Frontier bonds – thoughts of an ageing bondie….

After 35 years of analysing bond markets, one thing I've learned consistently over the piece is that ‘when everything turns gloomy and the outlook becomes clouded, this can often be the best time to start hunting for yield’. Based on this time-tested rule of thumb, the frontier bond market, which now yields almost 11% (JPM NEXGEM index)1, could be worth a closer look…

Frontier bond markets background

While there is no precise definition of a ‘frontier’ market, they are generally defined as countries with low per capita GDP. According to the UN, there are currently 46 such countries. Frontier market bonds have traditionally been the highest yielding part of the emerging market debt (EMD) asset class. The market has seen significant growth over the past few years, with total market capitalisation now standing at $865 billion, making for a more liquid and diversified market.

One well-known index, which seeks to proxy the frontier bond market and gives exposure to 42 frontier issuers, is JP Morgan’s NEXGEM index. For comparison, the current yield on this index is10.97%. That's 49% higher than the hard-currency sovereign emerging market bond yield of 7.38%. It's also 62% higher than the local-currency sovereign emerging market bond yield of 6.77%¹.

Comparative bond asset class yields

Source: JP Morgan EM Bond Index Monitor, 3 May 2022, all yields as at end-April 2022

Historically elevated yields

Of course, an optically high yield can never be a sufficient condition for investing. It's always important to consider the underlying drivers of this alongside a wide range of other financial metrics. In terms of unhelpful market factors, there's no shortage of concerns at the moment. The Covid-19 pandemic was closely followed by the Chinese real estate debacle, the meteoric rise in global inflation and tighter monetary conditions. Then there was the shock of the Ukraine war, which further exacerbated global inflationary pressures via higher energy prices.

All these factors have certainly increased the risks of owning frontier market bonds, which helps to explain why the yield on NEXGEM index has surged from 6.3% at the end of 2020 to nearly 11% at present1. However, the first thing to note within this broader context is the significant diversity within frontier markets, meaning varied exposure to such risk factors. For example, the inflation picture is not all negative because a number of frontier markets benefit from higher commodity prices, which supports their growth and tax revenues.

Volatility perspective

Another perspective on risk comes from the volatility of returns. Historically, the variance of frontier bond returns has been more in line with equities than typical bond asset classes. This shouldn't be too surprising since past frontier returns have also been similarly higher. Accordingly, when global equity markets sold off in the first quarter of 2021, frontier bonds followed suit. A difference today, though, is that equity markets have recovered some of the ground they lost as a result of the Russian invasion, while frontier bonds have not. This could potentially signal an investment opportunity. More broadly, the selling of frontier bonds tends to be closely associated with general risk-off periods. Since these are not often specific to frontier markets, they can potentially be fruitful periods for finding mispriced assets.

Favourable technical backdrop

The technical backdrop, which looks at the amount of supply of new bonds (i.e. new issuances) relative to demand, is also important for bond markets. In this respect, conditions look quite favourable at present for frontier markets since year-to-date new issuance has been very light. Furthermore, future issuance is likely to focus on domestic markets or support from the World Bank and other multilateral agencies. On the demand side meanwhile, re-investment (i.e. of coupon inflows) has also been net positive (i.e. higher than the volume of issuance), which helps support the stability of the market.

Importance of selectivity

Another key lesson I've learned over the past 35 years is the importance of selecting the right names. This matters in the context of higher-yielding bonds because downside risks are typically higher than for lower-yielding assets. So in this context, careful research aimed at avoiding those frontier countries where the high yields might represent more serious concerns becomes particularly important. On the flipside, logic also suggests the chance of finding underpriced assets might be better in smaller markets such as frontier bonds, as on the whole they tend to be less researched.

Putting everything together

In summary, the frontier bond market is presently offering a yield that far exceeds most other bond market segments. Historically, such periods have been opportune times to invest in the market, with the potential for both high income and capital growth from future yield normalisation. However, it's important to understand that, as in the past, high yields essentially reflect an environment of elevated risks, which investors need to carefully analyse and manage. As such, effective selection is paramount for investors looking to take advantage of the current opportunities in frontier bond markets.

References: ¹ JP Morgan EM Bond Index Monitor, 3 May 2022, all yields as at end-April 2022