A unique investment landscape

Frontier markets offer a diverse range of investment opportunities, spanning approximately 40 to 45 countries. Available securities include hard currency (those denominated in strong, globally traded currencies), local-currency government bonds, and hard-currency corporate bonds. This contrasts with frontier equity markets, which only have a handful of large-cap stocks in a few countries. As a result, frontier market bonds can provide better opportunities to diversify a portfolio, relative to their equity counterparts.

Addressing liquidity

Liquidity concerns have historically discouraged investors from venturing into frontier markets, especially from an equity perspective. However, worries about liquidity for frontier bonds have reduced over the past decade. Investors can further mitigate a liquidity crunch by utilising the range of investable securities.

Take the height of the Covid-19 pandemic. Then, liquidity dynamics took an unexpected turn, with local-currency bonds more liquid than their hard-currency counterparts. This was due to the concentrated exposure of mutual funds in hard-currency sovereigns. Many had to sell their holdings to meet redemptions. By contrast, there’s no standard index for local currency markets. As a result, international investors largely ignore these securities. Redemptions were therefore minimal. But, when markets started to recover, hard-currency bonds were again in favour. Performance was robust.

The take-home message? Liquidity can work both for and against investors. The key is to understand the dynamics at play and to conduct thorough market analysis.

The US dollar's role

US dollar strength is often a major consideration for emerging market (EM) investors. However, frontier bonds behave much more like credit markets than their EM equivalents and are less influenced by US dollar moves. Factors like a national crisis, ballooning current account deficits and rising inflation are more significant. For example, we previously held positions in Egypt, Nigeria, and Pakistan. They are now uninvestable due to currency misalignment (Egypt), elevated inflation (Nigeria) and political unrest/economic crisis (Pakistan).

So, a period of dollar weakness would help many emerging and frontier markets. However, investors should also be mindful of local issues and how they affect a bond’s performance.

Access to capital

One of the biggest challenges for frontier markets is access to international financing. Typically, investors avoid sovereign debt with a double-digit yield. Those who do invest, demand compensation for the additional risk. This typically runs between 600 and 900 basis points above the 10-year US Treasury yield. For much of the past decade, Treasuries yielded below 2%. Frontier market countries could therefore raise debt below a 10% yield.

However, 10-year US Treasury yields are currently above 4%. This immediately pushes many frontier markets into double-digit territory, making them inaccessible to international bond investors. A deterioration in credit risks and increased frontier market defaults have also weighed on the sector.

Navigating political changes and capital controls

Frontier markets are notorious (fair or otherwise) for political instability and the potential for sudden capital controls. Many nations face complex choices. Case in point is Argentina. Its new far-right President, Javier Milei, has a daunting in-tray. The federal deficit is huge, while the value of the peso has collapsed. Inflation is currently 140%. To tackle this, Milei has ambitions to adopt the US dollar as its official currency. However, the country lacks the foreign exchange reserves to make ‘dollarisation’ possible. Throw in an electorate quick to turn on its political class, and you can see the multifaceted challenges frontier countries like Argentina face.

That said, Argentine dollar bonds are trading around $27-33. This could potentially make them a good investment should a recovery materialise.

Frontier markets in the green transition

The world is transitioning towards greener energy solutions. Many resource-rich frontier markets are well-placed to benefit from the shift. Zambia, for example, is a major producer of copper, a critical component of electric vehicle batteries. True, the country has faced debt-restructuring challenges. Nonetheless, its ambitious plans to increase its copper output make it a potential winner as the energy transition gains momentum.

Final thoughts…

Frontier markets offer a unique investment landscape filled with opportunities and challenges. This includes its rich and diverse bond markets. Many nations are aligned to the key structural trends that will shape the coming decades. But navigating the sector requires careful consideration of liquidity, governance, currency dynamics and the potential for political shifts. That’s why we advocate an active approach to investing in this compelling asset class. 

Article adapted from a recent episode of our Emerging Markets Equities Podcast, “A sit down with a frontiersman – how to invest and holiday in the new wild west”, hosted by Nick Robinson.