Many investors think frontier markets are too risky, but strategically overweighting these markets in an emerging markets debt portfolio could offer higher return potential.

Video Transcript

Mike: Hi, everybody. Mike Corcoran with Institutional Investor. Thanks for joining us today with Yvette Babb. And we’re going to be talking with Yvette about why frontier markets matter in emerging markets debt (EMD) strategies right now, in an especially interesting fixed-income landscape. Yvette is a hard and local currency portfolio manager on William Blair’s Emerging Markets Debt team. And I think, Yvette, maybe we could start, given the current sort of environment in fixed-income investing, why do you focus on frontier markets in your emerging markets debt hard currency portfolio?

Yvette: Thanks so much, Mike. So, in our view, within an EMD portfolio, we feel the optimal strategic allocation is a combination of emerging market hard currency sovereigns with an overweight in frontiers and an overlay of corporate debt.

And why frontiers specifically? This is a part of the emerging market debt universe that is, in our mind, significantly underowned. And that market is also undercovered. And so, the fundamental information is harder to come by.

And we believe that there is a mispricing of risk i.e., that the actual fundamental premise of default risk in these countries is far lower than it’s being priced in times of particular distress.

So, the disconnection of perception of risk and the actual fundamental premise of default risk, in our mind, is where there’s a large amount of value that we as fundamental researchers can unlock. And so, we have a bias towards employing a strategic overweight, given the higher risk premium, higher returns, but lower volatility than in global equities over time.

Mike: But I think to a lot of investors, they hear “frontier markets” and they think, “Oh, risky, risky. I’m not.” Can you tell us a little bit about that? What’s your response to that when investors say that “Oh, feels a little too risky for me”?

Yvette: The truth is, the numbers don’t lie. And if we look at the historical default rates in sovereign and in frontiers specifically, we believe that it uncovers the fact that they are less risky than what’s perceived to be, given that the historical default rate in frontier markets specifically over the period 1995 to 2021 was 1.5%.

Another important number to mention in response to that question is that even for those countries that defaulted, that reflected an average default rate of 1.5%, the last given default was further mitigated by the fact that the recovery rates were relatively high for those countries that did default. So, the average default rate of that period was 1.5%, as I mentioned, but the recovery rate was 55 cents on the dollar.

So, that means that, I think, the perception that these countries are unlikely to give healthy returns given the associated risks in those, I think, is very quickly dispelled by these numbers.

I think the second aspect that I’d like to mention is that there are a vast number of frontier markets that we can invest in, which allows us to use a diversified approach i.e., we have a very strong risk-mitigation strategy that when a country that, due to unforeseen circumstances, does default, we limit the impact on our portfolio by having very large and diversified holdings across frontier markets. So, that diversified approach helps manage the risks of a country eventually facing those circumstances.

And so, I think the perception of risk is much higher than what the historical rates show and clearly you’re being also, in our mind, very adequately rewarded for taking these risks, given significant yield advantage that these countries have over developed markets, but also versus the investment-grade space and the broader high-yield universe of EMs. And so, it’s a very interesting, in our mind, sub-universe within the emerging markets universe.

Mike: Thanks for those insights, Yvette. As we continue our conversation with Yvette, we’re going to focus on environmental, social, and governance (ESG)—in particular how it factors into her process and how does it impact when looking at frontier markets and the opportunities therein. So, please join us for that part of the conversation.