Frontier bonds/inflation: investments on the edge of reason

The name says it all. Frontier market assets take investors towards the edge of risk tolerance. These bonds, currencies and equities do not even qualify as “emerging”. They can offer outsized returns if conditions are right. But their modish qualities as inflation hedges come at a price — linkage to the commodity cycle.

Frontier markets often benefit when prices for metals and hydrocarbons jump. One measure, the S&P Goldman Sachs Commodity index, has risen 24 per cent this year alone. In turn, inflation expectations have climbed, causing US Treasury prices to fall. Yet a JPMorgan price index of frontier debt has risen slightly.

Higher yields from frontier international bonds, which are usually priced in dollars, has made them more palatable. The coupon sweetener reflects higher sovereign risk.

African commodity exporters have been a popular choice recently. International bonds from oil producer Angola yielding around 7 per cent have performed very well this year, for example. A one-third jump in the Brent crude price is the reason for this. Yields for other comparable Ghana and Nigeria debt, all over 5 per cent, easily exceed that found for large emerging market issuers. Brazilian and Mexican bonds offer around half that yield.

High coupons theoretically mean that these frontier bonds have less sensitivity to movements in global interest rates. An indicator of this is duration risk, which reflects the trade-off between coupons and maturity payments. Angola’s 2029, 8 per cent dollar bonds have 6.3 years of duration. That is less than a comparable Brazilian bond, partly because the latter offers half the coupon. Then again, whatever pandemic problems Brazil currently faces, its economy is 20 times larger than Angola’s and much more diversified.

Frontier market securities have to offer more yield to offset higher risks. But for some issuers, such as Angola, investors have bet that oil prices will stay high. That should make Angola more creditworthy so long as commodity price rises continue. Lex thinks they will fizzle out. If so, the hedging role of frontier bonds will prove shortlived.

The Lex team is interested in hearing more from readers. What’s your preferred inflation hedge? Please tell us what you think in the comments section below