Roses and thorns among Africa’s local currency bond investments

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In the last few months much has been written about the overwhelming demand experienced by African eurobond issuers. Nigeria, Kenya, Egypt and more recently Ivory Coast have all come out smiling, having issued bonds at low rates that were unimaginable just a few years back.

While “kudos” might be the appropriate response to these issuers’ conquests in foreign lands, it’s important to keep an eye out for potential local opportunities. Unlike their attention-seeking spoilt cousins (eurobonds), local currency bonds have been steadily gaining traction given the general improvements in the global economy and, more importantly, the commodity price-linked cyclical economic recovery.

Synchronised global growth and a rebound in commodities have spurred risk-on sentiment, allowing investors to give local currency bonds a second look in the search for yield.

While positive sentiment is always useful, it is important to note that it is notoriously fickle, hence the need for macroeconomic policies to offer a solid platform for growth.

The improvements in fundamentals have largely been cyclical, owing to improvements in commodity prices. Nigeria and Ghana have particularly relished the commodity price dividend, being large commodity exporters themselves.

To be fair, these two West African giants have attempted to diversify their economies, but Ghana is further down the road than Nigeria.

“Big Brother”, the IMF, has certainly played a key role in ensuring fiscal restraint across the continent. Since the end of the commodities super cycle in 2014 we have seen the presence of the IMF growing — as it naturally does when finances are tight for most major commodity exporters. Say what you will about the IMF, but countries such as Ghana have really benefited from this support.

The cedi has been relatively stable, while inflation and fiscal expenditures have been kept in check — all components that make local currency bond investing attractive.

The Africa local currency asset class is akin to a sweet-smelling, thorny rose. Sweet-smelling in that there is a vast array of positive real yield opportunities, but thorny because there is a need to be discerning when picking the losers and winners.

We tend to favour Nigeria and Ghana for one similar reason: dovish central banks. For both economies, inflation is on a downward trajectory owing to both base effects and feedthrough from their currencies, which have strengthened over a multi-quarter basis.

On a year-on-year basis, Nigeria’s inflation has fallen by almost three percentage points, from 17.2% to the current 14.3%, while the naira has strengthened over the same period.

Economic growth has been on the mend, having recently emerged from a recession, and is now expected to register growth of 2% in 2018.

However, this level of growth is not sufficient to ensure positive growth of GDP per capita as the population is poised to increase by 2.7%.

The positive sentiment in Nigeria must be taken with a pinch of salt as the economy is still structurally dependent on oil production. If global commodity markets sneeze, Nigeria will surely catch a cold.

However, for as long as “black gold” remains favourably priced, offshore investors will continue to come in droves, which has caused the yield curve to compress from about 16.5% in late 2017 to just over 13% at present. We see further room for gains in 2018.

Ghana has also seen its yields fall in dramatic fashion for similar reasons to Nigeria — yields have compressed from around 18% in late 2017 to about 15% today. Unlike Nigeria, Ghana has a much more diversified export basket, with gold, cocoa and more recently oil all contributing to export revenues.

Moreover, the current IMF extended credit facility programme (due to expire at the end of 2018) has given offshore investors reasons to be bullish on Ghanaian bonds as the programme offers a policy anchor.

As we approach the third quarter of 2018, Ghana’s investor base will begin to ask if the country will be able to capitalise on the goodwill it has built up over the past three years under the watchful eye of Big Brother. As investors look to resolve this issue, we could see some risk premium built into bond valuations. Caution is warranted as we move towards the tail-end of 2018.

The thorns within our basket are Zambia and Kenya, for vastly different reasons. Zambia has fallen out of favour with most offshore institutional investors given the continued back and forth between the government and the IMF.

The status quo is that the IMF has rejected the Zambian authorities’ borrowing plans as these would put their debt-to-GDP metrics deeply in the red. To make matters worse, former finance minister Felix Mutati was reshuffled from his position during the negotiations with the fund, which considerably diminished any hope of a pragmatic and market-friendly deal.

Given the stalemate, investors are shifting towards other opportunities, particularly those outlined above.

Kenya’s issues are more self-inflicted than those of Zambia. In September 2016 the government instituted a law stipulating that interest rates charged to borrowers should not exceed 400 basis points above the policy rate — that is 13.5% given the current bank rate of 9.5%.

The challenge is that the government has not been willing to accept funding costs in excess of the cap, implying that bond yields have been artificially low, in a manner not reflective of the risks inherent in Kenya at the moment.

Picking the winners and losers is one thing. The key is to understand the regulatory and market nuances when investing in these countries.

Factors such as currency liquidity, exchange controls, secondary market bond liquidity and settlement procedures make the terrain froth with challenges and risks. If done right, this asset class has the potential to deliver healthy returns.