The Frontier Five: Here's Where To Find Opportunity In The Bond Market 1
Oil pump on background of flag of Argentina

Frontier markets have had a sharp rally these past two to three weeks, mitigating declines of the past year.

One driver could simply be valuations. Double-digit yields in many frontier countries may be just too tempting as sovereign default risks still seem low, says Exotix Partners.

Brazil and Kenya have been the top performers this year in emerging market bonds, while Belize and Mozambique have been the worst among countries included in JPMorgan’s benchmark EMBI Global Diversified index.

So which are the ones to buy now?

Here’s the top bunch according to Exotix analysts led by Stuart Culverhouse.

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BUY                 Argentina’s YPF       8.75% Bonds Due 2024        Yield 8.9%                 

Argentina’s biggest oil and gas company, majority owned by the government, has relatively low debt and stable cash flow thanks to the state regulating energy prices.

The first half of this year will see deterioration in cash generation because of the sizable devaluation of the peso. Yet indebtedness will remain on the low side. Net leverage at 1.35 times at the end of 2015 is unlikely to rise above 2 times this year.

Argentina’s restraint on YPF expansion is positive as this will bring the company closer to matching its money coming in with cash going out for a free cash flow neutral position. A projected 25% reduction in capital expenditure this year will have only a marginal cost in terms of production growth.

BUY                 Kenyan Government             6.875% Bonds Due 2024        Yield 7.9%

Masai tribe
Masai tribe

Last year’s commodity price shock triggered a fairly indiscriminate sell-off across Sub-Saharan Africa, including in places that should be beneficiaries of lower commodity prices, notably Kenya.

With the exception of just a handful of countries – including Cote d’Ivoire and Rwanda – many of the African frontiers saw their bond yields rise sharply. This might have been as much to do with investor behavior and bank liquidity as any view on fundamentals.

It’s true that Kenya spent much of 2015 stumbling from one small crisis to the next, making it very difficult for investors to get comfortable with what might otherwise be one of Africa’s best underlying stories.

But perception changed this year as Kenyan bonds outperformed all emerging and frontier markets with the exception of Brazil, producing total returns of 7.1%.

The bottom line is that Kenya should be more insulated from any resumption in commodity price declines as it has a more diverse economy than other frontiers.

High Resolution Countries Sign Concept
Ecuador – Angola

BUY                 Angolan Government             9.5% Bonds Due 2025            Yield 11.5%
BUY                 Ecuador Government            7.95% Bonds Due 2024          Yield 13.1%

While Angola and Ecuador have been among the hardest hit by the plunge in oil prices, the difference lies in how both have adjusted.

Angola saw a big shift in its real effective exchange rate (REER), down 11% last year. That’s a contrast from many currencies that haven’t adjusted at all, or even appreciated. Angola has also tightened its fiscal policy.

Dollarized Ecuador lacks monetary flexibility, which puts more of the burden on fiscal policy. Its restraint meant Ecuador’s current account had only a mild deterioration equivalent to 2 percentage points of GDP last year, according to International Monetary Fund figures.

Putting this together, both Angola and Ecuador receive good marks for their policy adjustments so far.

Caracas
Caracas

BUY                 Venezuelan Government       6% Bonds Due 2020               Yield 33.2%

Venezuela will continue to be an important theme for frontier investors in 2016 as continued lower oil prices raise default risk.

The probability of default must rise should policy inaction continue, with no economic adjustment in the face of lower export revenue.

Venezuela’s model is only sustainable subject to China’s willingness to continue lending sizable amounts – something that’s opaque to the financial markets, and certainly not a dependable economic policy.

External financing needs are still very high relative to export earnings, under prevailing oil price assumptions. Refinancing risks therefore remain.

Yet debt amortization is light in the first half of this year. Risks are back-loaded to the second half. With only one sovereign repayment in 2016 – a $1.5 billion bond in February – there is some breathing space.

 

Top 5 Picks                                      Price              Yield (%)

Venezuela 6% 2020                           37.1                 33.2

Ecuador 7.95% 2024                          74.2                 13.1

Angola 9.5% 2025                              88.3                 11.5

Kenya 6.875% 2024                           93.6                 7.9

YPF (Argentina) 8.75% 2024           99.1                 8.9

 

The above are edited excerpts from Exotix Partners’ reports, updated March 7.

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