December 2021 – The Perfect Storm
Portfolio Manager comment Coeli Frontier Markets Fixed Income December 2021
Summary
The fund gained 0.61% gross of fee in December, however lost 4.68% in the fourth quarter. The fund ended the with a spreads 847 bps and a yield of 9.7%. Main underperformance in the fourth quarter came from positions in El Salvador, Ghana and Sri Lanka. In December, Ghana recouped some of its losses, whereas Sri Lanka and El Salvador continued to be a drag for the fund. Our local currency exposure in Uzbekistan was our best performing position during the quarter with marginally positive performance. November weakness defined the quarter with continued fear of (i) rising inflation (ii) rising US yields and (iii) return of covid.
Since launch in March 2021, fund’s performance was negative 1.73% before fees. Zambia was the strongest performer followed by Angola. The main drag on the fund came from holdings in El Salvador, Ghana and Sri Lanka.
Key Market Developments
Q4 saw a continuation of the yield spread widening for frontier debt as we saw in the previous quarter although with a more erratic development in November and a muted rebound in December. Except for the short spike during March 2020 when the first Covid wave hit, this is still the highest spread in 10 years. The following macro developments lead to de-risking and outflows from our markets:
- Fear of US QE tapering combined with expectations of rising US interest rates.
- Stagflation concerns and concerns that the recent spike in inflation is going to be more sticky. US inflation at 6.8%, measured on the overall index, is now the highest in the “modern” cycle or since early 1982 after the second oil crisis hit in 1979.
- Finally, at the end of November covid once more took the center stage. A new mutation, Omicron, quickly brought back remembrance of a March 2020 scenario with a correction in the commodity space with a significant drop in oil prices. This new wave of covid was particularly difficult for Europe and European governments given that initial vaccinations, as we now have confirmed, provided protection from bad outcomes but not actual infection from the new variant.
In our frontier markets we had the following key developments during the quarter:
- El Salvador in public dispute with US and looking to issue a “bitcoin” bond
- Ethiopia entered a state of civil war
- Zambia initiated IMF and debt restructuring talks
- Sri Lanka balancing on the verge a restructuring with depleting foreign reserves
- IMF failed to deliver any details on SDR re-allocation to developing nations
Portfolio Developments
In a weak market, our high risk positions underperformed in the portfolio. Throughout this period we have added to our risk in the portfolio, ending the year at 129% versus at 118% in November and 123% in September.
El Salvador has been the worst performer in 2021 and Q4. Continued hostility between the president and US combined with bitcoin headlines have been the main culprit (with an overhang of a funding gap for 2022). We underestimated the negative momentum early on and later assessed valuations to be attractive too early. We have also given too much credit to the strength of the local economy, though this was confirmed by the positive IMF Article IV report released in the quarter. The report also expressed concerns about El Salvador’s like for bitcoin. Since, the IMF has however suggested developing countries should regulate crypto currencies as opposed to avoid them.
With an average price of 56 cents, significant downside priced in, and two upcoming catalysts we see an attractive scenario weighted return potential. The two upcoming catalysts are IMF discussions and the upcoming “bitcoin bond” issuance at 6% versus yields in the teens. We have further added to our position in December.
Sri Lanka’s foreign reserves reached a new low in December, and we see current levels pricing in a default with attractive optionality to an amicable restructuring. The option of financial support from outside of the IMF has been deteriorating, but the Government did increase reserves at year end. We continue to hold our position.
Ghana has also contributed negative to the performance on the back of a new budget proposal showing a larger than expect deficit of 12%. The budget deficit is expected to narrow towards 8% in 2022 as authorities expect a sharp increase in revenues, partly based on a financial e-transaction tax. The successful implementation of this e-tax and general tax collection will be the driver of Ghana’s bonds. We remain constructive on the prospects, however the market is less accommodating.
Egypt now counts for approximately for 5% of the portfolio and has been our largest new addition to the portfolio in the quarter. Egypt has done and are doing a lot of things right in economic terms, which is why it’s also been a favored trade for a broad investor base. Equally it is a high beta position. We think Egypt has a strong potential to lead any recovery in demand for risk in EM debt.
Pakistan is a country we have now fully excited on the back of tight pricing following another distribution from the IMF support package. Inflation remains a challenge and we do not believe current pricing and technicals are attractive.
Top 3 and Bottom 3 Contributors in December
TOP |
BOTTOM |
| Ghana – Partial rebound from November weakness | Sri Lanka– Continued shortage of hard currency reserves |
| Nigeria – Oil driven appreciation | El Salvador– Animosity with the US & bitcoin |
| Angola – Oil driven appreciation | Maldives – Delayed repricing from November |
Source: Coeli; Bloomberg; Based on December 2021 contribution to the fund’s performance
Outlook
We are entering into 2022 with a yield of 9.7% and a risk level in the portfolio of 129%. Frontier debt has repriced during the autumn and measuring by the benchmark the yield spread versus US rates hasn’t been higher in the last 10 years beyond the short-lived correction in March 2020.
US inflation at 6.8%, the highest since 1982, and the 10-year US yield at 1.6% present challenges for fixed income assets in the coming year. What follows is that either US rates rise substantially, or inflation will come down. Research has shown that EM and frontier markets perform worst in anticipation of a rates rising environment. This would suggest that current high yields have priced in a lot of downside already.
Our fund also provides substantial exposure to idiosyncratic events in our larger high yield positions in Sri Lanka, El Salvador, Ghana and Tunisia which will be a substantial driver of performance in 2022.
Though expectations for covid are that it becomes endemic in 2022, it still remains a risk factor. Vaccinations were not the savior we expected.
Finally, we still await new developments on the IMF’s SDR re- allocation and the EU’s Global Gateway initiative to support our frontier markets in early 2022.
Kind Regards, Lars and Maciej
| Fund metrics 1) | Fund | NEXGEM 2) |
| Total fund assets (USDm) | 39 | |
| Yield to worst (%) | 9.7 | 7.7 |
| Spread (bps) | 847 | 658 |
| Running yield (%) | 6.3 | 6.4 |
| Spread duration (years) | 5.4 | 5.7 |
| Number of countries | 29 | 36 |
| Number of bonds | 72 | 151 |
| Performance | MTD | QTD | Since launch |
| Fund (before fees) | 0.61% | -4.68% | -1.73% |
| Fund (I USD) | 0.53% | -4.91% | -2.46% |
| Benchmark (NEXGEM) | 1.74% | -2.82% | -0.04% |
1) As of end of Nov 2021, using weighted average data from JPM Morgan, Bloomberg, Coeli; proforma for any transactions completed before month end
2) NEXGEM refers to the Fund benchmark JPM NEXGEM
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