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  1. Analysis
May 20, 2020

A new frontier: private banks entering new markets

By Patrick Brusnahan

Everybody knows the pros and cons of both developed and emerging markets when it comes to investment. A segment now coming into play, especially during the Covid-19 epidemic, is frontier markets. How are private banks looking at this new opportunity? Patrick Brusnahan writes

A frontier market is commonly described as a developing country too small, risky, or illiquid to be considered an emerging market. Traditionally, they offer very high returns but not at speed.

Countries such as Argentina, Sri Lanka, and Vietnam fall into this bracket.

Union Bancaire Privée (UBP) has expanded its sovereign emerging market fixed income offering with the launch of UBAM – Emerging Markets Frontier Bond.

It is a frontier market strategy fund with the aim to take advantage of the attractive return potential offered by investments in frontier markets.

The advantage exists due to risk premiums overestimating default probabilities and underestimating recovery values.

Furthermore, frontier markets have grown at pace in the last decade and becoming an important part of emerging market debit and global fixed income. Frontier markets now consist of 35 countries and a $100bn market capitalisation.

In addition, these markets are more diverse than more realise and offer better diversification.

Speaking to PBI, Thomas Christiansen, deputy head of emerging market fixed income at UBP and lead portfolio manager of UBAM – Emerging Markets Frontier Bond, explains that this move was in progress for a while.

He says: “We originally started to look at it at UBP in as early as late 2018 and personally I’ve been looking at this for six years now. I think a lot of the arguments for wanting, or for a lot of the merits for owning, frontier debt as a sort of standalone asset class has been there for quite some time now.

“A lot of the longer term factors that make frontier debt interesting were there before.”

Has Covid-19 making frontier markets appealing?

Christiansen says: “The easiest and simplest answer is just that we have now yields and spreads at a level that’s comparable to what we had in 2008. So if you look at frontier markets and sovereign debt more broadly, default rates tend to be relatively low through the cycle. And recovery rates tend to be higher than what the market tends to price.

“So what do you see in the asset class is that historically, when you’ve had significant spread widening, in the previous episodes of financial stress, we haven’t seen a pickup in default rates or a decrease in recovery rates that’s been big enough to justify the spread widening. As a result, with the sell offs of the magnitude we’ve seen now, you tend to get very strong recoveries, because credit is a mean reverting asset class.”

Xiadong Bao, a portfolio manager at Edmond de Rothschild Group, believes that Covid-19 has forced a relook at certain investments and markets.

He states: “It is true that Covid-19 disrupted quite a lot of our market performance perspective. So for us, we still hold our structural view, which is we still see opportunities, of course, for frontier markest.

“But the opening up of these frontier markets may slow down a bit in the short term, from my perspective, because I’m an equity investor on the emerging market. Basically now even emerging markets have a lot of volatilities due to Covid-19 and due to the recession risks, so basically, we’re still looking to the frontier markets, for example, Vietnam, due to the geopolitical emergency that we can see. But let’s say in the ultra-short term, we are not being that proactive versus before Covid-19.”

“I don’t think [frontier markets are] coronavirus resistant because coronavirus is going to affect global growth. Obviously, this asset class is linked to some extent to global growth,” Christiansen adds.

“But what I would say is the selloff that we’ve seen as a cause of the corona virus, I think has been larger than what you would justify by the fundamental impact we’re expecting.

“In a number of places, moves have been exacerbated, especially when compared with the true fundamental impact we’re expecting. I wouldn’t say so much that it’s coronavirus resistant but I would say it’s less impacted on the fundamental side than what we’ve seen in other markets.”

Emerging markets

Many parallels can be drawn between frontier markets and emerging markets. Depending on growth, a number of countries currently considered frontier can become emerging.

How do they compare?

Bao states: “[They are] quite different actually. Why frontier markets are frontier markets is not only due to the liquidity of the market, but also the accessibility of the market. It is improving, but make no mistake, to access these markets is really difficult, even if you invest into it.

“Two or three years ago, people, especially from Asia Pacific investors, invested quite a lot into the Vietnam market seeing that as a good location apart from China. Given the trade war conflict, people said maybe Vietnam got it’s once a lifetime opportunity. But then the market is not that big.

“Firstly, liquidity is not good. Accessibility, for foreign investors is not that friendly. They cannot repatriate to profit. So that’s the common mistake foreign investors usually make so if you do not have a long ultra-long term view on this frontier market is it is hard to have a justified strategic view on these markets to invest into them.

“For the time being, we are mostly investing in emerging markets, but are we having a look at some frontier markets, some in Africa, some are talking about Vietnam, because it’s quite important nowadays, especially after Covid-19, to see the divergence more and more especially due to the China/US conflict.”

“Frontier markets today are quite a bit more diverse than what they were maybe seven to 10 years ago,” Christiansen says.

“And so the impact of something like this and of the low oil price as well for example, is actually quite differentiated across the different potential investments within that space. When you have significant oil importers and exporters as part of that investing universe, comparing with broader emerging markets, frontier tends to make up the higher yielding lower quality aspects.

“I think expecting some sort of an economic recovery, now in the second half of this year and then in 2021, the higher yield countries that have managed through this crisis, we would expect to outperform.”

Bao also believes frontier markets will come more into play as people look to diversify.

He purports: “Some frontier markets will see some spill overs benefits from emerging markets because the developed world needs to diversify a little bit more. They’re outsourcing facilities and looking for more, I don’t want to say cheaper labour, but looking to diversify the source of production facilities.

“This might be quite negligible for China, but for these smaller countries, the inflows will be proportionally quite important. From an investment perspective, these countries will see structural inflow of capital and potential opportunities for further development.”

Client education

As a reasonably new investment opportunity, frontier markets need to be explained to clients. This is natural for all investments.

Karine Jesiolowski, head of responsible investing at UBP, explains to PBI: “For some clients, there’s quite a lot of this that is new, and where education was, was very important. The fact that we started on this, I would say more than six months ago, last summer basically, we started to inform the series and our array of the private banking side also about what are emerging markets, what do they mean and so on and so forth.

“You need to do this education because sometimes people may feel that these are countries that they’re really not familiar with and that they would rather avoid. After you do this education and show them the growth potential, you show them that these countries are actually often far less indebted than maybe the biggest emerging countries. Some of these countries have traits that are really weak but you also have a big bulk of them that are in pretty sound situation so it’s high yield definitely.”

Bao sees some difficulty with knowledge of the investment as well.

“The interests of investors are quite spotty, let’s say. Because, firstly, it’s not that well known and there are a lot of prototypes on these markets. And given that we are in a volatile market situation right now, even for emerging markets, we’ve seen a lot of doubts. So all these are not really favourable conditions for frontier markets,” he says.

“There are interests out there, but like I said, it is quite spotty for the time being.”

Christiansen concludes: “I would say it’s, generally speaking, quite positive. Broadly speaking, we see this as a good opportunity and a good starting point. But we also have other clients where frontiers are less familiar to them. And there we have been doing some education.

“Depending on the person and on the client, there’s an element of getting up the curve. But for me, that’s one of the opportunities that we have in this marketplace. The lack of familiarity means that in some places you can find interesting opportunities that would probably get arbitraged away if it were more mainstream.”

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