With spreads on sovereign emerging market debt over US treasuries compressed at their lowest levels in history and returns on developing nations’ stocks likely to be at their smallest in four years, investors will have to focus on other areas in emerging markets in order to make sizeable returns. Funds with a strong stomach and a sense of adventure should maybe turn their attention to more esoteric markets such as sub-Saharan Africa, Cuba and Bosnia.
Although many of these markets will be off-limits to most traditional long-only fund managers, they could provide rich rewards to hedge funds and other investors that have the capacity to take on big risks. Take sub-Saharan Africa-ex South Africa, for example. So far this year in equities, this region is outperforming developed nations as well as the more mainstream emerging markets. Sub-Saharan Africa-ex South Africa posted a return of 17.4% in dollar terms in the first quarter, according to Exotix, a broker that, as its name implies, specializes in these offbeat markets. This contrasts with a return of 2.1% for the MSCI World Index and of 1.8% for the MSCI Emerging Markets Index over the same period.
In the debt world, it’s harder to offer a similar comparison. But one-off trades in illiquid or toxic instruments can be very profitable. Recent examples include Serbia’s London Club loans, Nigeria’s oil warrants and Bosnia’s B GDP warrants. Investors who bought Serbia’s London Club loans in the first year after the removal of Slobodan Milosevic in October 2000 earned returns of between 100% and 500% over three years, according to Exotix. Nigeria’s oil warrants offer a similar story. In January 2005, the oil rights were trading at $33 a right. By April 2006, the price was $190 a right – a capital gain of 575%. Today, the price is between $243 and $248 a right. The Bosnia Bs, meanwhile, are trading at a price of about 73% of principal compared with 1% in February 2002.
In each instance these instruments experienced a turn in fortune because of a specific event – for example Milosevic’s fall from power in the case of Serbia or the dramatic rise in the oil price in the case of Nigeria.
The challenge for investors is to spot the next opportunity, which is not that easy, partly because the trigger event might not be obvious. Another issue is that, as more emerging markets see their fundamentals improve, there are fewer distressed assets that fit the exotic bill. Serbia, for example, is now included in JPMorgan’s Embi Global index. Even if an investor does find an appropriate candidate, another problem is to know when to start building positions in it; if the timing is not spot on an investment could prove costly if things do not go to plan.
For example, Cuba’s London Club non-performing loans, which are estimated at about $1 billion in nominal value, with PDI between 100% and 200% depending on the specific security, could become one of the best recovery stories in the market if the debt is restructured. Cuba defaulted on these loans in 1986. The trouble is that no one knows if or when Cuba will restructure this debt; it is unlikely to happen while Fidel Castro is alive. Few potential investors can afford the huge opportunity cost of buying this debt but then holding it for another 20 years waiting for a restructuring. For the bravest gamblers, however, potential riches await.
