Passive investing is finding active challenges with Frontier bonds, according to the given text.
In the world of global finance, Frontier Market (FM) bonds offer a unique investment opportunity, despite their higher risk profile. These bonds, issued by countries considered as frontier markets, have gained attention due to their potential returns and the challenges they present.
Over the past two years, EM government bonds have seen a 27% increase in value. However, the high yield component of the JPM Emerging Market Bond Index, largely composed of Frontier Market bonds, has surpassed this figure, with a 36% rise. Over a three-year period, the high yield segment even outperformed the rest of the index, rising over 50%, while the rest gained just 14%.
However, the allure of Frontier Market bonds comes with its own set of challenges. The bid/offer spread on these stocks is often larger than that of Emerging Market bonds, and when issued in hard currency like dollars or euros, they are less liquid than their Emerging Market counterparts. When issued in local currencies, the illiquidity factor increases further.
The higher risk of default, as reflected in their credit ratings and higher yields on their stocks, is a significant concern for investors. This risk is further compounded by the lack of historical data compared to developed countries, as each Frontier Market country is unique in its own right.
Not all Emerging Market investors have the capacity to take advantage of the performance that Frontier Market bonds offer. A tailored and flexible approach is required to understand the fundamentals of which FM stocks to buy. Factors such as the government's revenue sources, export/import reliance, and commodity exports play a crucial role in this decision-making process.
The availability of foreign exchange (FX) can also have a significant impact on the liquidity of FM stocks, especially in countries with low daily FX volume. Some Frontier Market countries, like Kenya, have limited exposure to the US, with exports to the US last year being just $771m.
Investors need to be prepared for potential volatility in stock prices, as seen in the case of Ivory Coast in 2010, when the outgoing president was forcefully removed, leading to a default on a $29m interest payment on its Eurobonds. The election outcome in Ivory Coast in 2010 also led to a civil war, causing alarming volatility in stock prices.
Despite these challenges, Frontier Market stocks present an intriguing opportunity for investors who are willing to take on a higher level of risk. The largest investors in creditor committees for recent frontier market sovereign debt restructurings typically include major international asset managers and hedge funds such as BlackRock, Ashmore Group, and Franklin Templeton, as well as specialized emerging market debt funds and sovereign wealth funds.
In some cases, distressed stocks being restructured have yielded impressive returns. In 2024, Lebanese sovereign Eurobonds, for instance, jumped from 13 cents in January to 23 cents in September - a 77% return in just nine months.
One notable success story is Jamaica, which defaulted in 2013 and later accessed international bond markets again. Another example is Ghana, historically an oil exporting country, which now relies more on gold and cocoa exports, and lower oil prices currently help its current account.
In conclusion, Frontier Market stocks offer a promising investment opportunity for those willing to navigate their inherent risks. A tailored and flexible approach, considering factors such as a country's revenue sources, export/import reliance, and commodity exports, is crucial in making informed decisions in this dynamic market.
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