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Emerging frontier markets: Good reward for risk

The market for major emerging market (EM) government borrowers is well established. We believe it should continue to generate robust, if moderate returns. A new and expanding segment includes sovereign borrowers from a broad range of generally smaller and less advanced emerging economies, so-called frontier markets. While default risks are quite limited in this segment, yields are higher, in part due to lower liquidity.

Generally good macro fundamentals

Frontier markets are considered developing economies that exhibit strong growth and generally moderate debt levels. Measured by capitalization and issuance, the five largest markets in the JP Morgan Next Generation Markets Index are Sri Lanka (12.4%), Nigeria (9.5%), Ghana (5.6%), Azerbaijan (5.5%) and Kenya (5.3%). Smaller markets are Uzbekistan, Egypt, and Ukraine.

Since the financial crisis, most of these countries have been catching up with or even surpassing other EM in terms of real gross domestic product growth. At the same time, inflation is lower and current account balances have been improving. Yet access to the international capital market to fund growth has been constrained due to investor risk aversion and still limited liquidity. For bond investors, this translates into a substantial spread and total return premium.

Limited liquidity suggests buy-and-hold approach

Frontier market bonds usually have short maturities, so their sensitivity to US interest rates is lower than for the main EM bond index. At the same time, investors are likely to benefit as credit ratings should generally improve. That said, some markets may suffer setbacks due to political instability or governance issues, or if borrowers face sudden liquidity constraints. Frontier bonds are thus more suitable for buy-and-hold investors with a high risk tolerance. Broad diversification and active management are key. Our favored markets currently include Egypt, Ukraine, Uzbekistan as well as Ghana, due to improving domestic macroeconomic policy frameworks as well as governance, rich natural resource endowments, or good demographic and growth prospects.