Analysis: Risky frontier sovereigns evade government debt phobia

By Carolyn Cohn

LONDON (Reuters) – While investors balk at lending to debt-laden governments across the euro zone and even question holding low-yielding U.S. Treasury credit, some of the world’s riskiest governments are still finding willing lenders.

Sovereign debt from frontier markets is benefiting in part from revved-up investor desire for high yields and also diversification, given these frontier bonds tend to have a low correlation with the ebb and flow of major world markets.

Even given that rationale, some investors have had a lot of risk to absorb, considering this year’s outright default by war-torn Ivory Coast and the shrinking foreign exchange reserves of Soviet-style command economy Belarus.

Frontier markets such as Georgia, Montenegro and Nigeria have, even so, all issued or plan to issue sovereign bonds in 2011. And many of these bonds — such as Nigeria’s dollar bond in January — are debut issues.

Investors may well be skeptical about the performance of frontier borrowers, or nervous about their political or economic risks. But failing to hold them in portfolios can be a dangerous game because funds prefer not to travel too far from benchmark indices such as those compiled by JPMorgan.

“The attraction is diversification — new issuers have different economic drivers, you get some diversification in the portfolio,” said Graham Stock, chief strategist at Insparo Asset Management.

“There are lots of real money investors, long-only funds which benchmark against these indices. You stay neutral by buying the bond, or risk tracking error due to diversion from the index by not holding it,” he said.

Given ultra-low interest rates in the developed world, institutional investors have been struggling to grasp yield pick-up.

Frontier markets fill the gap which was once occupied by the traditional emerging markets like Mexico and Brazil, who now boast investment grade ratings, and therefore low debt yields.

Emerging sovereign debt spreads as measured by JPMorgan’s narrower EMBI+ index are trading at less than 300 basis points over U.S. Treasuries.

Brazilian long-term sovereign debt pays lower yields than Portugal, and Brazil has a better rating than Portugal from ratings agency Fitch. So investors need to go beyond emerging markets to the frontier markets for yield pick-up. African frontier borrower Ghana’s $750 million bond due 2017

has rallied sharply in price since its launch in 2007, but is still trading with a yield above 6 percent.

Traditional emerging market borrower Mexico’s $3.5 billion bond due 2017, in contrast, is trading at a yield of 3.5 percent.

Institutional investors in developed markets need higher returns to fulfill demands from policyholders, which asset classes such as frontier debt markets can provide.

“One of the big themes in the background is that of pension funds and insurance funds — one of the targets of pension funds is to meet annuity requirements of 6 percent or above to make adequate payments,” said Jeremy Brewin, a portfolio manager at Aviva Investors.

The lack of liquidity in some of this frontier debt also makes it less prone to the contagion and lock-step volatility which can hit global markets, providing a diverse play, away from more conventional borrowers.


Global emerging debt funds held around $230 billion at the end of January, according to Lipper data.

The vast majority are likely to benchmark against indices like the JPMorgan EMBI global diversified index, which currently contains 42 countries, including Belarus, Georgia, Nigeria and even the defaulted Ivory Coast.

All emerging market sovereign or quasi-sovereign dollar-denominated bonds totaling $500 million or more are eligible for the index, provided they meet liquidity and pricing requirements.

If a new frontier borrower enters the index, investors may not feel confident enough in their knowledge or judgment of the credit to avoid holding it in proportion to the index.

So they hold a “neutral” position in the bond, though in the case of frontier markets, this is likely to be a position of less than 1 percent of the overall index.

“Funds would have to have a pretty good reason not to be in the credit because if it did well, they would underperform and there would be questions from investors,” said Stuart Culverhouse, chief economist at frontier markets broker Exotix.

Ivory Coast was a fresh entrant to the index only last year, with a $2.3 billion debt restructuring. Many early buyers had to sell, due to the borrower’s failure to make a coupon payment. Ivory Coast’s bond has been surging in the past week, however, as investors speculate it will resume debt payments if presidential claimant Alassane Ouattara is successful in fighting against rival claimant Laurent Gbagbo.

Belarus also looks a more attractive prospect if the country, short of hard currency, gets a loan from Russia.

Culverhouse at Exotix says frontier debt returns are attractive, as long as investors do their homework before buying.

“For a lot of frontiers, with a couple of exceptions, the fundamentals are still pretty good.”

(Additional reporting by Sujata Rao; Editing by Ruth Pitchford)

Analysis: Risky frontier sovereigns evade government debt phobia