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Banking

Keeping the faith in frontier markets

Despite the eurozone volatility, frontier market bonds could outperform emerging market sovereign credit in hard currency, Exotix, a frontier market boutique, has argued.

Blink and you might have missed it. As eurozone-induced global market volatility vexes investors in developed markets, frontier markets have seemingly been in favour since July last year. At a press briefing on Friday, Exotix, an investment banking boutique, said its familiar marketing pitch has generated traction from yield-hungry investors over the past year.

“The major scares we saw follow the eurozone debt crisis are working their way through the system,” says Stuart Culverhouse, chief economist and global head of research at Exotix. “A Greek default is being contained, LTROs have come in, growth is not being as downwardly revised as rapidly as it was and economic data from the US has been better than expected,” he says.

Gabriel Sterne, a Europe and MENA economist at Exotix, agrees: “Although you may have missed it, the EU authorities have revealed a solution to the European debt crisis.” In an environment of relatively benign conditions, “people are becoming more comfortable with accepting frontier risk,” says Culverhouse.

Frontier markets that Exotix cover issue few Eurobonds, which are typically snapped up by an international investor base - although there are exceptions such as Argentina and Venezuela - and thus have lower refinancing needs. “In that sense, global stress should not derail frontier markets,” says Culverhouse.

Culverhouse argues: “But clearly there are tail risks out there and frontiers are not immune. Avoiding the losers in frontier markets is just as important as picking the winners, which is evident in the performance of the EMBI.”

Despite a return of 5.3% year-to-date on the EMBIGD spread, the individual constituents show a wide variation, Exotix explains in their recent frontier outlook, which perhaps unsurprisingly noted emerging Europe will be most vulnerable to weakness in the eurozone.

Culverhouse and his colleagues at Exotix believe that several frontier markets will outperform the aggregate EMBI because frontier market bonds are coming from a lower base. But there is still value in hard currency denominated emerging market sovereign debt. “The EMBI is still around 200 bps from its all time low so it can compress further because a lot of emerging market fundamentals are solid and people except this,” he says.

But the relative value of frontier market bonds compared with their more developed emerging market peers has not gone unnoticed by investors, says Culverhouse. “Yields are higher [in frontier markets], so there is scope for compression, and fundamentals are pretty solid in a lot of the frontier markets that we follow.”

Here are a couple of investment tips, courtesy of the frontier market shop:

Argentina GDP Warrants: Buy

Exotix have been bullish on Argentina GDP warrants for some time. And this is despite weak economic growth and deterioration in the country’s industrial production. Exotix believes that Argentina has reached the “bottoming out” in its economic cycle, forecasting 4% growth, more bullish than consensus. The Exotix report noted: “Even if growth was below the trigger this year, you would still be getting a $6 payment on GDP warrants. So you are recovering about 50% of the price of the warrant now, which we think is fairly compelling.”

Indeed, Exotix realises that they should have acted more quickly to YPF nationalisation which precipitated the recent sell-off, they still see long term value in the bonds.


 


Bosnia As: Buy

Bosnia is vulnerable to turbulence from the euro zone, has suffered a stalled IMF program and slow constitutional reforms continue to discourage investors from the country. But these perceptions are not all well-founded, says Sterne of Exotix. “When people think of Bosnia, they think of geopolitical headline risk and war, but if you actually do the analysis, the scenario in which the country completely falls apart is highly unlikely.” The problem with Bosnia is that “geopolitical headlines mask the low probability of tail risks,” he added. For instance, the public debt to GDP ratio in Bosnia is around 40%. “I know some other European countries that would die for these sorts of levels,” says Sterne.

And Bosnia’s A-series bond yields have notched positive returns. With an average maturity of 2.2 years and yields of 10.1%, the A series are performing well, “way above what is implied by its B3/B rating,” concludes Sterne.

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