As the Fed starts its interest rate cutting cycle, asset managers have been making the case for emerging market (EM) debt to recover.
Indeed, EM bonds stand to benefit from duration tailwinds, high yields and easing financial conditions for underlying borrowers, according to Mohammed Elmi, EM debt senior portfolio manager at Federated Hermes.
But within the EM debt universe, Elmi (pictured) tells FSA he is particularly optimistic on frontier market bonds, and is overweight a number of frontier regions.
“We think the market dislocated; there are still attractive valuations, but because it’s not everybody’s cup of tea, it’s a diversifier with respect to core EM, or equities or other asset classes,” he said.
“As long as you can get comfortable with the story, can appreciate the direction of travel in terms of the sovereign credit profile, it’s an interesting opportunity to pick up some mispriced securities.”
“Credit at its best”
Some investors have been hesitant to buy frontier market debt due to the heightened default risks after the pandemic shock, and an increasingly challenging economic environment.
But because the asset class has been shunned by global investors, it makes it relatively insulated from the ebbs and flows in global risk appetite.
This is because frontier bonds are driven more by idiosyncratic factors such as bilateral and multilateral support, exchange rate fluctuations and domestic policy shifts, according to Elmi.
Indeed, sometimes the external and fiscal imbalances of frontier countries can only be resolved by assistance from the International Monetary Fund (IMF) or the International Development Association.
Elmi said: “Each of these issuers have their own idiosyncratic stories and drivers behind them. Sometimes you get frustrated because prices might move on the back of the S&P 500 or rates, whereas these individual stories are so fine-tuned and hardwired into the idiosyncratic story. So from a credit analyst perspective, it’s really credit at its best.”
Although frontier bonds may still trade off on a global risk-off day, Elmi argues that the idiosyncratic story behind each issuer is really what drives investor gains.
A recent example of this is Egypt, where the sovereign bonds were starting to price in a default as the country struggled with inflation and with managing its foreign currency reserves.
“We always thought that a default was unlikely,” Elmi said. “There was an IMF programme in place, and the IMF programme was quite small for the economy of that size.”
“So we always saw that at some point Egypt would probably need a second type of bailout, and it being strategically important in that part of the world, policymakers and international partners would likely have to sit down and work something out.”
Indeed, in March of this year, Egypt secured a financial rescue package from the IMF and a currency devaluation ultimately saved it from a debt crisis.
“Initially, we were involved in the dollar debt because that was being priced to default, but when the bailout happened we sold out some of those positions, and then we reinvested those into local debt as the fundamental picture improved,” Elmi said.
The Egypt component of the J.P. Morgan EMBI Global Diversified index in the first half of the year returned 20.38%, according to data from Bloomberg.
The journey from Frontier to EM
Elmi said he is overweight various frontier issuers in sub-Saharan Africa in particular, because in his view, investors are being compensated for the risk taken.
“When it comes to these markets you’re on this transition from frontier to core EM,” he said. “You can see the transition taking place: you’re seeing checks and balances, the adoption of a framework, inflation targeting from the central bank, and liberalistion in terms of FX.”
“All of these things help in terms of the public policy and economic policy frameworks, to assist in the journey from frontier to core EM.”
“If our thesis is right investors should be part of that ride. You can outperform, and add value.”
However, he stressed that there are still risks involved, and highlighted Zambia as an example.
Zambia in November 2020 became the first African country to default on its Eurobond debt during the Covid-19 pandemic.
After a lengthy restructuring negotiation, in May this year it managed to secure a $1.3bn loan from the IMF with agreement from other creditors.
