African local bonds – an untapped opportunity?

African dollar bonds are increasingly gaining mainstream acceptance as the continent’s brisk economic growth and low interest rates in the developed world help buoy demand for high-yielding debt.

The size of Africa’s dollar-denominated debt market, not including South Africa, is now more than $20bn, accounting for 6 per cent of JP Morgan’s EMBI index. In sub-Saharan Africa, issuance of international sovereign bonds hit a record $6.9bn this year, with offerings from Kenya, Ivory Coast, Senegal, Ghana, Zambia and South Africa.

But amid the excitement over Africa’s growing role in international capital markets, some are beginning to question just how healthy the dollar borrowing spree is.

Antoon de Klerk, portfolio manager at Investec Asset Management, sees Eurobonds as only a short-term solution for African sovereigns and says developing local bond markets should be a priority. Although raising funds domestically can be expensive, with double-digit yields in many countries, compared to single digits on the Eurobond market, de Klerk argues that in the long term borrowing in dollars may not be as cheap as governments think.

“It’s not the structural solution to their funding needs. It’s not a substitute for developing a local bond market,” he told beyondbrics. “If you borrow in any currency other than your own you face that risk of balance sheet mismatch and actually paying more than you anticipated, especially if you’re running higher inflation than the currency in which you borrowed. That puts automatic pressure on your exchange rate.”

African local currency bond markets have been growing steadily, with total outstanding debt reaching more than $400bn this year, compared to less than $150bn a decade ago. However, there are currently only 15 investable local bond markets on the continent and analysts say foreign investors are deterred by the small size of many markets, limited liquidity and short yield curves. Currency volatility is also a concern.

“There aren’t that many markets that have the scale for international investors to get involved,” said John Bates, an emerging markets fixed income analyst at PineBridge Investments. “A lot of investors still see sub-Saharan African local markets as very much frontier with high returns, but also very low liquidity and really high levels of risk.”

De Klerk said African countries have been wise to take advantage of low dollar interest rates to address their considerable funding needs. According to the African Development Bank, the continent needs to invest about $360bn by 2040 to close its infrastructure gap.

But he believes local currency bond markets are a bigger and more affordable source of funding. African fixed income markets will have to raise close to $500bn in the next five years, Investec forecasts, taking the continent’s debt stock to more than $900bn. It means smaller markets like Kenya, Uganda and Zambia will need to catch up with countries like South Africa and Nigeria, which have higher levels of foreign participation in their domestic markets.

“Where I think they can go is the way of Nigeria where 10 to 15 per cent of that market is owned by foreign investors,” de Klerk said. That 10 to 15 per cent would supply more capital to governments than they could raise through a single Eurobond and the balance sheet risks are significantly less, he added.

Improving liquidity will be the key to attracting offshore players. Historically, the dominance of pension funds in many domestic markets and their preference for buy and hold strategies has limited the development of a secondary market, said Malick Badjie, head of investment solutions at Silk Invest. But that is changing, as reforms in countries like Kenya and Nigeria have allowed pension funds to diversify their investments and become more active investors. There is also greater transparency and trading and settlement systems have improved, Badjie said.

“Five years ago, most of the local bonds were not on Bloomberg or Reuters,” he said. “You literally had to call brokers in every single market (to get) excel spreadsheets… You could not go to any of the smaller markets and get a complete listing of all the holdings that were out there.”

Eurobond issuance from Sub-Saharan Africa is unlikely to dry up anytime soon, especially as countries still have relatively low debt-to-GDP ratios. But there is greater scepticism among government officials, de Klerk said, adding that Ghana is one country that “has done everybody a favour” by highlighting the risks of borrowing in dollars.

The West African nation, which has struggled to rein in high fiscal and current account deficits, turned to the IMF for assistance in August after its currency slid nearly 40 per cent against the dollar. Potential issuers took note. Uganda pointed to Ghana’s predicament when it said it was not yet ready to issue a dollar bond.

 TOSIN SULAIMAN