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Value investors tend to think of themselves as having a stronger character than the rest of the crowd. They certainly need it, since they often have to live with losing positions for uncomfortably long periods.

Right now there’s a lot of chatter among them about “frontier markets”, since value people seem to regard the developed world, particularly the US, as a sort of late Roman Empire. I would have thought there would be more of a party scene if we were about to be overrun by Goths or Vandals.

One frontier is Kazakhstan, which I took a bullish view on back in April. And Kazakhstani securities have performed in a classic manner since then, going from deep value to even deeper value. That is, the prices went down. For example, Kazkommertsbank (KKB), part of the banking sector I liked, is down by around half since the end of March. The mining companies, which have attracted most of the foreign investors, are also down, though not by quite as much.

The macroeconomic story on which I based my optimism is intact; the country’s gross domestic product grew at a year on year rate of 8.3 per cent between January and May. Unemployment is low, the currency is strong, and even the left-for-dead real estate market might have bottomed. The long-in-development Caspian hydrocarbon projects are still on track for a rapid increase in production next year, which will mean huge increases in export revenues. That cash may not be administered using the obsessive-compulsive accounting procedures of the Norwegian state.

Still, a lot of the money will flow through to the public and the banking system. Also, the Kazakhstani banks, which before last year had been looted by insiders and hollowed out by bad loans, have almost finished their reorganising and recapitalising. They are heavily subsidised with state deposits and high net interest margins.

So how come, then, that KKB is selling for around 60 per cent of book value, given that its loose lending days should be in the past, and its customers have a promising future?

One explanation is that resource plays generally, even indirect ones such as Kazakhstani banks, aren’t as popular as they were earlier this year. Another, even more obvious, is that the exchange offers that were forced on the banks’ foreign bondholders put a lot of Kazakhstani paper in the hands of unhappy, unwilling holders.

There was a lot of bad feeling in the fixed income world about the Kazakhstani authorities forcing the banks’ bondholders to take deep haircuts, as in half the face value, in exchange offers. As these discouraged investors get the new paper that replaces their old bonds, many push it out to the dealers and more calloused hedge funds. So if you want to buy the frontier market, countries of the future, there are eager sellers out there with Kazakhstani paper.

The most recent completed bank restructuring was that of Alliance Bank, which, back in April, was about to close its deal. The old bondholders got a package of paper, which included straight bonds with a 2017 maturity and a coupon of 10.5 per cent. They’re trading at a yield to maturity of around 13 per cent now. That’s not too much, considering that about 75 per cent of the principal on the bank’s loans is overdue, though there are already loss provisions for about 70 per cent.

Also in that package were the bank’s Recovery Notes, priced around 8 to 10 per cent of the maximum possible recovery of loan losses, which won’t happen. The holders are supposed to get quarterly payments on those things; one payment of 1.25 per cent has already been made. If more such payments are made the return looks pretty good. If not, you go from a very high yield to a big loss. These are for real gamblers or, who knows, someone with intimate knowledge of likely pay-outs.

There is one more Kazakhstani bank restructuring left to complete, that of BTA Bank. Exotix, the London dealers in frontier paper, refer to BTA as “the strongest of the defaulted banks in terms of having the best ongoing business; we expect it to trade inside of Alliance Bank in terms of yield and spread.”

Enough of the edgier value investors agree so that the old bonds trade in the mid-40s. That seems to assume the new notes issued in September will be priced to yield close to Alliance Bank’s, with Recovery Notes and some equity included like free toys in a cereal box.

However, one of the most successful frontier investors I know says: “These restructured bonds, or the old BTA notes, seem more speculative to us than just buying something simple like the KKB equity. A lot of time in emerging markets, you see people get into very complicated weird strange things, when they have something obvious sitting right in front of them.”

In other words, straight equity risk in the sounder institution is under-priced relative to complicated fixed income risk in the weaker ones, which sounds plausible.

Good luck on the frontier. You’ll need it.


Copyright The Financial Times Limited 2017. All rights reserved.

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