Emerging Markets (EM) governments used to finance themselves in dollars. Local markets were not well developed and foreign investors were reluctant to invest in local currency bonds for fear of high inflation, which would imply a probability of a significant loss of market value, often through currency depreciation. This inability for EM countries to borrow from foreigners in their own currency is referred to as “original sin” (refer to our blog of July, 2018, “Debt Sinners”). However, since the Asian debt crisis of 1997, many EM countries restructured their economies and introduced credible fiscal and monetary policies. Balance sheets improved thanks to a surge in global trade and an advantageous commodity cycle. With foreign investors looking for higher and diversifying returns, investing in EM local currency markets took off, especially after J.P. Morgan launched an investable index in 2003.  

Inflation risk in Emerging Markets is greatly exaggerated…

However, investing in local currency bonds is concentrated in larger EM countries. Smaller EM countries, often referred to as Frontier Markets (FM), are still mostly dependent on dollar financing if they wish to tap international markets. FM economies are less advanced economies in the developing world but, unlike undeveloped countries, still may offer viable investment opportunities. Most FM countries have a GDP of less than USD 100 billion. Examples are Kazakhstan, Kenya and Dominican Republic. Some larger countries, like Bangladesh, Egypt, Nigeria and Vietnam are often also labeled FM as their financial markets are less well developed or poorly accessible (or a bureaucratic nightmare to set up required accounts). Local currency financing is beneficial to EM countries for several reasons: it reduces their vulnerability to foreign capital flows, it allows for more effective fiscal policies by financing budget deficits in a non-inflationary way, and it can support monetary policy (e.g. quantitative easing). To put it differently, local currency financing frees a government’s fiscal and monetary policies from being yoked to those of the U.S. and Federal Reserve.

The idea of investing in local currency bonds of FM is not entirely new, but supply of investment opportunities and operational complexity have traditionally been barriers to the development of this market. TCX, a Dutch company, has provided hedging solutions since 2007 to multilateral development banks, mostly in the form of cross-currency swaps and FX forwards to transform dollar funding into local currency. TCX keeps some of the risk on its books but increasingly works with international investors to leverage its business. Multilateral development banks currently mobilize 0.6 dollars in private capital for each dollar they lend on their own account. Given high financing needs in FM, also to address climate change, development banks are asked to do more by mobilizing more private capital. In 2023, an independent experts group of the G20, convened by Larry Summers and N.K. Singh, has recommended to double this amount. The expert group specifically notes the scarcity of currency hedging opportunities for private investors to participate in projects, suggesting that private investors might be willing to take project risk if currency risk can be addressed. One way of doing this is for the development banks to issue local currency bonds or hedge risk with parties like TCX, whereby investors swallow the rate and currency risk but not the project risk. Of course, alternatively, FM countries themselves can issue local currency bonds. Some countries, for example Dominican Republic and Paraguay, offer easy access by issuing global bonds that are settled in dollars at the prevalent FX spot rate and can be cleared through DTC, Clearstream or Euroclear.

Investing in local currency FM can offer attractive returns due to high real yields; once these countries develop, real yields will decline. Domestic risk factors as opposed to global risk factors are expected to be much more important as involvement of foreign investors is low. This feature is expected to increase diversification when FM is added to a mainstream EM Debt mandate, consisting of larger EM countries that are included in the J.P. Morgan index. In order to assess the added value of FM, we constructed a simple FM index, consisting of 24 countries with data starting in January 2008 (it is difficult to find longer historical price series for many countries) to July 2024. For most countries we used bond data and for some countries, where this was not possible, we used non-deliverable FX forwards (with 2- and 3-year tenors). All countries were given equal weight in the index, with monthly rebalancing. We compared the monthly returns of our FM index with those of the J.P. Morgan index, the JPM GBI-EM Global Diversified index which is universally used to benchmark performance generated by EM Debt investment managers.

Over this period, FM achieved an annual return of 6.1% per annum against 1.2% for the J.P. Morgan index. Clearly, the history is limited and the outperformance was mostly generated in the period just after the outbreak of the covid-19 pandemic. The cause of this outperformance could simply be that FM typically has a shorter duration (2-3 years versus 5 years for the J.P. Morgan index) and that yields haven’t materially declined since the outbreak. So, once yields come down FM might underperform. Also, we did not take into account trading costs, which arguably are higher for FM investment instruments, and potential differences in taxes and other costs (e.g. custody costs). In addition, it may be an idea to review the optimal frequency of rebalancing (e.g. quarterly instead of monthly) as a higher frequency adds trading costs and could also reduce returns because of trending moves. But FM investment returns look promising.

Probably because of scary news headlines in respect of credit events, many investors perceive investing in FM as riskier than in the larger EM markets. This perception is not supported by the data, though. The graphs below show the distribution and dispersion of monthly returns for FM compared to the J.P. Morgan index.

Risk in FM is mostly of an idiosyncratic nature and in many cases initial losses are recovered by substantial repricing of the investment instruments (i.e. higher carry). FM has a low correlation to global risk factors. Clearly, diversification is key (but that is true for investing in general). Low liquidity is also often mentioned as a risk of investing in FM. We think that about one-third of a diversified FM portfolio is less liquid or illiquid. But duration of most investments is not longer than 2-3 years, especially for less liquid FM countries. We believe that a modest allocation to FM of say 10-15% in an EMD portfolio should be acceptable for most investors. This would help these countries to fund economic growth, improve living standards and prepare for climate change, whilst avoiding the risks of using dollar financing. Time to cross the next frontier…