By Carolyn Cohn and Natsuko Waki
LONDON (Reuters) - Iran, hoping for a full lifting of western sanctions, and North Korea are among extreme frontier markets that could attract adventurous fund managers with the stomach for high political risk in the search for higher returns.
Iranian President Hassan Rouhani told business and political leaders at the World Economic Forum in Switzerland on Thursday that Iran was negotiating with the United States as part of a "constructive engagement", inviting European companies to seize opportunities as relations normalise.
That follows the lifting of some Western sanctions on Iran on Monday in exchange for steps to curb some nuclear-related activity.
Iran has its attractions to portfolio managers as a big oil producer with a large population and an established local stock market.
North Korea's little-known economy also boasts rich mineral resources such as iron ore and largely untapped rare earth metals.
And investors are desperately on the look-out for new high-return markets, particularly after poor performance in established emerging economies in recent years.
But for international investors in debt and equity markets, it could be years before they gain access to Iran, while North Korea is even further down the road.
Iran does have a relatively sophisticated stock market, dominated by locals. It turns over $200 million a day on average and has total market capitalisation of $164 billion.
"We see attractive valuations in Iran, partly related to the fact that it's a closed market," said Henrik Kahm, portfolio manager at emerging market fund FMG.
"We will see very low price/earnings ratios and strong growth among many sectors. It is a very interesting market, if it opens up."
Kahm is an early portfolio investor in Iraq, having launched an Iraq fund in 2010. Its local stock market was set up in 2003, but it had to abolish blackboard trading for an electronic system before it opened the door to foreign investors.
Kahm has been looking into ways to invest in Iran. "We have done due diligence on the ground. It's still too early days."
Like him, the first portfolio investors into new markets - Myanmar and South Sudan being other recent examples - tend to be frontier debt investors, private equity investors in unlisted companies and small funds focusing on listed stocks.
In order to issue debt in international markets, Iran would first have to come to an agreement on its outstanding debt with the Paris Club grouping of rich-nation creditors.
Iran has a relatively recent history of issuing debt in international markets. The central bank launched a well-received euro-denominated bond in 2002, even though U.S. President George W. Bush had that year labelled Iran part of the "Axis of Evil".
If Iran follows Iraq's path, its debt could be popular.
Following the Iraq war in 2003, the Paris Club cancelled Iraq's debts in 2004, and Iraq issued a $2.7 billion 22-year bond of restructured commercial debt in 2006. The bond is now included in benchmark bond indexes, is held by mainstream investors and yields below 8 percent.
But for Iran, the main current obstacle is the United Nations sanctions, in place since 2006, which have taken their toll on its economy, which has rampant inflation.
"There is a long list of things in Iran that need to be dealt with. When you are building a country, making good with foreign creditors is low on the list," said Angus Halkett, emerging debt manager at Stone Harbor Investment Partners.
Private equity investors say the least-developed markets can be the most lucrative.
Research by private equity firm Abraaj shows that over the past 10-15 years, new markets such as South Sudan have produced better returns than more established frontiers like Kenya. But finding ways to invest in post-conflict countries is hard.
"Many of these markets tend to lack good quality management teams, the brain drain is so high. To invest on a standalone basis is very, very difficult," said Sev Vettivetpillai, partner at Abraaj.
One way in is indirect investment through more developed neighbours.
Abraaj has invested in an East African microfinance company that expanded regionally, including into South Sudan. Similarly, it has invested in Kuwaiti and Turkish firms that have business in Iraq.
And private equity investor TLG has invested in a Cambodian company aiming to expand into Myanmar. This proxy model could be used in the future in Iran.
But there are even harder nuts to crack than Iran.
Cuba has repackaged defaulted debt of nearly $300 million, according to 2011 data. Trade in the debt is restricted due to U.S. sanctions, but Denmark-based fund ISI holds a small amount, which its quantitative analyst Thomas Rytter says contributed 6 basis points of returns to one of its funds in 2013.
The final frontier, however, may be North Korea, another country under U.N. sanctions.
On a corporate level, some brave pioneers are already making inroads. Egypt's Orascom Telecom has invested in North Korea's telecommunications market for the past six years.
Distressed debt is another avenue. The country has syndicated loans with a face value of around $1 billion, tied to loans in default since 1980s. It has not undertaken any restructuring with its creditors.
In 2011, after the death of President Kim Jong-il, the debt, repackaged into a special vehicle called NK Debt Corporation in 1997, rose to 14/18 cents on the dollar from 13/15.
The sudden interest was driven by hopes the new Swiss-educated leader Kim Jong-un might make progress with the international community and open up the economy.
It is not only specialised distressed debt traders who deal with the fund. One of the holders of NK Debt Corporation's notes is Franklin Templeton Investment Management's Emerging Markets Debt Opportunities Fund.
According to its annual report, as of July 2013 the fund held about $830,000 worth of zero coupon bonds maturing in March 2020, denominated in German marks and Swiss francs, acquiring them between 2007 and 2011 for more than $3.1 million.
Back in 2007, a London-based fund was trying to raise $50 million to invest in the reclusive state.
The fund received regulatory approval but came to nothing, according to Robin Fox, chairman of Anglo-Sino Capital Partners, which operated the fund.
"We hoped at the time that North Korea would follow along a similar path to China or Vietnam, but the regime would not change and allow any worthwhile foreign investment," Fox said.
"North Korea still has natural resources and a disciplined and reasonably well educated workforce. It should be an interesting frontier market at some stage," he added.
(Editing by Will Waterman)