Frontier-market bonds acting as shield for investors against US election volatility

In the face of potential US election upheaval, investors are turning to frontier-market government bonds for protection.

These high-yield debt instruments from less advanced economies are seen as less vulnerable to geopolitical shifts and US policy changes compared to investment-grade countries, Bloomberg reported.

According to the report, money managers at William Blair Investment Management and Amundi SA are diversifying their portfolios with frontier-market government bonds — the high-yield debt of less advanced economies in the developing world such as Nigeria and Kazakhstan — saying these nations face limited exposure to geopolitical shifts and changes in US policies.

This stood in contrast with the risk faced by investment-grade countries like Mexico, which could encounter significant headwinds from new trade barriers under a potential Donald Trump presidency.

China, another high-grade issuer, might see Trump intensify the trade restrictions imposed under the Joe Biden administration, in addition to a more hostile foreign policy environment, it added.

Performance comparison between frontier market and emerging market bonds

Frontier-market bonds have been outperforming their higher-grade counterparts.

As of this year, dollar bonds from frontier nations have returned nearly 6%, significantly higher than the gains from higher-grade emerging-market peers.

This trend was also evident during Donald Trump's first term, where frontier debt returned 30% compared to the 21% from investment-grade issuers.

During Joe Biden's presidency, frontier debt continued to outperform, delivering 3% returns versus the 10% negative returns from their less-risky peers.

“We believe that now is a very appealing point in time to be looking at frontier markets,” Yvette Babb, a portfolio manager at William Blair said.

Higher yields of frontier debt offer cushion against rate volatility

The higher yields of frontier debt offer a cushion against rate volatility.

Currently, frontier and other junk-rated nations provide a premium of over 500 basis points over US Treasuries, compared to about 100 basis points for high-grade EM bonds.

This spread cushion is crucial, especially with potential fiscal concerns in the US impacting long-duration EM bonds.

“Long-duration EM bonds, particularly in the investment-grade space, have a little spread cushion,” Carmen Altenkirch, an analyst at Aviva Investors Global Services in London.

Structural reforms and fiscal strength backing frontier markets

Several frontier markets have undergone structural reforms, including currency devaluations and interest-rate hikes, boosting returns and fiscal strength.

These reforms have also reduced the risk of default, with the number of countries with bonds trading at distressed levels halving over the past year, according to data compiled by Bloomberg.

For example, fund managers like JPMorgan Chase & Co. and Pacific Investment Management Co. have recommended local-currency bonds from frontier markets due to these positive changes.

Risks and opportunities with frontier markets

Despite their potential, frontier-market bonds carry significant risks.

For instance, Bolivian bonds lost about a third of their value last year, with Ecuador and Belarus also experiencing severe losses.

Additionally, a second Trump tenure could bring mixed outcomes for these nations. While countries like Vietnam and Kazakhstan may benefit from a fractured global economy and redirected trade and capital flows, they could also fall victim to trade wars.

A second Trump tenure would be “a mixed bag” for frontier nations, said Amundi’s Yerlan Syzdykov, the asset manager’s head of emerging markets. He said he was “interested” in countries like Vietnam while also considering nations from central Asia such as Kazakhstan, a major producer of uranium.

Emerging-market bond inflows

Despite the risks, emerging-market bond funds have seen inflows for three consecutive weeks.

This trend is supported by the conclusion of debt restructuring in countries like Zambia and Sri Lanka, along with economic reforms in Egypt.

LGT Capital Partners, for example, has taken up positions in Egyptian and Nigerian bonds after years of staying on the sidelines, citing their insulation from global volatility.

Investment strategies and key events to watch out for

Investors are closely monitoring the potential fallout from a Trump-led White House and its impact on emerging-market assets.

Investors will be watching China’s July manufacturing PMI data due Wednesday for signs of further sluggishness while Indonesia, South Korea and Poland will all release inflation numbers this week that will provide clues on their outlook for local interest rates.

Mexico, Hungary and the Czech Republic's preliminary second-quarter GDP figures will also be on the investors' watch.

Further, Colombia’s central bank is forecast to cut rates on Wednesday, while Brazil’s policymakers are expected to keep them unchanged.

There’s also a rate decision in Chile on the same day; all these factors collectively will also shape investor sentiment.