Frontier Emerging Markets Lure Investors Back with High Returns - Latest Global News

Frontier Emerging Markets Lure Investors Back with High Returns

Attracted by these countries’ economic recovery and higher interest rates, investors are flocking to local currency bonds from former emerging market pariahs such as Kenya and Pakistan.

The local currency debt of Egypt, Pakistan, Nigeria, Kenya and other countries has been one of the most unpopular assets in emerging markets in recent years – aside from obvious defaults – as their economies have been hit hard by currency crises.

But such bonds are currently making a comeback, boosted by a series of interest rate hikes and foreign exchange liberalisation measures as these countries seek to repair their battered economies.

With interest rates falling in some more mature emerging markets such as Brazil, the double-digit yields on offer in frontier markets are too attractive for investors to ignore.

“To really make money, you have to go a little more off-piste into frontier markets,” says an emerging markets fund manager who invests in Egyptian government bonds and has also looked at short-term Nigerian naira debt.

“The frontier local currency still offers carry,” or above-average returns compared to U.S. interest rates, the manager said. They added that even if the U.S. Federal Reserve cuts rates just once this year, the frontier markets “will still bring a lot [yield]“.

In Turkey, where years of monetary mismanagement had scared off investors, 50 percent interest rates designed to combat double-digit inflation and stabilize the lira lured them back this year. Foreign investors’ holdings of lira-denominated government bonds have nearly quadrupled since the start of the year, reaching around $10 billion at the end of May, according to central bank data.

Egyptian government bonds have also been a popular trading asset this year. Foreign investors have poured $15 billion into Egyptian bonds, much of which followed a $35 billion investment by Abu Dhabi’s sovereign wealth fund to ease the country’s financial crisis.

The Egyptian pound was devalued this year and was allowed to float against the dollar to alleviate the foreign exchange shortage.

Investors are confident that similar reforms in Nigeria, Turkey and about two dozen other frontier markets will bear fruit – at a time when yields on other forms of emerging market debt are falling.

“Policymakers in frontier markets are becoming more sophisticated,” said Luis Costa, global head of emerging markets strategy at Citi.

The US dollar debt of many of these countries has already recovered as they avoided outright default, and many investors doubt that yields – which move inversely to prices – can fall much further from here.

At the same time, the rally in more creditworthy local currency bonds in emerging markets, driven by interest rate cuts, is also likely to come to an end.

Trading in the currencies of some major emerging markets has also failed recently, such as the sharp sell-off in the Mexican peso following this month’s elections.

Jonny Goulden, head of emerging markets bond strategy at JPMorgan, said investors were trying to avoid speculating solely on when the Fed would cut rates.

“There are a number of countries in emerging markets with idiosyncratic drivers,” he said, adding that a mix of currency devaluations, interest rate hikes, political reforms and bailout loans are helping to reassure investors.

They tend to be cautious about the local debt of riskier countries, which tends to be more volatile and dependent on currency movements. Many investors fear the sudden imposition of capital controls or the prospect of the debt market collapsing during a crisis as foreign investors seek to withdraw.

Analysts say there is little evidence so far that buying these debt securities is a crowded business or that investors are not considering the risks. “We have found that while positioning has increased, it is generally not that large,” Goulden said.

Although foreigners have returned to investing in Turkish lira bonds this year in response to more orthodox economic policies, they still only make up about 5 percent of the market, compared with a fifth before the 2018 currency crisis. In Egypt, foreign investors hold about a tenth of local debt. That’s more than a low point in 2022, but significantly less than a high in 2021.

However, the prospect of US interest rates remaining high for an extended period due to stubbornly high inflation as a result of the Fed’s struggle could prove to be a headwind for emerging market local currency bonds.

Egypt, Nigeria and Pakistan, which are forecast to spend more than a third of their government revenues on debt interest payments by 2028, are particularly at risk from high US interest rates, according to Moody’s analysts, as these could force them to keep their own interest rates high to attract capital.

This month, Kenya’s central bank said it could not cut its key interest rate from its current level of 13 percent because global interest rates could continue to cause investors’ money to leave the country.

“We have to be very careful that we do not take measures here that create the same problems that we have, where we see capital outflows again because yields are lower than abroad,” said Kamau Thugge, the bank’s governor.

However, some investors argue that even with high U.S. interest rates, local currency bonds and the returns they offer are still more attractive than those countries’ dollar-denominated debt.

While there is still some value to be found in dollar bonds, “valuations are relatively low,” says Daniel Wood, emerging market bond portfolio manager at William Blair Investment Management. “In local currency, this is more of the beginning of the story.”

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