Debt in riskiest markets a frontier too far?
Swing to smaller, riskier developing economies has brought the bulls out, but they may not be the safe haven their champions say they are
In the space of just eight weeks, investor sentiment towards developing economies has swung from exceedingly bearish to increasingly bullish.
Nowhere is this more apparent than in the smaller, illiquid and riskier parts of the developing world. Frontier markets - non-investment-grade and exotic credits such as Ecuador, Ivory Coast and Belarus - are in something of a sweet spot right now.
While their illiquid financial markets already make the asset class less correlated to price action in global markets - the MSCI Emerging Market equity index is down nearly 1 per cent over the past year, its frontier market counterpart is up 24 per cent - the recent improvement in sentiment towards risk assets is buoying demand for high-yielding frontier market debt.
In the past fortnight, three US dollar-denominated frontier market bond sales attracted significant demand from international investors.
On April 7, Zambia raised US$1 billion in Africa's first sovereign debt issuance of the year in a deal that was more than four times oversubscribed.
The following day, Sri Lanka sold US$500 million of five-year paper at a yield of just 5.1 per cent, with US investors accounting for half the demand.
Then, on April 9, Pakistan re-entered the debt markets after a seven-year absence, selling US$2 billion in five and 10-year bonds, with US investors accounting for two-thirds of the demand.
The sharpest declines in sovereign spreads over the past two months have been in the countries that form part of JP Morgan's Next Generation Markets Index (Nexgem), which tracks dollar-denominated government debt issued by frontier markets.
While spreads on mainstream dollar-denominated emerging markets debt have fallen by some 80 basis points since early February, Serbia's spreads have narrowed by 105, Vietnam's by 121 and Argentina's by 312.
Since the start of the year, returns on frontier market dollar-denominated bonds have exceeded those on emerging market debt and equities and even European and US high-yield (non-investment-grade) debt.
Nexgem returns are close to 6 per cent this year, compared with 3.8 per cent on European high-yield paper, 2.3 per cent on emerging debt and a meagre 0.7 per cent on emerging market equities, according to JP Morgan.
Indeed, yields on frontier market debt are sufficiently high to compensate investors for the capital depreciation stemming from the rise in US Treasury yields associated with the winding down of the Federal Reserve's monetary stimulus programme.
Yet there is a troubling disconnect between the strong demand for riskier frontier markets debt and the deteriorating creditworthiness of mainstream and safer emerging markets.
While the investor base for both asset classes is distinct, and frontier markets have proved resilient to the sell-off in emerging markets, the cat is out of the bag: last year's decision by the Fed to scale back, or taper, its asset purchases was supposed to have shaken investors out of their complacency when it comes to pricing risk.
If investors are still concerned about large and liquid emerging markets such as Turkey and Brazil, shouldn't they be more worried about shallow and illiquid frontier markets such as Pakistan and Zambia, to say nothing about Ukraine and Venezuela?
A cursory glance at the political, economic and financial challenges faced by frontier markets shows that the asset class is by no means the haven its champions claim it is.
Even Nigeria, now Africa's largest economy, has been looking more like a vulnerable emerging market than a supposedly resilient frontier market.
In February, Nigeria's president, Goodluck Jonathan, ousted the country's well-respected central bank governor, Lamido Sanusi, after his revelations about an alleged multibillion-dollar fraud in the country's oil industry embarrassed the government.
This put further strain on Nigeria's already vulnerable currency, the naira, which plunged to a record low against the dollar.
Nigeria's woes have thrown the vulnerabilities in frontier markets into sharper relief. The economic fundamentals of many frontier markets - including those that are now attracting strong demand for their debt - have been deteriorating of late.
Zambia's fiscal deficit reached 8.5 per cent of gross domestic product last year, helping fuel inflation, which, together with Zambia's weak currency, the kwacha, forced the country's central bank to raise interest rates by a hefty 175 basis points last month to 12 per cent.
The good news is that investors demanded a higher premium to buy Zambia's debt. The country had to pay a yield of 8.6 per cent on its 10-year US dollar-denominated bonds last week, compared with 5.6 per cent at a sale of 10-year paper in September 2012, eight months before the Fed let the tapering genie out of the bottle.
The bad news is that risks in frontier markets still appear to be underpriced. The spread between the Nexgem index (bar Argentina) and JP Morgan's benchmark EM bond index is now less than 80 basis points - close to its all-time low.
The frontiersmen are becoming too adventurous again.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy