Far from wild

Emerging market debt (EMD) has evolved from a homogenous to a much more heterogeneous asset class. Mainstream emerging markets (EM) can be defined by the original BRICS term coined in 2001 (Brazil, Russia, India, China), and the countries included in the enlarged G20, such as Indonesia, Saudi Arabia, South Africa, and Turkey. Frontier is the sub-asset class that has appeared largely due to the evolution of debt capital markets and the broad scale of issuance. For our purposes, EM frontier is defined as smaller countries with:

• High growth potential but low absolute levels of GDP
• Infrastructure deficits
• A low industrial base and low domestic savings 
• High dependency on imports of mainly manufactured goods 
• Issuers in need of “catch-up capital”
• Bilateral and multilateral support needed to manage economies

Characteristics of EM frontier issuers

The external and fiscal imbalances of frontier countries can typically only be corrected by assistance via the International Monetary Fund (IMF) and/or donor support such as the International Development Association (IDA), a part of the World Bank assisting low-income countries. During the post-Global Financial Crisis low-interest rate environment and periods of QE, a number of smaller and speculative-grade EM countries were able to expand their footprint. The tightening of global financial conditions in the wake of COVID and the Russia/Ukraine war was a setback, driving frontier-market yields and spreads to historically high levels and driving defaults. Today however, several potentially positive factors are supportive of frontier countries, making their debt an effective diversifier from other risk assets and core EM.

Frontier market countries are a vast subset of EM with many shared qualities, but each are also evolving at varying rates, requiring active managers to be selective and knowledgeable as to where each market is across the spectrum of development. Mexico and Brazil are examples of markets that have evolved from frontier status as demonstrated by their ability to increase reserves as a percentage of GDP since the 1990s. Argentina, on the other hand, is an outlier, not a frontier economy, but on the cusp while still a high beta/speculative debt market. Egypt is a typical frontier country in terms of the overall maturity of its economy. 

Diversification and growth potential

Today, frontier countries are well insulated from the ebbs and flows in global risk appetite, largely due to their hard currency bond performance being driven by a broader set of factors such as bilateral and multilateral support, exchange rate fluctuations and domestic policy shifts. Frontier bonds are slightly more illiquid and don’t typically move on a like-for-like basis with core EM, also offering an illiquidity premium. 

With the adoption of orthodox macroeconomic policies, IMF/WB support, credible central bank oversight and the building of FX reserves, defaulted names are successfully restructuring their defaulted debt on attractive terms to bondholders. Countries such as Zambia and Suriname have restructured their Eurobond obligations with new longer coupon bonds, with upside potential via instruments linked to GDP growth targets. 

In spite of the relative stages of development found in frontier countries, and perhaps counterintuitively, long-term default rates for frontier have been in line with broad EM, which typically varies between 2 and 4% year-to-year. Recoveries have hovered near 40%, so net loss experience has been quite low. With average spreads in the frontier space since 2001 of 593 basis points, risk/reward has been more than suitable. During volatile periods when defaults increase, frontier markets often follow selloffs with 8-12 month periods of strong performance, providing opportunity based on security selection for active managers.

We believe the majority of frontier market’s positive returns are the result of improving fundamentals on a country-by-country basis. As the Fed commences a rate cutting cycle, we believe additional opportunities will present across frontier markets. At the same time, a flexible and tempered approach to each unique opportunity is required.