We may be experiencing one of the fastest and deepest financial crises ever. As a result, the word “unprecedented” has never before been used so often in the financial context. Yet, even in the midst of a global pandemic and its humbling consequences, the pattern of the market fallout has not been at all surprising in our view.

When the coronavirus crisis spilled over to Europe and the global lockdown and its consequences became seen as inevitable, one of the fastest ever sell-offs ensued. Not only was the decline rapid and extremely volatile, but also, unlike 2008, markets were rattled by hitherto unseen volatility-of-volatility levels. For instance, March will go on record as the month with the most SPX limit-down and limit-up trading halts in history. By early April, we had already experienced a relief bull market too.

To make matters worse, liquidity dried up quickly, affecting not only illiquid assets and those traded over-the-counter (OTC), but also listed equities, large ETFs and government bonds. With the traditional short-term and sell-side liquidity providers taken out by regulation, markets remain structurally very shallow, and central banks are now the main driver of liquidity.

Volatility of volatility: the new fear index

In 2019, we wrote a volatility outlook piece where we advised readers not to dismiss the 2018 volatility spike as a one-off. We compared the market dynamic to a game of musical chairs where any reduction in central bank liquidity (the music) could result in a severe correction, with the next most vulnerable investment or investor potentially missing out on one of the remaining chairs. We also argued that the effect of the music stopping could be worse in an overextended economic cycle, when there are fundamentally fewer chairs.

In their decade-long quest to control deflation, global monetary authorities had inadvertently created an imbalance in the volatility of volatility. If the volatility market is relatively stable, markets’ ability to forecast the near future is good. But, if volatility itself is volatile, market visibility becomes murky and, if market liquidity is also shallow, flash crashes can become the norm. Following several risk-on/risk-off waves, the CBOE VVIX (volatility of VIX Index) became known as the new “fear index”, claiming the title from its less volatile and better-known predecessor the VIX.

Volmageddon scenario for UK pension schemes

In 2020, the simultaneous fall in equities and bond yields has created the perfect storm for UK pension schemes, which have been hit on both sides of their balance sheets: assets have dropped while liabilities have been revised upward.

According to Pension Protection Fund data, the aggregate deficit of the 5,422 schemes in the PPF 7800 Index is estimated to have increased to £135.9 billion at the end of March 2020, from an aggregate surplus of £22.1 billion at the end of April 2019, reducing the funding ratio from 101.4% to 92.5% over the last 12 months.

The problem may not be resolved in the near term, as “lower-for-longer” interest-rate policies could have lasting effects on both the assets and liabilities of pension schemes, given that funding levels are highly sensitive to real bond yields.

To hedge or not to hedge: that is still the question

As always, when it comes to hedging, there is no clear-cut answer. Hedging market corrections using popular methods may be both expensive and ineffective at this stage: just because volatility is high, it doesn’t mean it’s expensive, and when it’s low, it doesn’t mean it’s cheap.

Given the tug-of-war between data releases pointing to recession and waves of monetary and fiscal intervention, volatility is likely to remain volatile. We would point out that a valid alternative to market timing exists by overlaying a line of defence to existing portfolios in order to improve their overall risk/return profiles and ride the waves of volatility.

Such a defensive overlay solution should combine different hedging and financing strategies, allowing it to be flexible and to adapt to the market and volatility environment.

Another advantage is the overlay concept itself, which means that the hedging instrument is simply placed on top of an existing strategy. This means there is no need to take anything out of portfolios, and the hedge can be easily customised thanks to the use of cash-efficient, listed and highly liquid instruments.

In conclusion, these solutions allow investors to maintain control of their asset allocation but also create a cushion against further downside risk, before the music stops again.

Fixed-income frontier markets have seen significant growth in both importance and liquidity over the past decade. While still mainly thought of as part of global EM investments, frontier markets have “grown up” and deserve to be considered separately.

Frontier debt offers a compelling investment opportunity, with historical returns outpacing both broader EM sovereigns and the developed market high-yield segment.
The efficient frontier of a balanced portfolio is also improved by adding frontier debt.
Investing in frontier market sovereign bonds means lending money to those governments that need it most, increasing GDP growth in the world’s poorest countries and contributing to positive change.
The coronavirus-induced sell-off provides investors with the possibility of entering the asset class at yields near the historically high levels seen during the global financial crisis.
After significant growth over the last decade, we believe that it is time for global investors to start considering EM frontier debt as a stand-alone investment opportunity. All of the traditional arguments for allocating to emerging markets – faster growth, higher yields and diversification benefits – are even more significant in the case of frontier markets.

Frontier debt markets: a growth story
Frontier markets offer a strong growth story – both in terms of the economies of the countries in the frontier space, and when it comes to their sovereign bond markets.

Around fifteen years ago, frontier markets (as defined by JP Morgan’s NexGEM index) included fewer than ten countries with a combined market capitalisation of USD 15 bn. Since then, the markets have seen impressive growth: ten years ago, the index counted just sixteen countries and a USD 37 bn market cap; five years ago the numbers were 34 and USD 88 bn; and at the end of 2019 the index had 35 countries and a market cap of USD 129 bn.

Indeed, after a decrease in market capitalisations in 2018, in part due to the removal of Ecuador, growth continued in 2019, with thirteen new bonds entering the index, including a first-time issuer, Uzbekistan. Despite Egypt leaving the index during the year, the index’s market capitalisation grew to its highest ever level of USD 129 bn. Several countries included in this index have also issued euro-denominated bonds, so the investable universe of hard-currency debt has grown even more than the index’s figures would suggest. While this growth has created higher debt loads on average, many bonds have come from a range of debut issuers. Average-debt loads as a percentage of GDP remain manageable at just over half of what is seen in developed markets (DM).

As frontier markets continue their impressive growth, investors would be wise to start to think of frontier debt as its own asset class, and therefore assess its merits in more detail. Frontier debt is no longer a small and illiquid market best left to a few small specialist funds. Under normal market circumstances, many frontier countries’ bonds trade in significant amounts daily, and getting liquidity is generally not a problem for a well-diversified strategy until a reasonably large capacity (i.e. at least USD 1 bn) is reached.

Along with its stand-alone growth, frontier debt also accounts for a growing proportion of the broader sovereign index. Indeed, in contrast to equities, where emerging and frontier markets’ indices are separate and mutually exclusive, in the bond space the frontier index is a subset of the commonly used JP Morgan EMBI Global Diversified.

Over the last ten years (2009–2019), frontier markets’ weight within the broader EM index grew from 5% to a peak of almost 25% before decreasing slightly in the recent sell-off due to mark-to-market effects. This means that anyone invested in funds benchmarked to the EM sovereign index has already been growing their allocation to frontier markets – perhaps even unknowingly in some cases. Having exposures that are not deliberate means investors are not able to assess – and ultimately optimise – their investments. We believe that this is what has happened to some investors’ frontier allocations.

Not viewing frontier markets as investments in and of themselves causes two separate problems. Firstly, the specific facets of this investment universe are ignored and are instead grouped together with broader emerging markets with which they at times have little in common. Secondly, investing through the largest global EMD funds means one could be foregoing significant alpha opportunities within the frontier debt space. Of the 35 countries included in the JP Morgan NexGEM index at the end of 2019, twelve had USD 1 bn or less worth of bonds in the index. A manager with a large global EM sovereign fund would be practically unable to invest in a country such as Tajikistan, which has only USD 500 mn worth of bonds outstanding. If this hypothetical fund wanted to build a 1% position, it would end up owning too much of the outstanding debt. Acquiring such a position – or potentially selling it later on – would take a significant amount of time and, even with the most skilled trader(s), it would almost certainly move the market, both on the way in and on the way out.

As a result, we believe investors should view frontier debt as a potential stand-alone investment. The investable universe is now sufficiently large and liquid, and its history long enough that its merits as an allocation can be appropriately considered, either as an alternative, or as a separate opportunity, to any broader EM investments.

High yields and low default rates mean impressive returns
Frontier markets offer an attractive investment opportunity for a number of reasons. The most obvious is that returns have outpaced most other fixed-income asset classes, even when the recent sell-off is included. The risk premium imbedded in the yields of EM sovereign bonds overcompensates for the risk associated with defaults. This is due to the combination of defaults being relatively rare and recovery rates being relatively high. Firstly, sovereigns are usually loath to default, as it means losing access to capital markets and US dollars. At the same time, multilateral institutions are often on hand and willing to provide concessional financing and technical assistance for any reforms that are needed, as well as support during any restructuring. Recently, the IMF announced that is was making USD 1 trillion of financing available for countries suffering from COVID-19-related issues. While all sovereign debt benefits from this, the arbitrage is most significant for the higher-yielding frontier part of the index. This is because defaults only comprise a slightly higher proportion of the frontier than of the broader emerging market space, while recovery rates are similar. The slightly higher incidence of defaults is not nearly enough to wipe out the pick-up in yields. The NexGEM index was launched in 2011 but the data has been created back to end-2001, meaning there is almost twenty years of data for analysis. Over this period, the NexGEM index returned 8.8% (annualised to 31 March 2020), significantly outpacing all other EMD sub-asset classes.

Frontier also outperforms all DM bond indices that we have reviewed over time. The most natural comparison is with US high yield (both indices are purely high yield and USD-denominated). Since the start of 2002, frontier bond markets have outperformed US high yield by 1.66% (annualised).

Yields on NexGEM have historically been only marginally higher than US high yields, but defaults have been meaningfully lower and recovery rates higher.

Of course, frontier market debt does not come without volatility. That being said, over the last ten years, EM frontier debt markets have been able to deliver higher returns with similar Sharpe ratios to EM sovereign debt (and much greater risk-adjusted performances than EM local debt or global aggregate indices).

Many of the factors that have contributed to frontier debt’s strong performance remain in place and indeed some are even stronger today than they were previously.

Growth rates in frontier markets continue to outpace not only those of developed markets, but also emerging markets more generally. Indeed, with many of the traditional BRICs slowing down, the faster growth rates of frontier economies should continue to stand out.

Clearly the coronavirus-induced market sell-off is having a significant impact on projections for both global defaults and growth rates. Frontier countries will not be immune to this. That said, we are still projecting growth in 2020 for frontier markets to outperform both developed markets, with likely negative growth, and EM more broadly. We have also seen a number of EM countries default, but among the NexGEM markets only Zambia has thus far announced an intention to re-profile its debt but we expect others will as well (we see Angola and Sri Lanka as being most at risk). However, we believe these risks are being compensated by yields and spreads that are near the historically wide levels seen in the global financial crisis in 2008 at aggregate level. We see relatively strong borrowers offering very attractive yields and believe the majority of the countries currently in default or at risk of default are already pricing in very negative restructuring scenarios, having overshot our estimates. It is not the case for all issuers, however, hence investing in frontier markets requires active management and in-depth fundamental research to limit the risks associated with potential credit events.

Recovery rates, meanwhile, have also trended higher in recent years. The emergence of so-called “vulture funds” which buy distressed debt with the aim of going through the courts to eventually realise profits, means that sovereigns are less likely to apply punitive terms to any restructuring for fear of being dragged into drawn-out litigation.

A superior diversifier
Absolute and risk-adjusted performances are, of course, among the most crucial factors of any investment. That said, few investments happen in a vacuum. One of the traditional supporting arguments for investing in emerging markets – and indeed any “new” asset class – is the diversification it offers to an existing portfolio. Indeed, emerging market debt offers an improvement on the efficient frontier of a portfolio made up of global equities and bonds.

However, a significant proportion of the broader sovereign index – the JP Morgan EMBI Global Diversified – offers little by way of diversification. The higher-rated countries in Latin America, such as Peru and Chile, tend to trade with high correlations to US investment grade debt, with very similar – and tight – spread levels. Meanwhile, CEE countries – Poland and Hungary, for example – are highly correlated to developed Europe; to a large extent the fates of all of this debt, along with that of highly rated Asian sovereign and quasi-sovereign issuers, are generally closely linked to US Treasuries.

The real diversifiers in the index are found in frontier markets. This effect can be seen when we take our efficient frontier of global stocks and bonds, and swap the EMBI Global Diversified for the NexGEM index instead. The improvement in the efficient frontier is much more significant with frontier debt than with broader EM sovereign debt.

Contributing to positive change
Investing in frontier market sovereign bonds means lending money to governments that need it most. Access to foreign capital allows governments of frontier countries to undertake important infrastructure projects, which in turn increases GDP growth and brings up median incomes. However, a point can be reached at which increasing debt loads become an impediment to growth. The BIS estimates this threshold to be 85% of GDP for government debt. With the average debt-to-GDP ratio below 60%, we are not at risk of reaching this level in frontier economies any time soon. The World Economic Forum states that foreign currency debt has become an important source of development finance for African economies. Infrastructure investments can help improve access to clean water, food and sanitation, as well as to improved healthcare facilities, which sets off a virtuous cycle that, in turn, increases life expectancy. In the last fifteen years, significant progress has been made and many of the poorest countries in the world (including a number of frontier countries) have seen marked increases in life expectancy. In 2003, there were thirty countries in the world where life expectancy at birth was less than fifty years, including nine with a life expectancy below forty.

In 2017, no country in the sample had a life expectancy below fifty. Despite this, a number of countries, many of which are a part of frontier debt markets, still have room for significant improvement. Specifically, many of the countries whose life expectancies remain below sixty now have international debt, or are looking at potentially issuing it.

One factor that can help bring down life expectancy in a given country is its infant mortality rate. The Royal Society of Medicine has found that, before adjusting for covariates, the relationship between income and infant mortality is -0.95. That is, if a country has an infant mortality rate of 50 per 1000 live births and GDP increases by 10%, infant mortality will decrease to 45 per 1000 live births. They conclude that, “…income is an important determinant of child survival.” Global infant mortality has declined drastically in the last few decades from 65 deaths per 1000 in 1990 to 29 deaths per 1000 in 2017, thanks largely to improvements in Africa, where it has declined from 107 deaths per 1000 live births to 51. However, there is still much work to be done in Africa, as 51 deaths per 1000 live births still is well above the average and far from the European regional average (8 deaths per 1000 live births). With Africa making up a significant – and growing – part of the frontier debt markets, an investment could positively contribute to the continuation of this trend.

While higher GDP growth shows a strong correlation to higher life expectancy and lower infant mortality, this correlation is not constant across countries. Countries with more inclusive growth, a greater focus on infrastructure investment and with less corrupt governments show a higher correlation. Therefore, while a blanket investment in frontier debt would be likely to have a positive impact on the world, this effect is most powerful when an active assessment is made as to how strong governance is, and therefore how constructively the money will be spent.

Stronger governance and social factors also make for a more attractive destination for FDI. Saying what proportion of the contribution to GDP growth is due to FDI and what is due to government debt is impossible, but it is fair to assume they have each played a significant part in the positive stories we have seen.

Ultimately, a less corrupt government spending borrowed money to improve the country and spurring on growth is also likely to lead to improved credit metrics and positive returns for clients. The investment team therefore attaches significant importance to both the motives and abilities of the governments of the countries in which we invest.

As a result, the investment process gives both subjective and quantitative weight to governance and societal factors. From a quantitative standpoint, credit screening and scoring tools give significant weight to assessments generated by, for example, the World Bank Doing Business, the Heritage Foundation Corruption Index, the Heritage Foundation Economic Freedom and Monetary Freedom, the World Bank Governance Voice and Accountability Index and the World Bank Government Effectiveness Index.

While the quant tools used provide inputs, all investment decisions are discussed and debated beyond just the numbers. The investment team spends a significant amount of time discussing the clarity of the governments’ objectives and the motivations behind them. At this stage, other factors are also assessed, such as the World Press Freedom Index.

Finanz und Wirtschaft (06.05.2020) – Eleanor Taylor Jolidon, Co-Head of Swiss and Global Equity at Union Bancaire Privée, endorses companies that can withstand crises and warns about too much optimism

Did the global pandemic catch you off guard, Ms Taylor Jolidon?

Such a decline to the March trough was not expected at the beginning of 2020. However, we did make a cautious start to 2020, and expected economic growth to be weaker at a global level as compared to 2019. Consensus earnings expectations appeared too high, particularly in cyclical sectors such as energy, materials and capital-intensive industries. We noted subdued growth figures from China. As such, we were already defensively positioned before the global coronavirus crisis.

How did you react to the global pandemic?

Calculating what could be the magnitude of the effects on the global economy, led us to adjust the portfolios we manage to a more defensive tilt. We increased our exposure to companies that are better able to withstand the current downturn and are potentially able to benefit from some behavioural changes which may result from the pandemic. The Swiss stock market is well positioned on both these points.

How so?

The Swiss market tends to outperform other markets, on a relative base in crises, in particular, European markets. This is partly due to the well-observed defensive nature of the heavyweights, Nestlé, Roche and Novartis. Furthermore, investors appreciate the safe-haven status of the Swiss franc, which can be an added advantage.

That’s the generally accepted interpretation.

We prefer to look deeper and concentrate on the fact that the Swiss equity market offers particularly attractive high and stable levels of cash-flow return on investment (CFROI). Companies that are able to increase or maintain at a high level their CFROIs, are value creative. That value creation enables them to withstand crises with greater resilience and return to growth once the economy stabilises or grows again. The comparison is particularly marked with European stock markets, which have significantly failed to create value, or increase their CFROI beyond a breakeven level since the Great Financial Crisis. Indeed, the US market and Switzerland stand out with their strong and sustainable value creation.

How are these companies different?

These relatively crisis-proof businesses will tend to have strong balance sheets. They can continue to manufacture and sell their products and services, thanks to well-established networks of suppliers and customers. They can finance their business and they continue to generate cash flow. Furthermore, in current circumstances, if a company produces necessities, such as is the case for the aforementioned food company and pharmaceutical companies, they will see less cyclicality in their end demand. Indeed, they may even witness higher demand for their products.

Where would you see higher end demand?

Beyond some consumer staples and selected healthcare, there is a potential for stable or increased demand for IT and software companies, particularly those that are involved in the digitalisation of businesses, which has become even more important in this work-from-home setting. SoftwareONE, which provides software license management and advisory services plays into this indirectly; Temenos and Crealogix, which specialise in banking software; and Logitech, which produces computer peripherals would be selective examples of this.

However, this could also simply be a flash in the pan. Who is winning structurally?

Now that we have a heightened awareness of pathogens, private individuals and companies may also envisage renewing their infrastructures, for example by updating ventilation and air conditioning systems. Companies like Belimo, a leading provider in this area, could benefit.

Would the pharmaceutical and healthcare sector be the big winner now?

Caution is advised here. Many companies are currently researching vaccines or treatments for COVID-19. However, there is a valid opinion that for reasons of social responsibility, these may enter the market at major discounts, or even free of charge in some countries. Success in the fight against the virus will therefore not automatically translate into higher returns. In addition, the demand for some specialist drugs or materials has been disrupted by the pandemic.

But there must also be winners in these areas.

Yes, there are. One company that is benefitting during the pandemic, due to changes in regulation, is the online pharmacy “Zur Rose”. The German authorities have now not only allowed electronic prescriptions, but the legislature will actually make them mandatory from the beginning of 2022. This makes it relatively more attractive to order medication online than previously.

Contract and development manufacturing organisations (CMO/CDMOs) such as Lonza, Bachem, Siegfried, and maybe also Dottikon, stand to benefit from research into a vaccine or therapy for COVID-19 and higher sales of existing drugs used to treat the viral side effects of COVID-19. Furthermore, their long-term positive drivers have not been disrupted.

And which companies are you avoiding?

The exit from the crisis may be slower than initially thought. Millions of jobs have disappeared, at least temporarily, and the unemployment rate in the USA is around 15%. Consumption will only recover slowly, and this slow recovery may have negative repercussions on retailers in particular. Furthermore, it is unlikely that sales figures of car manufacturers will spring back to the already depressed pre-crisis levels. A large proportion of the population may be cautious about types of travel and leisure activity that involve large numbers of people in close proximity for extended periods. The aviation, travel, tourism and events industries may need more time to recover.

Which Swiss companies are affected?

One example is the exhibition provider MCH Group, which was already experiencing problems before the crisis. Duty free retailer Dufry will face half-empty airports for some time yet.

The market has rallied since the March trough. How sustainable will it be?

Markets may be underestimating the likelihood of a second wave of infection and another lockdown. Although profit expectations for this year have fallen sharply around the world, there may be further necessary downgrades. The publication of Q2 numbers may reveal more regarding the severity of the economic downturn caused by the pandemic.

How will things look after the crisis?

Both public and private debt will be higher. Balance sheets will be adversely affected – and possibly in particular those of consumers. Recovery may be slower than was initially assumed, an assumption that has led to the apparent optimism in the market at the moment. Hopefully that optimism is not misplaced. Nevertheless, further market corrections may well happen.

Many forecasters assume strong economic growth in 2021.

This is understandable. The crisis will peter out with our infrastructure intact. Many businesses will have their machinery up and running again at the flick of a switch. The question is how quickly consumption will return to its pre-crisis level. Governments and central banks are supporting the economy in general, including companies that were already in difficulties prior to the crisis.

What is wrong with that?

This comprehensive support scheme will also rescue businesses that would have gone bankrupt under normal circumstances. In the particular case of the financial sector, for example, the rules on capital adequacy are being temporarily relaxed, thereby supporting those institutions which have long ceased to be sustainably profitable; but at the same time everyone is virtually banned from paying dividends, which means that the strong cannot display their strengths. This is ultimately a missed opportunity for beneficial consolidation.

Are you sceptical of financial stocks?

There are no disturbingly weak or precarious listed banks, insurance companies or financial service providers in Switzerland. The major banks and financial services companies have actually profited from the high level of customer activity in Q1. However, it is questionable whether this will continue in Q2. The banking sector continues to face a long-term trend in terms of higher regulation and lower earnings opportunities which make it less value creative. Insurance is more preferable in that context.

What will be important in the coming months?

The success of exit strategies will be key. Second waves of infection such as experienced in Singapore would surely be a major setback.