Investors turn more cautious on “Frontier” debt

• Debt issuance by “frontier” economies has soared
• But low liquidity remains a problem for frontier debt
• Attention shifting to Asian energy importing nations
• Investors to seek risk premium from Africa oil exporters

LONDON (Reuters): Investors are turning more cautious about dollar bonds from “frontier” markets – a fast growing but less developed and higher risk sub-set of emerging economies – due to sliding oil prices, low trading volumes and expectations of smaller returns. Within the diverse group of economies, which ranges from Belarus and Belize to Egypt and Pakistan, interest is likely to shift in 2015 towards energy importing nations that will benefit from cheaper crude, and away from oil exporters. Debt issuance by frontier countries is a small proportion of the total for emerging markets, which are dominated by bigger names such as Brazil or Russia. But their governments have made the most of investors’ hunt for better returns while interest rates in developed economies remain ultra low.                         According to Thomson Reuters data, frontier countries sold $19.7 billion in hard currency debt last year - an almost 50% rise from 2013 and nearly three times the 2012 level. Yet many, especially oil exporters such as Nigeria and Ecuador, are likely to be hit hard this year by the dramatic drop in crude prices, said Kevin Daly, portfolio manager at Aberdeen Asset Management’s emerging debt team. “The outlook is tenuous for some countries, given the sensitivity for oil,” said Daly. “Investors will be a little bit more circumspect and demand a higher risk premium when it comes to these kind of commodities-sensitive countries in the current backdrop.”   With emerging market sovereigns overall issuing just over $100 billion in hard currency bonds last year, frontier markets remain a niche investment but they have been a rewarding one. Anyone who bought bonds from the around 30 countries in the benchmark JPMorgan Next Generation Emerging Markets index (NEXGEM) would have made a return of just over 10% last year. That compares with 7% for mainstream emerging sovereigns or 3.6% for emerging market corporate debt. Around half the frontier countries in the index achieved double digit returns as this graphic shows: http://link.reuters.com/jyk73w Few believe this performance can be repeated in 2015, but Aberdeen’s Daly expects a still healthy 4-5% return across NEXGEM in 2015. Roy Scheepe, senior client portfolio manager at ING Investment Management predicts 7-9%. Almost all of the world’s fastest growing economies in recent years fall into the frontier category, he points out.   “Fundamentals might be a little bit weaker, but for investors there is always the issue of alternatives - it’s not as good as it was, but then look at everything else,” said Scheepe. ING IM has $550 million of its assets under management in frontier markets, mostly hard currency debt. Among these alternatives are German 10-year bonds, yielding as little as 0.44%, or Brazil, whose dollar bond maturing in 2043 yields just over 5%. Investors are focusing on Asia – a region heavy in oil importing frontier countries such as Sri Lanka, which is holding closely-fought elections this week. On the flipside, they are averse to crude producers, especially sub-Saharan African economies like Angola, Nigeria or Gabon.   Issuance to continue? Overall, weak economies and falling oil prices bring more risk, making it costlier for governments to raise foreign capital. The cost of servicing dollar debt is also likely to rise once the US Federal Reserve raises interest rates, a move widely expected to come at some point this year. Paul McNamara at investment management firm GAM, which has $5 billion under management and invests in frontier debt, expects a lot of opportunistic issuance this year, making it hard to predict overall volumes. “Relatively few of these countries will have external issuance as core part of their budget or balance of payments for the year,” said McNamara, investment director at GAM. “In most cases, they can manage without, but they will issue ... if they can.”   JPMorgan expects issuance across NEXGEM countries to amount to $15.5 billion this year. Investors say the sector’s small size and high risk has in fact shielded frontier debt, as it tends to attract buy-and-hold funds with a high risk tolerance. The number of issues has grown from eight in 2012 to 18 last year. However, a lack of liquidity has prevented many investors from buying into frontier market debt, especially in uncertain times, and that is unlikely to change, says ING IM’s Scheepe. Tighter regulations since the global financial crisis aimed at encouraging banks to stay clear of higher risk assets have exacerbated the situation.   “The big issue is still liquidity - the number of investors, the number of issuers has grown, which is a good thing, but you just need one bit of bad news to change that,” said Scheepe. GAM’s McNamara is cautious. “The frontier sovereigns will be able to borrow, I am just not sure it makes a lot of sense from a buyer’s point of view,” he said. “This doesn’t strike me as a time to pile into relatively illiquid assets.”