Aberdeen Asset Management crosses the frontier

Twelve years after a tumultuous default that wiped out two-thirds of compliant investors' capital, Argentina is still battling holdout creditors through the international courts.

Against this backdrop, it might be considered either brave or foolhardy for an investment house to launch a debt fund based on an index that features Argentina as it largest weighting, at a chunky 15.5 per cent.

Step forward Aberdeen Asset Management, which has gamely taken on this role.

Aberdeen has unveiled what is believed to be only the world's second frontier-market bond fund, investing in the sovereign and corporate debt of countries that lack the size or liquidity to be considered emerging.

To be fair, Aberdeen is not trying to pretend this is a vehicle aimed at widows and orphans. Its own marketing material states that frontier markets are often "low-income countries", boasting "poor governance", "limited information" and "under-developed capital markets", which are all too often "dependent on international aid".

"There is political risk. There is a lot less known about these countries. They tend to have one-party rule, which is not necessarily a great thing, and there tend to be incidents of corruption," affirms Kevin Daly, emerging market debt manager at Aberdeen. He was speaking hours after a former rebel group attacked a police station in Mozambique (a meaningful weighting in the fund) and declared the end of a 21-year truce that has held since a million Mozambicans died in the civil war.

So one might be forgiven for asking why investors should reach for their cheque books. Mr Daly is equally loquacious in answering this question, pointing to everything from favourable growth dynamics in the frontier world to low levels of debt.

However, chief among the perceived advantages is the yield frontier markets can deliver, particularly in a world of depressed bond market returns.

JPMorgan's Nexgem index of frontier sovereign bonds trades on a yield of 7.7 per cent, two points above hard currency emerging market bonds and 5.7 points above developed world sovereign debt.

Aberdeen says its own fund has a yield to maturity of 9.8 per cent, with a modified duration of 3.85 years and an average credit quality of BB-.

And despite annual default rates of around 6 per cent over the past decade, frontier market sovereigns have delivered an annualised return of 11.2 per cent, with a Sharpe ratio, a measure of risk-adjusted return, of 0.69, Aberdeen says. This outstrips the returns from all other segments of the debt market (although US investment-grade credit had a Sharpe ratio of 0.81, albeit from a lower annualised return of 7.3 per cent).

"The attractive yield is a key element behind this," says Mr Daly. "It is very much an under-owned asset class, it's under-researched."

"It is almost twice the yield of traditional emerging markets," adds Morten Bugge, chief investment officer of Danish house Global Evolution, which beat Aberdeen to the punch by launching the institutional share class of its Frontier Markets (Fixed Income) fund in December 2010.

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This pioneering fund, now $1bn in size, has returned 25.2 per cent since inception and currently yields 11.1 per cent.

Another selling point for frontier debt is, historically at least, a complete lack of correlation with movements in the US Treasury market.

This came into focus during this year's will-they-won't-they shilly-shallying over the tapering of quantitative easing in the US. As a result, hard currency EM debt lost 9.5 per cent in the first eight months of 2013, and its local currency equivalent 11 per cent. The Nexgem index fell just 3 per cent.

"In periods where US yields are rising, high-yield bonds tend to cushion you from that. That is what we saw this year," says Mr Daly.

Mr Bugge also cites this as a significant advantage. "Emerging markets are so sensitive to risk-on, risk-off, which is not really the case for frontier markets that have very little foreign participation," he says.

"Emerging markets have developed fantastically for the past 20 years but now [that] they are investment grade, they are so closely linked to developed economies. That is the disadvantage of the convergence to developed markets.

"Frontier markets are early in the cycle, they look like emerging markets did 10 years ago. Many of our investors see this as a natural step in terms of taking a bit of profit from emerging markets and riding the convergence that we have seen in the emerging markets in the past 15 years."

However, Philip Saunders, head of the global asset allocation team at Investec, puts a less favourable spin on the "spillover effect" that kicks in as value disappears from the conventional emerging market space.

"Inevitably what begins to happen is that money has to pursue less liquid opportunities at the margin. The capacity of the markets to absorb large flows is relatively limited," he says.

Investec runs a number of African fixed income funds, utilising its strength in its "backyard", but not a pure frontier bond fund.

Mr Saunders cites a perceived lack of clarity around default rates as one concern, with many frontier markets having little history of issuing public debt. However, he says the "big issue" is illiquidity and wide bid-offer spreads, which mean investors may have to adopt a buy-and-hold approach.

The most liquid of Investec's African bond funds has monthly redemption windows. Mr Saunders describes Aberdeen's decision to opt for weekly liquidity as "ambitious".

Mr Daly says Aberdeen is hoping to attract investors who are more "equity like, not looking to move their money in and out all the time".

Global Evolution goes further still, offering daily liquidity for its vehicle. The group says it has done this in its family of funds for 15 years without problems, although Mr Bugge admits a 2008-like crash could force a suspension.

As for defaults, he says GE has not had a single one in 18 years of investing in emerging and frontier markets, thanks to the house's "early warning system", which endeavours to spot deteriorating economic or political conditions.

Despite the creation of the Nexgem index conferring greater respectability on frontier debt, both existing funds have the freedom to diverge sharply from it - a relief no doubt to those wary of the Argentine debt markets.

"Would we be running 15 per cent Argentina risk in this fund? No," says Mr Daly.

Instead, both funds have short-term Nigerian debt as their largest position, with Aberdeen also favouring the likes of Kenya, Pakistan and Honduras, and Global Evolution Malawi, Uganda and Sri Lanka.

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