Hot demand for frontier debt is poised to start cooling off

Investors in frontier-market bonds are on course to get their best returns in seven years. It looks like it'll be a lot tougher in 2020.

Some of the biggest money managers are already becoming more selective. BNP Paribas Asset Management, which oversees almost $500 billion in assets, is sticking to countries with sound fiscal management such as Ivory Coast, or those with investment-grade ratings like Kazakhstan, Uruguay and Morocco. Aberdeen Standard Investments sees opportunities to get above-market returns by buying the bonds of Sri Lanka, Ecuador and Ghana.

Rising debt loads and the increasing prospect of defaults in Argentina, Lebanon and Zambia are making investors more nervous. The International Monetary Fund's estimate that the world economy is growing at its slowest pace in a decade is scarcely helping.

"We're going to have more and more defaults in the asset class," said Bryan Carter, London-based head of emerging-markets fixed income at BNP Paribas Asset. "Argentina, Lebanon, Zambia -- they're coming up. If it becomes a risk-off environment, spreads will easily rise again. Invest in investment-grade bonds in that environment. And there are very few frontier markets that are investment grade."

Read more: What Are Frontier Markets and Why Invest in Them?

Rising Debt

Total debt in frontier markets rose to a record $3.2 trillion in the second quarter of 2019, equivalent to 115% of gross domestic, according to the Washington-based Institute of International Finance, which covers about 30 such countries. More than 40% are under "debt stress or at high risk," nearly double the proportion in 2013, it said in a report on Oct. 31.

JPMorgan Chase & Co.'s Next Generation Markets Index, which tracks the dollar debt of what it calls pre-emerging countries, reached a record high this month. That's happened as the increased pile of negative-yielding securities -- now about $12.5 trillion -- and the U.S. Federal Reserve's monetary easing caused investors to buy riskier assets.

The average yield for the Next Generation index is 6.3%, about 118 basis points above that for emerging markets overall. It's gained 17% this year, the most since 2012 and beating the 13.2% return on the bonds of developing nations as a whole.

Read related story: Premium on Frontier Dollar Debt Attracts Yield Seekers: Chart

Assets in Aberdeen's frontier-market funds more than doubled over the past year to about $600 million, according to Kevin Daly, investment director for emerging-market debt in London. NN Investment Partners's equivalent funds grew nearly 30% to $390 million in the first nine months of the year, said Leo Hu, the firm's Singapore-based senior portfolio manager.

Reduced U.S.-China trade tensions, steady Chinese growth and the Fed and European Central Bank retaining dovish stances will be a prerequisite for the less developed emerging markets to reap "low double-digit" returns next year, Hu said.

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