Reaching For Yield On The Frontier 2
It is this sensitivity to external USD financing conditions, as well as the often volatile nature of frontier markets that make their bonds risky investments. Which speaks volumes as to how desperate cash rich investors are for yield that they are flocking to such markets in ever growing numbers.
Of course, frontier debt compensates for their higher risk by paying investors much higher yields, at least relative to what’s on offer in developed markets. These higher rates are more than just compensation for higher credit risk, however. They also reflect higher growth rates.
Unlike developed markets, where interest rates are mired at or close to 0%, reflecting low growth and poor prospects for future growth, frontier (and emerging) markets tend to have interest rates north of 5%.
These higher rates mostly tend to reflect higher growth and inflation in frontier markets. This may come as a surprise to some, since frontier markets are not generally wealthy countries, but frontier markets have higher growth rates relative to developed economies simply because there is so much “room” for them to develop further.
This “room” includes many categories of development, and is highly dependent on individual aspects of each frontier economy. This can include improving, or building new industrial capacity; and constructing more infrastructure like roads, train tracks, and airports to transport higher volumes of goods and people. Also, more residential construction to house a rising middle class, and the development of the consumer retail market to cater to their changing wants and needs. Last, but not least, the development of nascent, and sometimes brand new service industries like banking and finance, insurance, accounting, etc.
The simultaneous development of some, if not all, of these aspects naturally requires large amounts of capital. Some of this capital enters the frontier economy via foreign direct investment, where foreign companies look to capitalize on the country’s potential growth by starting operations there. Capital can also enter the economy from local companies borrowing money from international bond markets, where like sovereigns, they can issue local and/or hard currency debt.
Finally, governments of frontier economies can, and in many instances, do get directly involved in their economies. In these instances, they would, just like local companies, look to raise capital from the international bond market, just as they are currently doing.
The influx of foreign capital into a frontier economy kickstarts its development, and high growth tends to follow. Of course, higher levels of growth brings about higher levels of inflation, which contributes to even higher interest rates for investors.
While this may sound like a lender’s dream – lending at high rates into an economy that still has seemingly limitless potential – it comes with significant risk. For instance, what happens if the influx of foreign capital ends? Since the frontier economy cannot yet sustain its own development by generating enough capital for domestic capital expenditures, a lack of foreign investment also equals a lack of growth.
When this happens, government tax revenues fall very quickly, sharply raising the probability of it defaulting on its debt. Naturally, the price of the bonds it issued will also tumble as investors look to offload their holdings in lieu of the higher credit risk.
No one wins when this happens, and unfortunately it happens quite regularly. Examples include the Asian Financial Crisis in 1997, the long lasting and still ongoing problems in Argentina; as well as 2008 and 2020, when foreign capital stopped flowing into frontier markets because of global crises.
Consequently, frontier markets prone to bouts of economic volatility, which would be enough of a headache on its own, except that such countries tend to be susceptible to political volatility as well. Which begs the question, are investors in frontier debt truly brave and savvy, or are they simply picking pennies in front of a steamroller?
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