After several years of strong performance in fixed income, the easy gains in credit markets appear largely exhausted. With corporate spreads now hovering near historical lows, investors are once again confronted with a familiar challenge: how to generate meaningful carry without assuming disproportionate downside risk. For Ville Iso-Mustajärvi, portfolio manager responsible for fixed income and alternatives at Finnish pension insurer Veritas, the answer lies beyond traditional credit benchmarks and increasingly outside developed markets. Local currency bonds in frontier markets represent one such opportunity pool.

When evaluating fixed income allocations at a broad level, Iso-Mustajärvi believes the starting point must be economic rather than benchmark-driven. “You really need to ask yourself how much excess return you are generating over your cost of capital, and what other benefits that asset class brings to the overall portfolio,” he explains. Government bonds, even if they offer limited excess spread over funding costs, still serve a purpose. “Government bonds can provide a degree of diversification under normal market conditions.”

“You really need to ask yourself how much excess return you are generating over your cost of capital, and what other benefits that asset class brings to the overall portfolio.”

Ville Iso-Mustajärvi

However, further out on the credit risk spectrum, he sees limited value. High-yield bonds currently offer “equity-like downside with very little upside,” given tight spreads and asymmetric risk-return dynamics. This assessment has prompted Iso-Mustajärvi to look elsewhere for carry with diversification characteristics. “I ask myself whether there is another part of the asset class spectrum where you can achieve a similar carry profile, some diversification benefits, but with meaningfully better return prospects,” he says. One such area is frontier markets local currency debt.

Looking Beyond the Indices

To uncover attractive risk-reward opportunities in emerging and frontier markets, Iso-Mustajärvi argues that investors must move beyond benchmark-driven thinking. “You need to think outside the box and look beyond the indices,” he says. While he sees limited value in hard currency emerging market debt at present, the opportunity set broadens significantly in local currency and more frontier-heavy allocations. “Frontier-type investments can still yield between 10 and 15 percent,” he notes. Additional upside may also be found in emerging corporate debt.

“You need to think outside the box and look beyond the indices. Frontier-type investments can still yield between 10 and 15 percent.”

Ville Iso-Mustajärvi

Traditional benchmarks such as the JPMorgan EMBI Global Diversified Index are dominated by larger issuers including Brazil, China, South Africa, and Poland. By contrast, venturing into smaller issuers such as Kenya, Ghana, Uruguay, Mongolia, and Egypt can open up meaningful alpha opportunities. “There is tremendous room to generate added value if you look beyond the typical index constituents,” Iso-Mustajärvi says. “If you opportunistically mix in some corporates and selectively include larger countries from the broader EM universe, you can construct portfolios with combined yields above 10 percent and a relatively stable credit profile.”

“If you opportunistically mix in some corporates and selectively include larger countries from the broader EM universe, you can construct portfolios with combined yields above 10 percent and a relatively stable credit profile.”

Ville Iso-Mustajärvi

He is careful not to understate the risks. “It’s not risk-free,” he stresses. “But if you compare that to high-yield indices with single-B or single-B-minus profiles offering spreads below 300 basis points and running yields around 6 percent, you are talking about 1.5 to 1.6 times the running yield for arguably slightly lower credit risk,” argues Iso-Mustajärvi. “And the diversification characteristics are better, the correlation profile is different.”

A Key Carry Driver

Within Veritas’ €5.2 billion portfolio, emerging markets debt, particularly local currency frontier exposure, has become “one of the main carry drivers in the fixed-income portfolio,” according to Iso-Mustajärvi. To maximize the risk-return profile, he frames the allocation clearly: “What am I trying to achieve with this portfolio component? The answer is carry with a diversifying profile.”

Approximately half of the allocation is dedicated to local currency frontier exposure, which he describes as “a relatively uncorrelated, high-yielding component under normal circumstances.” While individual countries may experience periods of political or economic stress, cross-country dispersion can work in investors’ favor. “Many of these countries diversify each other quite well. What happens in Mongolia often has very little to do with what happens in Uruguay,” he explains. By contrast, developed market equities tend to exhibit far higher cross-asset correlation.

“Many of these countries diversify each other quite well. What happens in Mongolia often has very little to do with what happens in Uruguay.”

Ville Iso-Mustajärvi

That said, the risks are neither negligible nor easily quantifiable. Currency volatility represents a primary source of uncertainty. “Currencies can weaken substantially and individual countries may face idiosyncratic challenges,” Iso-Mustajärvi cautions. Tail risk is particularly difficult to model. Historical data may indicate low volatility and limited correlation, but this can partly reflect low liquidity and limited foreign participation. “If a specific event occurs and everyone heads for the exit at the same time, liquidity can quickly become a challenge,” he says. “It’s difficult to quantify precisely what happens in that scenario, so you need to remain very conscious of that risk.”

Avoiding Index Pitfalls

The other half of Veritas’ emerging markets exposure is structured to avoid structural inefficiencies embedded in traditional benchmarks. Iso-Mustajärvi considers some EM indices overly concentrated and less representative of the broader opportunity set. “For example, the JPMorgan EMBI Global Diversified Index is heavily concentrated in a few large names. In hard currency debt, you often see a sharp divide between very high-yielding, near-distressed issuers and tight-spread investment-grade names, with very little middle ground.” Moving into corporates requires additional caution, especially where state ownership creates high correlation between sovereign and corporate exposures.

“In hard currency debt, you often see a sharp divide between very high-yielding, near-distressed issuers and tight-spread investment-grade names, with very little middle ground.”

Ville Iso-Mustajärvi

To capture the full opportunity set while avoiding unintended overlaps between external managers, Veritas has opted for unconstrained mandates. “We have deliberately selected teams with broad capabilities across the full spectrum, rather than separating everything into different sleeves,” he explains. While about half of the allocation sits with dedicated local currency frontier managers, the remainder is run through flexible, unconstrained mandates. “The end result, how much sits in corporates versus sovereigns, varies considerably and is often driven by relative value considerations.”

“We have deliberately selected teams with broad capabilities across the full spectrum, rather than separating everything into different sleeves.”

Ville Iso-Mustajärvi

He contrasts this structure with peer approaches that rely on multiple managers across segmented local and hard currency strategies. Given the limited issuer universe in benchmark indices, such construction can lead to low aggregate active share. “It becomes questionable how much alpha you can truly generate. You end up largely owning beta,” Iso-Mustajärvi argues. “And the indices that define that beta are not necessarily the most interesting opportunity sets. That’s not a flaw in index construction, it’s simply a structural feature.”

External Expertise and Active Currency Management

With a lean internal team, Veritas relies predominantly on external managers for implementation. Internally, the team focuses on currency overlay and tactical foreign exchange decisions. Currency positioning can materially influence returns in emerging anf frontier markets debt. “How you position on euro-dollar can have a significant impact on performance,” he explains. “Taking a pragmatic and active stance on EUR/USD within the EM debt portfolio added meaningful value last year.”

“You need relatively deep benches if you want to manage EM internally. Over the past ten years, after all costs, we have generated very strong alpha from our managers. I’m satisfied, it has been money well spent.”

Ville Iso-Mustajärvi

After nearly a decade refining this approach to emerging markets debt, Iso-Mustajärvi remains confident in partnering with flexible, return-oriented managers alongside dedicated frontier specialists, arguing that such a structure provides broader opportunity capture than more benchmark-bound solutions. “You need relatively deep benches if you want to manage EM internally,” he says, explaining why Veritas continues to rely on external expertise. “Over the past ten years, after all costs, we have generated very strong alpha from our managers. I’m satisfied, it has been money well spent.”