06

Insight with Dr. John Heptonstall, Director AWR Advisory Group

In the management of wealth, nothing is more important than asset allocation. Only a gambler would invest all of his wealth in a single equity security. The importance of diversification, of spreading investment risk by holding a spread of shares, is widely recognized. But the importance of diversifying further, by holding a spread of asset classes, is less widely recognized. At a seminar for senior bankers in Lagos a couple of years ago, I found that few of them had ever considered how bond holdings can improve the risk/return potential of an investment portfolio.

In fairness, I have to recognize that this equity-dominated viewpoint rises largely from the fact that until very recently the range of bonds available in African markets has been limited. Now, with the surge in high-quality African sovereign issues and the growth of the corporate sector, the picture is changing. This brief article examines a market that will inevitably grow rapidly in attractiveness and importance for the African investor.

In recent years an important variant, the Corporate Bond, has grown much faster than the sovereign sector. Such bonds, issued by banks and non-financial corporations, are seen as riskier than the sovereign issues, and the coupons are correspondingly higher. The risk of holding corporates, however, can now be easily offset through a specialized derivative, the Credit Default Swap. The corporate market in the US has developed so rapidly that it is now common for corporate issues to exceed total new equity financing. Again, these issues can be very large and almost all use the international market. They differ from sovereigns, which have fixed coupon rates, in that a significant part of the corporate issues are made at floating interest rates.

The corporate market has also given rise to an important sub sector, the High Yield market (formerly the ‘junk’ market) in which low- or un-rated issues are traded. The risks are high, but so are the returns, and in the current period of historically low returns, investors looking for yield have been drawn increasingly to this sector.

All of these types of bond exist in African and other developing markets. While the sovereign markets are now highly developed in some African states, particularly Kenya and Uganda, the corporate markets are still in a very early stage of development. It is particularly this sector, however, that we believe offers excellent opportunities to the longer term investor.

Sovereign Bond Markets

Figures for the dollar value of new bond issues or annual turnover do not give a true indication of the relative levels of development in the various African bond markets. Total issuance in the South African market is of course greater than in Uganda – because the South African market is many times as big as that of Uganda. To obtain a meaningful measure of market maturity, therefore, it is preferable to use the market value of bonds as a percentage of GDP. In Africa as a whole, the average figure for total sovereign bonds during the past decade has been 14.8%, and if South Africa is excluded the figure drops to 14.2%. Some African nations show figures well above the average, with 40.3% for Uganda 29.4% for South Africa, and 28.2% for Ghana. The comparative figures for developed markets, however, are 55.8% for Europe as a whole, and 75.7% for the United States. These figures clearly indicate that there is still considerable room for further development.

The African sovereign bond market is indeed growing, and was very attractive in the early part of last year to developed country investors wishing to diversify their bond portfolios. Foreign demand benefited from political problems in Russia and in the Euro market. Also, the size of the individual issues has started to increase. In 2011 the average African sovereign issue was around $500 million. In 2013, however, Kenya successfully marketed a massive (by emerging market standards) issue of $2 billions, and Zambia, Ghana, Morocco and South Africa all made $1 billion issues in the international markets.

The introduction of Islamic ‘Sukuk’ bonds offers further scope for development and diversification. Senegal issued a sharia-compliant note in July 2014, and South Africa had a 5-year $500 million Sukuk in September 2014 which is considered a benchmark issue. More than half of the South African issue was sold to investors in the Middle East.

One serious handicap that the African sovereign market experiences, though, is the inability of African sovereign borrowers to offer bonds denominated in their own currencies to investors in the international markets. The currencies are not yet acceptable in what is essentially a dollar market. South Africa sold some euro-denominated bonds in 2012, but the recent gyrations of the euro itself has probably shaken confidence in that sector. The ability to issue in national currencies is an important factor if the full potential growth in the African sovereign market is to be achieved in a timely manner.

Nevertheless, regardless of all problems, further acceleration can confidently be anticipated: because the major part of Africa’s very large infrastructure project needs, particularly in power generation and in transportation, are very likely to be financed in this market in the next few years.

Corporate Bond Markets

If sovereign bond markets in Africa can be said to be under-developed, the corporate markets are even more so. Using the same metric of market value to GDP, the figure is just 1.8% for Africa as a whole and 1.3% excluding South Africa. Again, a few countries score well above the average, with 15.9% for South Africa, 3.5% for Ghana and 2.0% for Botswana. Africa’s biggest economy, Nigeria, scores only 1.1%. But again, if the figures are tiny, the potential for growth is enormous – given the right conditions.

The High Risk sector of the markets, that has grown very strongly in developed markets in recent years, does not yet play an important role in Africa, but it does exist. Bloomberg reports some sub-investment grade African bonds as being traded ‘offshore’.

What, then, are the requirements for corporate bond markets to achieve their full potential in fuelling Africa’s further growth? A recent study carried out by the African Financial Markets Initiative (AFMI), at the request of the African Development Bank (AfDB), produced some valuable insights.

They identify as problems:

The fragmented nature of the markets and consequent lack of coordination- not only between countries but within them. There is vast potential synergy, but it is not yet being achieved.

– A lack of liquidity, and dissatisfaction with the primary dealer system.

– A widespread ‘buy-and-hold’ philosophy on the part of investors in the region, leading to shortages of securities and very limited secondary market trading.

– High transaction costs, and widely differing taxation rules.

– The very low employment of credit ratings. (According to Bloomberg, out of 1,394 bonds issued, only 179 were rated; excluding South Africa, the figure falls to 63).

– Difficulties that smaller companies experience in trying to access financial markets.

– Problems in payment and settlement when bonds are purchased.

– Inefficient duplication of facilities if each nation, however small.

– Has its own securities exchange and the consequent duplication of uncoordinated regulatory authorities.

One problem that AFMI did not mention- and which applies to both the sovereign and corporate sectors –is currency volatility. At the present time, with almost all African international issues being in US dollars, there is no problem for the investors, but a rise in the dollar’s value makes servicing the bonds more expensive for the issuers. In the future, as more issues use the issuer’s own currency, the problem will be reversed.

Some of these problems are already being attacked. Ghana has taken action to improve the dealer system and to reduce transaction costs. In Nigeria a new electronic dealing platform is designed to improve the transparency and therefore credibility of the markets, a sovereign bond repo market has been created, and the entire legal and taxation system is under review. The development of derivatives markets in the region will make the currency issue much easier to solve.

Clearly, there is still a long way to go. But equally clearly, provided that governments in the African continent continue to pursue investor-friendly legal, political and economic strategies, there are rich opportunities for investors willing to accept some short-term volatility as the price of generating solid longer-term wealth.

John Heptonstall
February 2015