Is Frontier Market Debt overheated?
We have expressed our concerns about Frontier Markets’ bonds on several occasions. Most recently, here. Since then, we have had a number of issues, including:
- Cote D’Ivoire (BB) issued a 10-year note, $750mm at 5.625%
- Kenya (B+) issued a 5-year note at 5.875% and a 10-year note at 6.875%
- Trinidad and Tobago (A) issued a $550mm 10-year note for 4.375%
- Sri Lanka (B+) issued a $500mm 5-year note at 5.125%
- Lithuania (A-) issued a €500mm 10-year note at 3.46%
- Romania (BBB-) issued a €1.25bn 10-year note at 3.7%.
- Bulgaria (BBB-) issues a €1.5bn 10-year note at 3.055%.
What is noteworthy, is there are a number of sub-investment grade issues that have gone through and a number that are scheduled for the remainder of 2014. Fixed income markets have been searching for yield since 2010. Corporate high yield was the first market tapped, followed by emerging market debt (EMD). 2014 has definitively been the year of frontier market debt (FMD). Local currency issues have been quite successful, but our note today is focused on foreign currency (FC) debt.
USD-denominated yields are close to all-time lows. However, the absolute spreads are low, but not concerning. See the figure below.
As far as investment-grade debt is concerned, there should be no concerns about the market. The market is being driven by central bank intervention, but the relative risk of debt indicates a robust investment-grade market. BB and B spreads have compressed significantly since 2010 and are approaching all-time lows, but on their own are not overly concerning. The only thing that concerns us is the compressing spread between B and BB-rated securities.
You may be looking at the chart above and wonder what is causing the hoopla about compressing spreads? Well, it is all about tenor. The figure below is on a 5-year basis.
On a 5-year basis, spreads are essentially at their all-time low. B-rated securities have a 3% spread over US 5-year notes compared to a 6.6% average over the last 20 years. That spread compression for sub-investment grade securities explains why both Kenya (B+) and Sri Lanka (B+) issued 5-year notes.
Sovereign risk different than corporate risk. The recourse towards sovereign entities is limited. The fracas between Singer and Argentina is proof of that. It is far more difficult to seize assets of a sovereign entity than it is to do the same for any developed market corporate.
It is also important to remember how rating agencies themselves view their ratings. A BBB rated security is considered to have ‘adequate payment capacity’ whilst a B-rated security is considered to be a ‘high-risk obligation.’ At June 30, a BBB-rated entity could issue at 3.8% while a B-rated entity could issue at 5.7%. Does 190bps compensate for the added risk? In the fixed income world, the answer is clearly that is does compensate for the additional risk, given the demand and attention such bond issues have had. FMD funds are building a portfolio of securities and sub-investment grade investments are usually only a 10-25% portion of the total portfolio. In our view, this has made some complacent to the risk that such securities pose. While not the main driver of investment returns they still do bear a disproportionate share of portfolio risk and thus merit attention.
Bonds, like equities are not a catch-all. We recommend the same due diligence to Frontier Markets’ bond issues as you would have to equity selection. There are opportunities to intelligently invest in a country with an increasingly optimistic outlook. As an example, Rwanda and Sri Lanka are expected to have declining debt/GDP ratios over the next five years and have experienced strong economic growth despite their instability. If your analysis illustrates that this could result in a compression in yields above and beyond what the country’s rating suggests, then it may be a good investment, even in a rising rate environment.
However, the more that yields compress the less and less attractive frontier markets’ debt becomes. The investment grade part of the market is healthy, but the sub-investment grade sector is approaching overheated territory. We would recommend staying away from FC Frontier Market debt that is sub-investment grade until spreads are above at least 400bps.
LC Frontier Market debt still has potential opportunities but they are primarily informed by outlook on currency.
As always, if you have any questions, let us know
Below is a list of the countries we cover and their credit rating as at July 20, 2014. #NA indicates that no rating is available by the three major rating agencies (S&P, Moody’s, and Fitch). The only country for which no S&P rating is available and a Moody’s rating is available is Mauritius.