Constructive on frontier market corporate bonds

What do Uzbekistan, Paraguay and Vietnam all have in common? All three offer investors far higher potential returns than more established components of the emerging markets universe. They are among the so-called “frontier markets” – countries that are still in the early stages of economic development, but already possess fully functional financial markets, making it possible to invest in them. On top of that, many have favourable demographic structures with young and growing populations, as well as a bourgeoning middle class with its steadily rising demand for services and consumer goods. All have achieved above-average economic growth over the past several years and, according to the International Monetary Fund and the World Bank, will continue to do so in the period ahead. Some frontier markets also possess significant reserves of raw materials, which, in light of current global developments, are likely to gain enormously in importance.

J.P. Morgan’s NEXGEM government bond index reflects the investment opportunities available on frontier markets. As of the end of April, NEXGEM was showing a risk premium of 780 basis points. Prior to the Covid pandemic, this spread ranged between 400 and 500 basis points. Is this surge justified? In other words, are investments now far riskier than they were two years ago? It’s true that frontier markets ultimately cannot escape global trends. Like industrialised countries and more-established emerging markets, frontier markets are more heavily in debt than they were before the pandemic. And in an environment of rising interest rates, refinancing can be appreciably more expensive. Higher food and fuel prices usually also hit a poor country harder. That being said, corporate and country-specific developments are still the greatest performance drivers in frontier markets, and a thorough analysis of local conditions can therefore unveil correspondingly attractive opportunities to an active portfolio manager.

Vietnam looks especially attractive to us at this point in time. Often overshadowed by the problems of its large neighbour, China, Vietnam possesses all the aforementioned qualities: 25% of its 100 million-strong population belongs to the middle class – within 10 years it could be 50%. Its average per capita annual income of USD 2700 (as of 2021) has doubled in the past decade, and is expected to quadruple by 2030. Or take Paraguay, a small Latin American country with a population of 7 million that is benefiting from heavy demand for agricultural goods. Soybeans and beef account for 50% of its exports. Uzbekistan is also worth a closer look. The Central Asian country debuted on the international capital markets in 2019 and is steadily building up its financial markets. Government debt is at a low 40%. Its links with Russia are manageable. Remittances from seasonal workers in Russia amounted to about USD 6 billion in 2021 but will surely decline. On the other hand, Uzbekistan’s most important export commodities (gold, natural gas, cotton and other agricultural goods) are seeing stronger demand.

Investment opportunities can be found not just in government bonds but also corporate bonds. Often, these are smaller issues that don’t make it into the major indices and are penalised with an initial issue premium. Companies typically active on the capital markets stem mostly from the property and agriculture sectors. A real-estate developer in Vietnam, for example, plans and builds quality, high-value properties, providing homes for millions of the local population. And a meat producer in Paraguay benefits from abundant available farmland and, hence, lots of room for cattle. Bonds from such companies frequently trade at yields over 10% – an attractive risk-reward ratio.

There are few opportunities to invest in individual USD-denominated corporate bonds in these countries. However, if opportunities are pursued rigorously, a quarter or more of a portfolio comprising established emerging markets can be invested in these high-yielding emerging markets as a means of diversification. And diversification of fundamental risk factors is also very attractive for investors. The high correlation in prices that various frontier markets may show over short periods of time is driven mostly by liquidity. However, investors with a longer-term horizon should benefit from diversification potential.