The equivalent of ‘buying low and selling high’ in bond markets is buying when yields are high and selling when yields are low. In this respect, it’s clear bond markets now look much more attractive than 18 months ago – but it’s the near 14% yield now available from frontier market bonds that stands out most of all.
Of course, another tenet of bond investing is the positive relationship of yields to risk. So the key decision for bond investors is always whether current yields give enough compensation for all risks.
Some key background on frontier bonds
While there’s no precise definition of ‘frontier’ markets, they are generally defined as being relatively more established than the ‘least developed countries’ but less established than ‘emerging markets’. This helps explain why frontier bond markets have traditionally been the highest yielding part of the broader emerging market debt asset class. The market has seen significant growth over the past few years. According to the Institute for International Finance, the total market capitalisation of frontier market government debt (both local and hard currency) is almost US$2 trillion.1
One well-known index, which seeks to proxy the hard currency frontier bond market and which gives exposure to 41 frontier issuers, is JP Morgan’s NEXGEM Index. For comparison, the current yield on this index of 13.78% is 63% higher than the hard-currency sovereign emerging market bond yield of 8.46%. It’s also 111% higher than the local-currency sovereign emerging market bond yield of 6.53%.2 The attractive comparative yield for frontier bonds reflects an historically high spread above US Treasuries of over 1000 basis points.
The current NEXGEM Index yield is currently inflated by the continuing inclusion of Ghana, Zambia and Sri Lanka. However, even if these three defaulted countries are excluded, yields are still just under 11%, which is historically and comparatively attractive.
Of course, a high yield can never be a sufficient condition for investing. Instead, it’s always important to understand the underlying drivers of that yield. In terms of unhelpful market factors, there’s no shortage of concerns. A major contributor to higher yields across all global bond markets has been surging US Treasury yields. This has stemmed from the unprecedented pace of US monetary tightening aimed at tackling high inflation. With interest rates rising almost everywhere, global growth is markedly slowing, with increased recession risk seen for the US and Europe.
Slower global growth entails a negative external demand backdrop. However, domestically, the credit position of frontier markets has generally weakened in recent years. A key driver of this was the unexpected surge in pandemic-related spending, which significantly increased public debt around the world.
The Russia/Ukraine shock has been another blow for frontier countries, essentially meaning lost access to international bond markets due to borrowing costs soaring to well above 10%. Nonetheless, while external risk events in recent years have led to defaults in countries such as Sri Lanka and Ghana, we don’t view this as a broader risk to debt sustainability for most of the other countries in the index.
…the key question for investors is whether today’s elevated yields provide sufficient compensation for all the risks.
All the above issues help provide context for the big surge in the NEXGEM Index yield from less than 7% as recently as September 2021. Going forward, however, the key question for investors is whether today’s elevated yields provide sufficient compensation for all the risks. There are four factors that give us a constructive view on the outlook for frontier market bonds.
- Fading negative impetus from US monetary tightening – US interest rates are expected to peak around the current level of 5.0-5.25%. Furthermore, the impetus from US monetary policy could well turn positive if current market expectations for US interest rates cuts before the end of 2023 are correct.
- Declining inflation – in virtually all countries, inflation has peaked and is now on a clearly downward path, which, as in the US, should pave the way for rate cuts quite soon. It’s also worth noting that the economic impact of sharply declining energy and food prices is larger for frontier markets, given these items’ heavy weighting in consumption baskets.
- Credit standing is highly idiosyncratic – while credit risk has generally increased, it’s worth noting that frontier countries with no market access don’t have any immediate upcoming maturities in 2023 and 2024. Additionally, there’s significant variation among frontier countries and genuine credit stress is limited to a few well-known cases. For skilled active investors, this environment can present opportunities to pick up high yielding bonds without taking too much credit risk.
- Historically attractive valuations – in addition to being a risk gauge, yields also serve as a key valuation indicator for bonds. In this respect, current frontier yields stand out against other bond segments. The current NEXGEM yield of 13.8% is over 60% above the long term 20-year average yield of 8.6%. By way of comparison, the current hard currency sovereign yield of 8.5% exceeds its long-term average by 31%.
Putting everything together
It’s notable that frontier market yields now far exceed most other bond market segments. While this historically indicates increased risks, in our view the amount of compensation of offer is more than adequate. This is particularly so amid a backdrop of some earlier concerns, including inflation and rising interest rates, either fading or even reversing. Finally, the significant degree of variation among frontier markets suggests a potentially attractive environment for credit selectivity and for achieving attractive yields without too much additional risk.
- Frontier Markets Debt Monitor, April 2023 Institute for International Finance.
- JP Morgan EM Bond Index Monitor, 3 May 2022, all yields as at end-April 2022