By Alexis Roach and Ehsan Iraniparast, analysts at Payden & Rygel
One of main appeals of emerging markets debt is the breadth of geographical exposure available to investors.
The asset class has grown significantly in the past two and a half decades. There are 69 countries in JP Morgan’s popular EMBI-Global Diversified index today – when it launched in 1995, there was only eight.
In line with this expansion, there has been a growing number of smaller, high-yield rated issuers that have entered into the index. These ‘frontier economies’ are off the radar versus the more developed markets such as Brazil, Mexico and India.
Shocks and challenges
Emerging markets have confronted multiple shocks since 2020, including the pandemic, the increase in food and energy prices, and higher global interest rates.
For frontiers, which are smaller economies, this has resulted in higher yields and more limited access to dollar-denominated funding.
These global challenges raise the question – why should I invest in frontier economies? We consider three points to be salient.
First, among the 38 countries in the space, there is diversification potential. Second, there is plenty of differentiation among the sovereigns. And last and most important, frontiers have significantly outperformed the broader dollar-pay EM bond indices since inception.
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A comparison between the JP Morgan EMBI-Global Diversified index and the NEXGEM index substantiates this point. During 2023, the NEXGEM index returned 21% – nearly 1,000 basis points better than the EMBI-Global Diversified.
This outperformance continued through the first quarter of 2024, with NEXGEM climbing 5.2% compared to the 2% return from the EMBI-Global Diversified index.
Concerns and defaults
After the shocks following the pandemic period, some clients asked whether investing in frontier markets was too risky. We put some perspective on this issue.
Together, the seven frontier markets that defaulted on external index-eligible debt since 2020 account for just 1.4% of EM GDP.
Likewise, many of the weakest countries have already entered into payment difficulty and many of the weakest hands have folded. Our view is that the default cycle has played out.
With many investors drawing a similar conclusion, there was a strong rally in frontier sovereign debt in 2023. Many frontiers were expected to face payment stress over the period, but when this did not occur, they outperformed.
The other group of countries are those that already defaulted. The investment thesis is that these sovereigns are prepared to settle with their creditors on terms better than initially feared.
This highlights another relevant point – for most countries, the relationship with their creditors does not end after a restructuring. Countries typically renegotiate the terms of their debt and continue to engage with creditors as they restructure.
Diversification
Frontier debt investing allows for exposure to countries that cannot easily be found in other asset classes. This is not limited to dollar-denominated debt, as investing in frontier local markets also presents dynamic opportunities. Because frontier markets are smaller, they tend to be driven more by internal market dynamics.
This has two implications. First, local currencies in these economies are less correlated with other EM currency markets.
Similarly, these markets are not as saturated by international investors, so macro considerations in these markets can be more important than global drivers. Although, the potential for higher returns in such markets can come at a cost of less liquidity.
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How do we put this into practice? In the early months of 2024, we added local frontier exposure in markets such as Nigeria and Egypt.
From a top down perspective, these new additions come in a context in which global growth is supportive and multilateral support has been strong for EMs.
Looking from the bottom up, the medium-term debt outlook has shifted more favourably in these economies over the past day.
In Egypt, for example, it was due to significant external support from the Middle East and the IMF that was announced in February 2024.
Selection matters
It is clear that frontier economies have delivered superior returns compared to the broader EM universe since inception, but these greater return often come with greater risk. How should investors evaluate this risk-return puzzle?
Country selection is key. Investors need to evaluate whether country fundamentals are improving or deteriorating. This has translated in our portfolios to an overweight position that is concentrated in the countries where we have a positive outlook.
Our active positioning in frontiers has typically been above their share of the benchmark, but where we see a challenging outlook, we will take zero exposure.
See also: Diverging performance: What is driving emerging market returns in 2024?
