Kristin J Ceva, Managing Director, Payden & Rygel, writes that Emerging Market Debt (EMD) has continued to develop as an asset class, bringing with it a new subset of countries—EM frontiers.
We use three criteria to classify frontier economies—investment credit rating status (high yield), income status, and issuance size. Our definition of the EMD Frontier universe currently includes 36 economies.
Emerging Markets have confronted a number of shocks since 2020. This includes the pandemic, the increase in food/energy prices, along with a move higher in global interest rates. For frontiers, which are smaller economies, this has resulted in higher yields and more limited access to dollar-denominated funding.
Recent global challenges raise the question: What is the case for investing in frontier economies? Three are salient. First, among the 36 countries in the space, there is diversification potential. Second, there is plenty of differentiation among the sovereigns. Last and most importantly, since inception, frontiers have significantly outperformed the broader dollar-pay EM bond indices (proxied by the JP Morgan EMB-Global).
A comparison between the JP Morgan EMB-Global Index and the NEXGEM Index substantiates this point. The NEXGEM Index proxies frontier sovereign performance; it currently includes 33 of the 36 countries in our frontier universe. During 2023 the NEXGEM Index rose by 21 per cent, nearly 1,000 basis points better than the EMB-Global. This outperformance continued through the first half of 2024, with the NEXGEM returning +4.8 per cent vs +1.8 per cent for EMB-Global.
In terms of the macro trends in frontier economies, growth is higher for the group, which would be expected as they are starting from a smaller base. Turning to monetary policy, the news on inflation is less encouraging; it is higher, and food has a larger weight in the CPI baskets.
For investors, the willingness and ability of a sovereign to pay is the foremost concern. It is important to analyse the fiscal and external balance sheets across frontier economies and examine factors that determine payment capacity.
Our investment process entails evaluating whether country fundamentals are improving or deteriorating. In frontier markets, this has translated into an overweight position in the countries where we have a positive outlook on the countries’ fundamentals.
Too Risky?
The concern among investors is whether it is too risky to invest in frontier markets. Reflecting this concern, in December 2023, nine frontiers were trading at spreads 900 basis points above US Treasuries (we remove Lebanon from our market calculations). Excluding the sovereigns already in default, that left five countries in “distressed” territory.
Most of the economies that have defaulted are smaller and therefore have not had a systemic impact on the asset class. Together, the seven frontier markets that defaulted since 2020 account for just 1.4 per cent of EM GDP (using the EMBI ex-China as our universe). Second, after the shocks of the last four years, the weakest countries have already experienced payment difficulty. Colloquially, many of the weakest hands have folded.
With defaults tapering off, there was a strong rally in frontier sovereign debt in 2023. For context, while the NEXGEM Index returned 21 per cent last year, countries that were rated CCC or in default returned 50 per cent. Dividing this performance into two different categories, there are frontiers that many investors, going into 2023, expected to face payment stress. When this did not occur, these countries rallied strongly (El Salvador and Pakistan). The other group of countries was those that already defaulted. The investment thesis was that these sovereigns were prepared to settle with their creditors on terms better than initially feared. This has borne out in Suriname, Zambia, and most recently Sri Lanka.
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. Unlike some of the examples in the corporate universe, the net present value (NPV) on restructured sovereign debt has averaged about 50 cents on the dollar during the 1998-2022 period. Friendly restructurings can have an NPV over 75 cents on the dollar.
Diversification
Frontier debt investing allows for exposures to countries that can’t 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. Second, because these markets are not as saturated by international investors, macro considerations can be more important than global drivers. To be sure, in such markets, the potential for higher returns can come at the cost of less liquidity.
Differentiation
Looking at frontier economies as a group presents a unique set of challenges because this group of countries is so disparate. All are high-yield rated, though, we argue that not all can be painted with the same brush.
Some of the frontiers are ‘BB’ rated economies; within our universe of 36 countries, 14 are rated ‘BB-’ or higher by at least one rating agency. These countries are less vulnerable to event risk and have solid credit metrics. Examples of countries in this category include the Ivory Coast, Morocco, Paraguay, and Costa Rica.
On the other end of the spectrum, there are ‘B’ and ‘CCC’ rated credits, which could, in an adverse case, suffer from creditworthiness concerns. We saw some of these countries fall into distress post-pandemic. There are many countries between these two extremes—in some, credit fundamentals may not be rock solid, but there is not currently a high risk of default; examples would be Jordan, Nigeria, and Angola.
Our active positioning in frontiers has typically been above their share of the NEXGEM benchmark, but where we see a challenging outlook, we will take zero exposure. For context, within the NEXGEM universe described earlier, accounts that we manage only have exposure in 19 of the 33 countries. In short, we believe this market sector presents significant investment opportunities to those prepared to undertake in depth analysis of individual countries.
