In an especially interesting fixed income landscape, frontier markets matter in emerging market debt strategies right now. Within an emerging market debt portfolio, the optimal strategic allocation is arguably a combination of emerging market hard currency sovereigns with an overweight in frontiers and an overlay of corporate debt.
So why frontiers specifically? This is a part of the emerging market debt universe that is significantly under-owned, and under-covered, so the fundamental information is harder to come by. There is also a mispricing of risk – that is to say, the actual fundamental premise of default risk in these countries is far lower than is being priced in times of distress.
In short, the disconnection of perception of risk and the actual fundamental premise of default risk is where there is a large amount of value that fundamental researchers, such as ourselves, can unlock. As a result, investors should consider a bias towards employing a strategic overweight, given the higher risk premium and higher returns, alongside lower volatility than in global equities over time.
Numbers do not lie
Many investors think of frontier markets as being excessively risky but, the truth is, the numbers do not lie. If we look at the historical default rates in sovereign debt, and in frontiers specifically, it uncovers the fact that they are less risky than markets tend to perceive them to be. Over the period 1995 to 2021, for example, the historical default rate in frontier markets specifically was just 1.5%.
Another thing to note is that, even for those countries that defaulted – those that reflected an average default rate of 1.5% – the recovery rates were relatively high. Thus, while the average default rate of that period was 1.5%, the recovery rate was 55 cents on the dollar. The perception these countries are unlikely to give healthy returns, given the associated risks, is very quickly dispelled by these numbers.
It is also worth observing there are a vast number of frontier markets to invest in, which allows those who cover them to use a diversified approach. As an example, we operate a very strong risk-mitigation strategy so that when a country, due to unforeseen circumstances, does default, the impact on our portfolio is limited as a result of having very large and diversified holdings across frontier markets. That diversified approach helps manage the risks of any country eventually facing those circumstances.
The perception of risk is much higher in frontier markets than the historical rates show us. Furthermore, investors are being very adequately rewarded for taking these risks – not only given the significant yield advantage these countries have over developed markets, but also versus the investment-grade space and the broader high-yield universe of emerging markets. It is a very interesting sub-universe within the emerging markets space and one that should not be disregarded.
Yvette Babb is a portfolio manager at William Blair Investment Management