African Eurobonds provide investors with risk-adjusted strategy

Over many years, SA investors’ preferred route into the rest of Africa — equity instruments — has failed to compensate them for the risks they have assumed. But equity is not the only asset class available. African credit offers significant upside opportunity.

Pension fund investors who wish to take advantage of the additional 10% offshore allowance under Regulation 28 of the Pension Funds Act for investing into Africa can look at other instruments. One of those is hard-currency credit, which can be either listed or unlisted. Looking at historic returns over three, five or 10 years, African sovereign Eurobonds have consistently been one of the highest-returning asset classes globally, in rand terms.

By investing in hard-currency credit, investors immediately fully mitigate local currency risk, which can be a significant limiting factor on equity returns. For South Africans, exposure to hard-currency credit still leaves the investor with residual exposure to rand-dollar fluctuations, but historically this risk has generally been the “right way round”, as the dollar has appreciated against the rand over the long term, and boosted returns.

But that is not always the case when investing in African economies. Two of the largest equity markets in Sub-Saharan Africa outside SA are Nigeria and Kenya. While the Nigerian naira has lost more than 20% of its value over a 10-year period, the Kenyan shilling has appreciated 75% against the rand in the same period.

A related risk when investing in local currency instruments is the ability of the asset manager to convert local currency proceeds from a sale of instruments into the fund’s currency. 

This risk can be further broken down into the rate at which the conversion is effected and the time it takes, both of which will depend on the central bank in question. This can result in an opportunity cost, because the asset manager is unable to redeploy those funds into other investments.

Enhances liquidity

The size of the investable universe and the liquidity of instruments within it are important considerations for an asset manager when constructing a portfolio. They affect the diversification the asset manager can achieve and the strategy of the fund, in particular whether the manager will be able to trade in and out of positions when the portfolio needs to be rebalanced or when relative valuation opportunities occur.

African sovereign Eurobonds now constitute a large and liquid asset class listed on global exchanges, with a total investable universe exceeding $130bn. Many global and emerging market funds allocate a proportion of their portfolios to this asset class, which further enhances liquidity.

Unlisted credit is another asset class that benefits from many of the same characteristics as African Eurobonds, and it is worth serious consideration for inclusion in an African hard-currency credit offering. 

This is an often-overlooked asset class, but it has a long history. Some issuers in Ghana and Angola have been successfully accessing the international syndicated loan market for almost 30 years and have a consistent track record of performance.

There are also benefits to combining African listed and unlisted credit. Adding unlisted credit to African Eurobonds provides greater portfolio diversification, by country and by sector. While many African sovereigns have issued publicly listed Eurobonds, many, including Tanzania and Uganda, have not.

Portfolio volatility

Apart from sovereigns, the only sectors that can really be accessed via the Eurobond market are African multilateral agencies and development banks, a few of Nigeria’s financial institutions and some oil and gas and telecoms infrastructure entities.

Another significant benefit is the dampening effect loans have on overall portfolio volatility, particularly when that volatility arises from sentiment-driven movements in listed markets. Beyond that, two linked benefits result from the floating rate nature of unlisted credit markets. One is that investors benefit from rising interest rates on the loan element in the portfolio. The other is that the inclusion of loans reduces overall portfolio duration. This enables an asset manager to take higher duration positions elsewhere within the portfolio to enhance return, when doing so offers relative value.

The many and diverse countries across Africa remain viable investment destinations for SA pension funds looking for portfolio diversification. But the way those opportunities are accessed will determine the risks in the portfolio. Credit markets allow investors to benefit from Africa’s strong growth rates, while avoiding many of the risks inherent in an equity strategy. 

To paraphrase a famous quote from a former US defence secretary, “There are known knowns and there are known unknowns.” In the context of investing in Africa, it is sensible to limit the risks to the “known knowns”.

• De la Pasture is with Stanlib Credit Alternatives.