Deliberating EM Debt

Frontier markets move to the fore

With compelling valuations and strengthening fundamentals, frontier markets are starting to move back onto asset allocators’ radars as the external backdrop improves. Careful navigation is key, but the potential rewards are substantial.

10 Apr 2024

14 minutes

Thys Louw
Balwinda Hackett

At a turning point

In the wake of COVID-related turmoil, Russia’s invasion of Ukraine in 2022 sparked a tightening of global financial conditions, resulting in the closure of external-market access to a broad swathe of frontier markets. This brought frontier-market yields and spreads to historically high levels. It also resulted in Ghana, Sri Lanka and Zambia and several other stressed markets defaulting on their debt. Today, few frontier market economies face refinancing risk, and many have robust fundamentals – with growth, debt-to-GDP ratios, and fiscal balances typically healthier than in some key developed markets.

With external pressures now easing, asset allocators are starting to re-engage with the frontier-market opportunity. And with a market cap of over US$1.4 trillion – similar in size to the c.US$1.2 trillion US high-yield market – comprising 50 liquid investable markets and with daily turnover of c.US$2 billion, the frontier debt market universe has reached the scale at which more significant capital deployment is possible.

Defining frontiers

The distinction between frontier and emerging markets relates to their relative level of economic and financial-market development. Approaches take into consideration the following:

  • Economic development criteria: per-capita income; government institutional quality.
  • Financial market development criteria: qualitative and quantitative assessment of financial market development and liquidity; representation of the respective country within global fixed income benchmarks.

Under this framework, we currently classify about 50 countries as liquid frontier bond and currency markets (i.e., markets with daily traded instruments).

The frontier market space is a subset within EM debt and has traditionally been the highest yielding part of the broader asset class. Frontier markets generally provide a significant yield pick-up for almost half the duration of more mature emerging markets. Crucially, these favourable duration and yield comparisons do not always reflect higher risk, but rather market-development factors; nascent domestic savings industries in frontier-market economies mean that demand for longer-dated assets is less entrenched than in more developed markets.

We believe the growth and demographic dynamics that favour frontier markets will see them continue to become a larger part of the global economy, and that frontier-market debt provides direct access to the long-term growth and development story.

Liquid frontier market universe

Africa Angola, Benin, Botswana, Cameroon, Egypt, Ethiopia, Gabon, Ghana, Côte d’Ivoire, Kenya, Morocco, Mozambique, Namibia, Nigeria, Rwanda, Senegal, Tunisia, Uganda, Zambia
Asia Maldives, Mongolia, Pakistan, Papua New Guinea, Sri Lanka, Vietnam
Europe & CIS Armenia, Azerbaijan, Georgia, Kazakhstan, Macedonia, Tajikistan, Ukraine, Uzbekistan, Montenegro
Latin America Argentina, Barbados, Belize, Bolivia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Guatemala, Honduras, Jamaica, Paraguay, Suriname, Uruguay
Middle East Bahrain, Jordan, Iraq

Source: Ninety One, as at December 2023
Key: Local Currency Bond and/or FX Market Access; Hard Currency Bond Market Access; Hard and Local Bond/FX Market Access.

Valuations

While it is logical that investors should expect frontier markets to pay a premium – related to rating and liquidity differentials – over emerging markets, this is now close to historic highs, as shown in Figure 1. This reflects a brutal few years for fixed income, when frontier markets were caught in the eye of the storm. Relative to other asset classes and to historical yields, the entry point for both frontier local currency and hard currency markets is compelling, in our view.

Figure 1: Historic yields across various fixed income asset classes

Source: Ninety One as at 31 January 2024, Representative indices shown (detailed in Appendix).
For further information on indices please see Important information section in the PDF.

Furthermore, on a risk-adjusted basis, we find that investors in frontier markets are being adequately rewarded for the associated currency and credit risk, as outlined below.

Using our proprietary currency risk model (‘FRISKI’), we found:

  1. Frontier markets face a similar risk of a currency crisis to that faced by broader emerging markets, suggesting from a fundamental perspective that the risks are similar across the two subsets.
  2. Even though fundamental risks are similar across frontier and emerging economies, frontier markets pay investors over 2x the volatility-adjusted carry.

Turning to credit risk, we looked at the historic spread differential between emerging and frontier markets and compared that to the rating differential between the two. We use five-year maturity sovereign spreads and median ratings from Fitch, Moody’s and S&P. On average, over the last 10 years, there has been a reasonably consistent six-notch rating differential between frontier and emerging economies, but the premium or ‘spread’ investors are being paid to own that risk is significantly higher than in the past, with this only having been higher during peak crisis times, such as June 2020 (COVID).

A highly diverse opportunity set

The term ‘frontier’ is often associated with a sense of the unpredictable, which in investment terms usually equates to higher risk. Yet the reality is often more nuanced and requires an understanding of both the huge variety of economies the universe represents and the different assets that can be used to access the opportunity set. Significant differences exist in the risk and liquidity characteristics of frontier local versus hard currency markets even for the same issuing country. These often relate to investor participation and degree of market development, as summarised in Figure 2. Key observations include:

  • Local currency frontier markets have historically been less volatile than hard currency frontier market debt markets and the more mature EM local currency debt markets. They have also offered higher yields and smaller drawdowns. This is due to a relatively low level of foreign participation within these markets, given limited representation in established benchmarks, administrative hurdles to entry, and the lack of understanding of local dynamics. As a result, slower-moving capital flows generally determine the direction of travel for these assets.
  • Hard currency frontier markets: this universe comprises a larger number of investable markets with higher levels of liquidity. For larger issuance needs, frontier-market issuers often look towards US dollar debt markets, where they can access deeper pools of international capital. Most of this issuance also goes into global benchmarks, which have minimum liquidity requirements – meaning a certain degree of liquidity is available through the cycle. However, this comes at the cost of lower diversification potential (i.e., higher beta to global indices) in general.

These differences provide active managers with plenty of opportunities to seek to maximise risk-adjusted return potential and build diversified – and diversifying – portfolios.

There is significant diversity both in the economies underlying the frontier-market universe and the characteristics of the assets that can be used to access the opportunity set.

Figure 2: Hard vs. local market debt – frontier markets

Frontier market hard currency debt Frontier market local currency debt
Return drivers US Treasury yield and spread Local bond yield and FX return
Universe* 45 countries 24 countries and 31 Non-Deliverable Forward (NDF)/deliverable FX markets
Yield 11.1% 17.9%
Duration 5.2 years 5.1 years
Volatility 12% 4%
Max. drawdown -31% -12%
Advantages
  • More than double the daily turnover of frontier local (on average).
  • Offers higher returns than other EM asset classes (over the long-term).
  • Some countries can only be accessed through US dollar debt.
  • Very low beta to global indices.
  • Small max. drawdown across diversified local currency portfolio.
  • Yields more consistently close to double digits.
  • Majority of universe off-index and no other way to get exposure.
  • NDFs provide the ability to manage conversion risk.
Disadvantages
  • Higher beta to global indices.
  • Higher returns come with high volatility and higher drawdowns.
  • Exposure can be gained through other high-yield equivalents.
  • Less liquid and liquidity is more concentrated in certain names.
  • Overall lower returns historically.

The amount of income payable may rise or fall.

Source: Ninety One as at 31 December 2023. *Universe is referencing the ‘liquid frontier universe’ which we define as having turnover of more US$20 million a month. Frontier dollar debt returns are based on JP Morgan NEXGEM returns; frontier local debt is based on an equal-weighted local portfolio of frontier local markets (Azerbaijan, Botswana, Costa Rica, Egypt, Georgia, Ghana, Ivory Coast, Kazakhstan, Kenya, Morocco, Mongolia, Mozambique, Namibia, Nigeria, Pakistan, Serbia, Sri Lanka, Tunisia, Uganda, Ukraine, Uzbekistan, Vietnam, Zambia). Volatility shown is annualised 10-year volatility. Max. drawdown uses peak to trough from monthly observations, from 31 December 2013 to 31 December 2023.
For further information on indices, please see Important information section.

Historical return outcomes for frontier markets

Historically, local currency frontier-market debt has – in aggregate – delivered lower absolute returns but higher risk-adjusted returns than hard currency frontier-market debt due to its lower volatility, as shown in Figure 3. It can also be seen that hard currency frontier market debt has higher volatility in aggregate, but over the cycle rewards investors with significantly higher returns relative to other emerging market fixed income asset classes.

Figure 3: 10-year annualised return vs. annualised volatility of frontier and global fixed income indices

Past performance does not predict future returns; losses may be made.

Source: Bloomberg, Ninety One calculations, 31 December 2023. Representative indices shown (detailed in Appendix). For further information on indices, please see Important information section in the PDF.

Fundamentals

Over the last 10 years, investors have faced several large shocks. The first came in 2015 with the collapse of oil prices and subsequent volatility in oil markets, which significantly impacted the structural growth trajectory and funding environment for oil-exporting frontier markets. The second was in 2020 with the global COVID-19 pandemic; the economic toll of this event was particularly heavy for frontier economies given their lower levels of domestic savings and a large exposure to tourism in some countries. The final and most recent shock happened in 2022 with the Russia/Ukraine war, and the subsequent tightening of global financial conditions, which resulted in the closure of external market access to a broad swathe of frontier markets. These shocks dented many global sovereign balance sheets, and in the case of frontier markets, led to pockets of distress and, ultimately, defaults. But here it is important to look beyond the headlines; below we analyse how frontier economies have fared and share our expectations for the future.

Despite the headwinds they have faced, frontier economies have continued to show resilient growth – especially outside of the oil exporting countries, which have faced more growth volatility post the 2015 oil-price correction - as Figure 4 illustrates. From a structural perspective, this growth trajectory is supported both by more favourable demographic dynamics and by significant scope for (and structural reforms to ensure) increased participation and investment of the private sector in many economies.

Favourable growth dynamics not only support continued improvement in countries’ credit quality, but also act as a catalyst for continued expansion and development of these countries’ financial markets. However, it is important to note that given the breadth and idiosyncratic nature of many frontier markets, there is diversity within the space. Even though we have split the universe between oil importing and exporting nations below, the underlying growth drivers often vary dramatically even within these subsets; economies such as Costa Rica, Dominican Republic and Kenya are more services driven, while the likes of Morocco and Senegal have structural growth drivers related to the development of new industries within their economies. An in-depth understanding of the underlying drivers of each of these diverse economies is vital for investors.

Despite the headwinds they have faced, frontier economies have continued to show resilient growth.

Figure 4: Real GDP growth premia vs. United States

Forecasts are inherently limited and are not a reliable indicator of future results.

Source: IMF WEO October 2023, Ninety One calculations. For details of countries included in the frontier oil exporter and frontier oil importer categories, please see Appendix. For further information on indices, please see important information section in the PDF.

As further evidence of fundamental strength, debt balances of frontier-market economies are currently undergoing their largest decline since the early 2000’s, driven by significant tightening of fiscal balances and a rebound in growth. The NEXGEM index represents frontier hard currency markets, and Figure 5 illustrates how debt/GDP ratios of frontier countries in this index appear to have peaked; this stands in sharp contrast to the dynamics seen in other markets, where debt balances have continued to rise.

Figure 5: Debt to GDP

Forecasts are inherently limited and are not a reliable indicator of future results.

Source: IMF WEO October 2023, Ninety One calculations. For further information on indices, please see Important information section.

Furthermore, we find that even in a world of higher-for-longer interest rates, frontier markets are running primary balances that are now well above what is required to continue to bring debt down and are forecast to record positive primary balances as a percentage of GDP for 2024 and 2025.1

External pressures are easing, with refinancing risks concentrated in select names

Higher global rates and tighter external funding conditions naturally raise questions about debt sustainability across frontier markets, especially as some markets’ external debt maturities start to pick up over the next few years. We examined external financing pressures using an analysis of the financial inflow required to stabilise reserves at three-months’ import cover. This revealed that at least two-thirds of frontier market countries did not require inflows to stabilise reserves, and only six countries (El Salvador, Namibia, Kenya, Tunisia, Bolivia, Angola) from 31 analysed required between 10-25% of GDP, and thus could be deemed more at risk from external financing requirements.2 Nevertheless, with the relative stability seen in US Treasuries and evidence of frontier markets accessing external capital and issuing again in 2024 (e.g., Côte d’Ivoire, Paraguay, and a debut issue from Benin), pressure has reduced across the board.

In the short term, various support packages from the IMF, World Bank and other multilaterals have reduced immediate funding concerns, with the IMF’s approval of higher quotas providing an additional boost for countries that approach the institution for funding. See a recent note on Egypt here. In addition, and as already mentioned, the easing of global financial conditions as global inflation and monetary policy risks abate will provide some level of market access to a number of frontier markets, further reducing the fears of the impact of a prolonged ‘sudden stop’ of capital.

Over the long run, the scale to which market access will be available is yet to be determined. Therefore, continued reform momentum and the expansion of funding options geared towards sustainable investing are vital, in our view. To that end we have already seen several countries lead the way, creating a template for what the future of financing in frontier could look like.

Sustainable issuance is gaining in prominence

Under a recent deal with the EU, Senegal will receive EUR2.5 billion to help fund its energy transition, establishing a goal to reach 40% renewable energy in the electricity mix by 2030. Elsewhere, Ecuador, Barbados, Seychelles, Gabon and Belize have all carried out various forms of ‘debt-for-nature’ swaps, often backed by The Nature Conservancy, and sometimes coming with guarantees or risk insurance from multilateral development banks, reducing risks.

In summary

Frontier markets are currently at an exciting juncture where excessive premia meet improving fundamentals in a growing, under-invested and under-researched asset class. Informational asymmetries make detailed and diligent analysis a vital first port of call for risk management, but frontier-market debt offers scope for attractive risk-adjusted returns for investors with the right expertise. Current yields and spreads are high, both in a historical context and relative to other asset classes, yet fundamentals are improving.

The expected growth differential of frontier markets vs. the US, as well as the declining trajectory of debt balances looks favourable. While pockets of distress remain, the potential rewards coupled with improving external dynamics are likely to lead to a continued increase in focus on the asset class, especially as external headwinds fade.

Download PDF

1 Source: IMF WEO October 2023, NEXGEM Frontier countries, Ninety One calculations. Forecasts are inherently limited and are not a reliable indicator of future results. For further information on indices, please see Important information section.
2 Source: IMF WEO October 2023, Moody’s, Bloomberg, Ninety One calculations.
For professional investors and financial advisors only. Not for distribution to the public or within a country where distribution would be contrary to applicable law or regulations.

General risks. The value of investments, and any income generated from them, can fall as well as rise. Past performance does not predict future returns, losses may be made. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments

Specific risks. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g., bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Derivatives: The use of derivatives may increase overall risk by magnifying the effect of both gains and losses leading to large changes in value and potentially large financial loss. A counterparty to a derivative transaction may fail to meet its obligations which may also lead to a financial loss. Interest rate: The value of fixed income investments (e.g., bonds) tends to decrease when interest rates rise. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other system.

Authored by

Thys Louw
Balwinda Hackett
More in the 'Deliberating EM debt' series

Important Information

This communication is provided for general information only should not be construed as advice.

All the information in is believed to be reliable but may be inaccurate or incomplete. The views are those of the contributor at the time of publication and do not necessary reflect those of Ninety One.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.

All rights reserved. Issued by Ninety One.

For further information on indices, fund ratings, yields, targeted or projected performance returns, back-tested results, model return results, hypothetical performance returns, the investment team, our investment process, and specific portfolio names, please click here.