The risk premiums imbedded in the yields of EM sovereign high-yield bonds overcompensate for the risk associated with defaults, as defaults are relatively rare and recovery rates are relatively high. In fact, a 200-year study1 found that frequently defaulting sovereign issuers have outperformed sovereign issuers that never defaulted, on average, as the significantly higher yields they offer have overcompensated for the eventual, relatively small, realised losses. Frontier markets have also outperformed other high-yield assets.
For over twenty years, frontier markets have seen roughly half as many defaults as US high yield, and almost double the average recovery rates. The combination of this means realised losses in frontier markets have been 160 basis points (bps) lower, per year, over the past couple of decades. Since frontier markets have also yielded slightly more, the net result is that frontier markets have outperformed US high yield by over 200 bps, annualised, since the start of 2002. In addition to their absolute performance, frontier markets also offer significant diversification benefits to a global fixed income or multi-asset portfolio.
Frontier markets continue to drastically outperform other fixed income asset classes, having delivered an annualised rate of return of 8.8% since 2004 (using the JPM NexGEM Index). We believe that active management, coupled with the high carry of the asset class, more than compensates investors for the risks involved, further building on the compelling investment case. Currently, frontier markets are offering a USD yield of close to 7% (which is historically wide compared to most other fixed income assets), having already delivered more than a 4% return to date this year. Investment opportunities have arisen recently in Benin, where an SDG bond was issued, and in Ecuador where the new administration is ushering in more prudent policy-making, including a renegotiation of their IMF programme likely to be concluded in the coming months. Combined with the recent SDR allocation, which has boosted reserves considerably, the outlook for Ecuador has improved, though significant challenges remain as President Guillermo Lasso faces an uphill battle to get his policies approved in a split congress.
1J. Meyer, C.M. Reinhart, C. Trebesch (2019), Sovereign Bonds since Waterloo (Faculty Research Working Paper Series 25543), Harvard Kennedy School.
