your horizon. The attention on FM debt has caused yields to reach silly levels. Rwanda issued debt in April yielding less than 7% and Kenya is issuing debt yielding less than 8% for 10-year debt. Nigeria has 10-year notes yielding less than 7%, and are looking to tap the market before the year-end for longer issues (up to 20 years). Mozambique issued $500mm of 7-year debt in September yielding 8.5%. In a dangerous case of circular logic, these low yields have recent been used as a justification for further tightening in the high-yield US corporate market, as the perceived risks of a sub-investment grade US corporate is arguably less risky than debt from a sub-Saharan African government.
Being Frontier Markets investors (albeit equity investors), we are delighted that more and more attention is being paid to these markets. Hard currency issuance boosts corporate governance and increases attention on the issuing sovereigns. All of this is good. However, frothy would be an understatement for current yields. We believe the risk-reward trade-off is much better in Frontier Markets’ equities as a whole. In the event of a significant increase in yields for many of these issuances, they could become very attractive.
We’re currently working on developing a fixed income dashboard for Frontier Markets. If there is anything in particular that you would like to see on this dashboard, let us know.