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Greek Turmoil Threatens Frontier Market Success

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The sudden and heightened crisis surrounding Greece has created new tension for financial market participants who had hoped for a smooth ride in the second half of the year. The problems could have repercussions for all asset classes, including emerging markets and frontier markets debt.

Ironically, frontier markets were not even an asset class until the onset of the Eurozone crisis, said Jeff Kalinowski, a portfolio specialist in the fixed income division of T. Rowe Price. As most investors took refuge in such safer debt instruments as developed country sovereign bonds, others looked toward parts of the globe that they probably would not have considered before to capture yield, he said, buying up the bond issues of numerous countries that had never tapped the capital markets before—Rwanda and Bolivia, to name a couple — but were able to take advantage of the very low interest rate environment to issue debt internationally for the first time.

These countries have been able to develop their yield curves and convince investors of their creditworthiness, but now, the good run they’ve had may be headed for a slowdown with the resurgence of the Greek problem, and many more investors seeking safe havens, Kalinowski said.

“Investor sentiment is very fragile right now with Greece and you have an unusual situation where monetary policy has been so stable but that appears to be coming to an end,” he said.  “The ultimate impact on frontier countries that are reliant on foreign capital is as yet unknown but it’s clear that impaired liquidity will be a challenge for a lot of markets. The risk of capital flight and associated investor sentiment with some of the big macro changes that are taking place will impact frontier and emerging market countries.”

Daniel Broby, a hedge fund manager specializing in frontier markets, predicts a volatile time for the asset class.

“Investors have seen too many adverse credit events recently for an easy ride,” Broby said.  “Ukraine was a big problem and the Middle East continues to prove politically unstable.”

Broby said that the end of QE as well as the ongoing Greece/Eurozone debt talks will have more bearing on frontier market yields and volatility due to their bearing on the whole yield curve.  

“A lot of hot money from yield hungry emerging market managers has found its way off benchmark into frontier debt, and this could well prove to have a short fuse,” he said.

Nevertheless, investors such as Kalinowski are still open to new issues from frontier market issuers that are substantive and that offer the best risk adjusted value. He participated, for example, in a recent issue from Mongolia’s Trade and Development Bank, not only because it is guaranteed by the Mongolian government and came in at a very attractive level (offering double the spread of Mongolia’s sovereign bonds and a 100 basis points pick up over Treasuries), but also because the bonds will finance a large gold and copper mining project between mining giant Rio Tinto and Turquoise Hill Resources. The Oyu Tolgoi project bodes very favorably for Mongolia, Kalinowski said, “as it will create more wealth for the country and this gives us more confidence.”

That Rio Tinto, an investment grade company, is involved is another reason to be optimistic, he said, “and although Mongolia’s policies are not as robust as we’d like, we believe there is potential to improve.”

Egypt’s $1.5 billion Eurobond, the sovereign’s first every that came out in early June, was also an interesting deal, Kalinowski said, and supported by Egypt’s improving fundamentals.

“The risk-reward in Egypt, we believe, is quite fair value and there is a good story behind what is going on there, particularly with the new president who’s been able to move the economy from creating stabilization to consolidation,” he said.

But Kalinowski is nevertheless cautious about the frontier market issues he invests in, particularly at a time of heightened market uncertainty. The growth in frontier market issuance, fueled by investor search for yield, has allowed some sovereigns with very little creditworthiness to come to market in these past years, he said, and though it’s likely that more countries will be looking to borrow quickly while the interest rate window is still favorable, he and other investors will be more picky about who they lend to.

Still, for those investors keen on yield, the attraction is simple, Broby said, since frontier market debt offers 230 basis points above emerging market debt for similar sovereign credit ratings and maturity. “Risk is misperceived, he said, and defaults are rarer than one would imagine.”

Also, corporates in these markets tend to be higher rated than in others, he said, and this is because only the stronger companies can tap the markets.