Frontier markets are often an under-researched area for both equity and fixed income investors. Interestingly, while equity investors are usually bottom-up in their approach, in frontier markets, they tend to be more closely aligned to the approach of fixed income investors, having to take into account the more volatile nature of the countries.

A unique investment landscape

Frontier market investing offers a diverse range of opportunities. These markets encompass hard currency sovereign bonds, local currency government bonds and hard currency corporate bonds, presenting investors with a universe spanning approximately 40 to 45 countries. This is in contrast to frontier equity markets, which are characterized by a handful of larger-capitalizations stocks in a few countries, providing a much narrower set of investable securities despite the relatively large geography. Consequently, frontier market bonds can provide more opportunities to diversify relative to their equity counterparts.

Addressing liquidity and governance

Liquidity and governance concerns have historically discouraged investors from venturing into frontier markets, especially from an equity perspective. However, for frontier market bonds, liquidity concerns have reduced over the past decade. By using the full range of securities on offer, such as hard and local currency government bonds and hard currency corporates, it is possible to avoid a liquidity crunch, as experienced during the height of the pandemic.

During the height of the pandemic, liquidity dynamics took an unexpected turn, with local currency bonds proving to be more liquid than their hard currency counterparts due to the concentrated exposure of mutual funds in hard currency sovereigns. These funds were forced to sell down due to redemptions, while the local currency market was less stressed, with a lack of a recognized index meaning many investors ignore these securities. Once markets began to recover, hard currency bonds ended up having a period of strong performance for the last three quarters of the year. This experience underscores the importance of thorough market analysis and the understanding that liquidity can work both for and against investors.

The role of the US dollar

The interplay between local currency and hard currency bonds in the context of the US dollar's strength is often a major consideration for emerging market debt investors. However, frontier bonds behave much more like credit markets and, therefore, moves in the US dollar are less impactful. Factors such as a crisis in a particular country, a country running a large current account deficit, or rising inflation can significantly impact these markets. For example, Egypt, Nigeria, and Pakistan are some of the largest local markets, however, are un-investable due to the challenges they currently face, such as currency misalignment, below-inflation interest rates, and a deterioration in country fundamentals.

Consequently, while a period of weakness in the US dollar is expected to generally help some of these frontier countries, these markets are still trading more like credit markets, as opposed to the currencies trading off the US dollar.

Access to capital

The biggest challenge for frontier markets today is access to the international bond market. Typically, investors will avoid sovereign debt with double-digit yield, but they will also want to be compensated for the additional risk they are exposed to with frontier market countries, which is typically between 600 and 900 basis points more than the equivalent US Treasury.

For much of the past decade, the 10-year US Treasury has been yielding below 2%, meaning that frontier market countries were able to raise debt below a 10% yield. However, with the 10-year yield now around 4%, this immediately puts frontier markets into double-digit territory and consequently blocks their access to most international bond investors. This situation has been further hampered by a deterioration in credit risks, with an increase in defaults in frontier markets that seems likely to continue.

Navigating political changes and capital controls

Frontier markets are known for their political instability and the potential for sudden capital controls. With its recent political changes and ambitions to dollarize the economy, countries like Argentina serve as examples of the complexities these countries face. While, in principle, dollarization may help counter inflation rates that are regularly above 100%, the country lacks the foreign exchange reserves to make this possible. When combined with the fiscal deficit the country is running and an electorate historically prone to turning on its politicians very quickly, the difficulties frontier countries face despite well-meaning plans are apparent. That said, looking through an investor’s lens, Argentine dollar bonds could potentially be a good investment opportunity, currently trading around $27–$33 and with prospects for recovery still relatively attractive.

In the green transition

As the world transitions toward green energy solutions, some frontier markets stand out due to their resource positioning.

Zambia, a notable copper producer, is well-positioned to benefit from the global demand for copper, a critical component of electric vehicle batteries. While it has faced recent debt restructuring challenges, Zambia's ambitious plans to increase copper production make it a potential winner in the green transition and is a market worth watching closely.

Final thoughts

Frontier markets offer a unique investment landscape filled with opportunities and challenges. While there are risks involved, frontier markets continue to provide opportunities for active investors, while the bond market offers more diversity than may be expected. While navigating these markets requires careful consideration of liquidity, governance, currency dynamics and the potential for political shifts, there are many countries poised to benefit from key structural trends over the coming years.

Article adapted from a recent episode of our Emerging Markets Equities Podcast, “How to invest (and holiday) in the new wild west”, hosted by Nick Robinson.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.

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