The rise in interest rates in the U.S. to above 5% means investors around the world are demanding significantly higher premiums for riskier investments. For global investors, the Abrdn Frontier Markets Bond Fund is one example of a fund offering substantial returns. Its yield was around 10% as of July 18, according to FactSet data. But these returns are tied to higher levels of risk, and might not be for all investors. Most of the assets held by the fund are focused on low-income economies, according to Kevin Daly, investment director for emerging market debt at Abrdn. The fund is invested in Nigeria, Kenya, Iraq, Ecuador, Uzbekistan, and Mozambique, among others. These countries “are by definition high yield and higher risk, but at the same time, have proven to be very good investment opportunities,” Daly told CNBC Pro, arguing that investors should consider stepping off the beaten path. What are frontier markets? While there is no formal definition, frontier markets are typically low-income, developing countries with underdeveloped capital markets, according to Daly. Many have only started issuing dollar-denominated bonds in the past decade or so. “Most of them are countries that are viewed as ‘distressed countries,’ given that yields on existing dollar bonds now are double-digit territory somewhere in the range of 11% to … 14-15%,” he said. My projection going into the year was returns of 7 to 12% on the fund. As of the end of June, we were closer to 9%. Investment director for emerging market debt, Abrdn Kevin Daly The appeal of these frontier markets is twofold, according to Daly. He said they tend to outperform mainstream emerging markets during risk-on periods and prove resilient during risk-off periods. How risky is the fund? Over half of the fund is invested in bonds rated B or higher. Rating agency Fitch defines B-rated debt issuers as “highly speculative” where “material default risk is present, but a limited margin of safety remains.” However, Daly said that investing in these markets requires diligent research and understanding, with the Abrdn team meeting with government and central bank officials and attending International Monetary Fund (IMF) and World Bank meetings. “There is quite a bit of dialogue between investors and these countries,” added Daly, whose team manages the fund. He added that these countries are “upping their game and improving investor outreach” as a sign of their commitment to improving their credit markets. For instance, after issuing its debut Eurobond in 2019, Benin, a French-speaking West African nation, began issuing monthly newsletters for better communication with debt holders. How does the fund yield 10%? Despite efforts to improve access to data for investors, information gaps remain. “If you’re invested in these markets, you hope to exploit it,” Daly said. For example, when IMF officials expressed concern about Kenya’s debt sustainability levels earlier this year, Daly said he went against the consensus view and held on to the bonds. “I think what the Kenyans are doing is showing their resolve to cut the fiscal deficit, to look for alternative financing means, and their willingness to repay that bond next year is very high,” Daly said. Sure enough, in the weeks that followed, Kenya secured new financing and undertook fiscal reforms — which led to a rally in its bonds. Nigeria, the fund’s largest geographical exposure, appears to be showing promising returns too, according to Daly. In the past, the country has been forced to issue debt at very high interest rates due to a lack of structural reforms by successive governments. For instance, a bond issued in 2014 – when rates were generally low worldwide — pays 14% in coupons. However, this is set to change, according to Daly. “You’ve got a new president who’s come in, and on day one of his leadership … they announced the removal of fuel subsidies. The fuel subsidies cost Nigeria somewhere on the order of 3% of GDP last year — a major fiscal drain for the country. They can’t afford it,” Daly said. “Nigeria has been a huge outperformer, certainly in late May and June, on the back of these measures,” he added. Managing FX risks Managing foreign exchange risk is tricky in frontier markets, where hedging instruments are often inefficient or unavailable. Instead, according to Daly, the fund takes a total return approach, expecting some currency depreciation but high yields to compensate. He said, for example, that Zambia’s debt yielding 24% in local currency can deliver double-digit returns even with modest currency weakening. In addition, debt investors typically fund their purchases in dollars, euros, or sterling – known in the jargon as a carry trade – which typically have lower interest rates than their investment destinations. “The carry is so high in these markets that you are looking to benefit from a total return that potentially exceeds investing in dollar bonds,” he added. Outlook for the second-half Daly expects continued volatility in frontier markets as a hawkish Federal Reserve affects Treasury yields throughout the second half of this year. However, he said several catalysts — such as Zambia’s restructuring progress — can boost sentiment. “My projection going into the year was returns of 7 to 12% on the fund. As of the end of June, we were closer to 9%,” Daly said. “I still stick with that 7 to 12% range. But yeah, there will be periods of choppiness out there.” The fund is accessible to investors in Europe, South Korea, Singapore, and Taiwan via stockbrokers.
