Analysis: Frontier Markets booming but risks mounting


With the world's biggest central banks driving yields on safe assets to near zero, some investors are tossing caution to the wind and rushing to buy illiquid and previously overlooked bonds sold by countries with no capital markets track record.

Even the biggest investors acknowledge that "frontier markets" like Vietnam and Romania aren't for the faint of heart because nobody knows whether these new debt market players will be able to make good on their obligations.

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Buying their bonds could prove painful just as it did with emerging markets during the Argentine economic crisis of 1999-2002, Asian financial crisis of 1997, and Russian financial crisis of 1998.

As investors rush into frontier markets, analysts suggest careful selection among countries. Some fund managers even say not to bother with the sector, as its risks outweigh returns.

"The main risk when you buy a bond is the risk of default," said Nicolas Jaquier, emerging markets economist at Standard Life Investments, with $272.6 billion in assets under management and holder of Paraguay's debut bonds. "But it is a bit mistaken to group frontier markets all together because it is a very diverse group ... with diverse credit worthiness and default risk."

Bolivia, Paraguay and Honduras, three of Latin America's poorest nations with a collective gross domestic product of roughly $67 billion - less than half of war-torn Iraq's economy - have each recently debuted sovereign bond sales.

Paraguay, a first-time issuer with no track record of repaying foreign investors its debt, auctioned $500 million of sovereign bonds in January, four months before its presidential elections.

"The election wasn't much of a worry because in Paraguay there is a fairly broad consensus among the policy makers and parties around economic policy-making and what is good for the country," Jaquier said, adding that politics play a big factor in investment decisions.

The sale was nothing anyone anticipated. Investors grappled for a piece of the junk-rated 10-year bonds despite their paltry 4.625 percent interest. By contrast, highly rated General Electric 10-year bonds go for 0.58 percentage points more than Paraguay's.

Paraguay's debt offering, which had demand 12 times its total amount of debt for sale, or triple the norm, taps into the investor temperature for risk-taking and yield-hunting.

It illustrates the unintended consequences of the more than $2.7 trillion the Federal Reserve has injected directly into the U.S. economy. More recently, the Bank of Japan (BOJ) has joined the fray, launching a $1.4 trillion asset-purchase program of its own.

The aggressive policies of central banks like the Fed and BOJ have pushed investors - even conservative ones - to buy into more illiquid assets in underdeveloped and opaque markets that offer slightly higher returns, but at a much higher risk, amid persistently low rates for safer bonds.

Jim Carlen, portfolio manager of Columbia Management's Emerging Markets Bond Fund, with $166 billion in assets agrees that investment is on a "country by country basis but if you look at all these countries as a whole, like Rwanda, Paraguay, Honduras, and you ask yourself: are you really getting compensated for the level of risk in these countries? I would argue not."

"The tightness in the spreads that you are seeing in these countries is really a factor of the significant level of liquidity in global markets and significant inflows into emerging market fixed income specifically," Carlen added.

The frothiness of investing in frontier markets are mounting, however.

Not only are these small countries raising capital on international markets for the first time but are doing so at rock-bottom interest rates that would have been inconceivable less than half a decade ago.

In late April, Rwanda, ravaged by genocide 19 years ago, sold $400 million of euro-denominated bonds, its first international debt sale, with a coupon of 6.625 percent, only half a percentage point above the average yield to maturity for a U.S. high-yield corporate bond, according to Bank of America Merrill Lynch Fixed Income Index data <.MERH0A0>.

The deal, described by one underwriter as "priced to perfection," drew $3.5 billion in orders .

Frontier markets are considered a risky subset of an already risky asset class: emerging markets. Few have track records for making good on their obligations, and countries such as Argentina, have had a history of political upheaval and sudden regime changes.

In 2002 Argentina defaulted on more than $100 billion, the biggest loss to sovereign debt investors in modern times, caused by weak economic policies, hyper-inflation, recession and extreme indebtedness.

Investors, however, are picking and choosing their holdings by doing due diligence including traveling to the country and talking to all sectors of society. Many emerging market investors have offices throughout the world to stay on top of the regions's political and economic pulse.

"If you look at Egypt, they are on the brink of collapse and you can chase it down to politics and their lack of willingness to address subsidies," Jaquier said. Since its Arab Spring 2011 revolution, Egypt has experienced instability in the banking system, absence of financing support, run-down of international reserves and a sharp rise in government funding costs among others.

Before buying frontier debt investors assess default risk by how much debt the country holds, its fiscal and external balances, and how it can generate foreign exchange.

"Paraguay has very low debt, the central bank has been targeting inflation, and the budget process is fairly sound. They give us more confidence that the government will meet their obligations and it is going to want to pay its interest and repay our principle," Jaquier said. "Compared to other countries like Honduras, where we are less positive, given their fairly high debt profile."

Honduras issued their first international bond last year because they were running out of financing options domestically. Honduras last month issued a $500 million bond due in 2024 with a 7.5 percent yield, or 547.9 basis points over U.S. Treasuries.

Access to global capital markets is allowing many frontier countries to lock in long-term financing at manageable interest rates. It is also helping some shed their dependence on official aid flows.

For investors, it means a rapidly expanding universe of issuers, diversification, and higher average yields. And frontier economies are among the least indebted and fastest growing economies in the world.

Big sovereign wealth funds such as the Abu Dhabi Investment Authority, the world's second biggest with $600 billion under management, and institutional investors including Standard Life Investments and Ashmore Investment Management, own frontier assets that in the past they would otherwise have turned down.

Jan Dehn, co-head of research at emerging market specialist firm Ashmore Investment Management, which owns $78 billion in emerging and frontier market assets, said: "There is a bubble in fixed income, but it is found in the heavily indebted developed countries, not the frontier markets."

Dehn contends U.S. government bonds are riskier than frontier markets, saying a U.S. 10-year Treasury Note that yields around 1.65 percent provides inadequate compensation for inflationary risks he sees as likely to emerge.

Still, Treasuries benefit from the U.S. dollar's status as the world's primary reserve currency, which helps burnish their global acceptance. And unlike nascent frontier issuers, the United States has an established track record of repayment.

"In fairness, many of these so called more advanced emerging economies were all frontier countries at some time except that when they came to issue in the market in that point in time they didn't have this current liquidity condition," said Hari Hariharan, Chairman of NWI management a hedge fund that manages more than $2 billion in emerging market debt.

(Reporting by Manuela Badawy; editing by Andrew Hay)