The struggle for yield is getting real again, with investors once again pushing into frontier markets in search of meaningful returns on their capital. This most recent foray into the most exotic of investment destinations has brought capital to previously unfavored locations in far flung places including Myanmar (even with the coup), Sri Lanka, Armenia, Burkina Faso. Not forgetting Tanzania, Uzbekistan, Kazakhstan, and everyone else of course.

When it comes to frontier market bonds, it is important to understand the difference between local currency bonds and hard currency bonds. “Local” refers to bonds the government of a frontier market nation issues in its domestic currency. For example, the Sri Lankan government issuing debt to foreign investors denominated in Rupees. “Hard” refers to bonds these governments issue to foreign buyers denominated in USDs (sometimes Euros, or maybe Yen).  

Issuing USD denominated debt to overseas buyers is a common practice and tends to suit both the issuing countries as well as investors who buy their debt. Issuers tend to need USDs more than their local currencies, as USDs are used to to pay for imports of goods, services, and especially commodities. Also, countries can print their own currencies, but they can’t print USDs, which makes getting USDs via payments for exports, tourism, or borrowing in international debt markets a priority. 

For investors, purchasing USD or Euro denominated sovereign debt issued by a frontier nation allows them to earn higher returns without taking on currency risk. If they were to purchase frontier bonds issued in local currency, investors would be exposed to not just the risk of their bonds falling in value, but also the risk of the local currency depreciating.

For example, if investors purchased local currency bonds, say Sri Lankan bonds denominated in Rupees, they would receive their coupon and principal payments in Rupees. As such, should the Rupee depreciate against the USD, investors would get less USDs for the same amount of Rupees, and their overall investment return will be less. In order to mitigate this risk, investors who purchase local currency bonds tend to hedge their currency risk with some form of FX derivative.   

However, it is important to note that currency hedging can only help in times where markets are more or less stable. Should international USD lending markets freeze up, the price of these countries’ bonds will still plummet very quickly as everyone across the globe scrambles to raise USD funding at the same time (a la 2008 and 2020).

It is also important to remember that on top of currency risk, investing in frontier sovereign debt carries a higher degree of credit risk. Credit risk of course refers to the risk of the foreign government defaulting on their debt obligations, leaving investors scrambling to recover whatever amounts they can salvage (Venezuela and Argentina are good examples of this). 

To be concluded…