Hunt is on for African currency bonds

Continent's debt offerings get attention of emerging markets firms

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Concerning: Kevin Daly likens illiquid markets to ‘Hotel California.’ Investors can ‘check out (but) ... can never leave.’

Emerging markets debt managers are looking to local currency bonds issued by African governments to boost returns and increase diversification as institutional investors pour money into the asset class.

Many of these managers have been watching — or in some cases investing sporadically in — African local currency debt markets for years. But markets like Nigeria and Ghana have provided good entry points recently, rewarding investors with yields of 20%.

Fans of African debt also cite these bonds' diversification benefits: They are among the least correlated markets to global bond indexes, as are their currencies to the movements of those in major markets.

“Until October, for the past two years, we were not overly excited about sub-Saharan Africa. But now valuations have become very compelling,” said Didier Lambert, London-based executive director and lead portfolio manager for local currency emerging markets debt at J.P. Morgan Asset Management (JPM).

JPMAM managed $1.85 billion for institutional clients in local currency emerging markets bonds across all markets as of Sept. 30, up $1.1 billion from Dec. 31, according to data from eVestment Alliance LLC, Marietta, Ga. For the three years ended Sept. 30, JPMAM outperformed its J.P. Morgan Government Bond Index-Emerging Markets benchmark by an annualized 63 basis points.

JPMAM's largest investment in Africa is in Nigeria, which was included in October in the GBI-EM. Inclusion in the index sent yields in Nigerian local currency debt tumbling nearly 400 basis points to about 12%, following the Aug. 15 announcement. Mr. Lambert bought in March, when yields were at 16%, he said.

“The prospects for Nigeria are (still) quite good,” Mr. Lambert said. The stability of Nigeria's currency, the naira, “won't be challenged because they have ammunition” in the form of strong foreign exchange reserves, he said.

As a rough estimate, he expects Nigerian bonds to deliver returns of about 15%, five percentage points better than his projection for the GBI-EM. “At worst it's a compelling carry story, and at best you'll always make money on the duration,” Mr. Lambert said.

“Our favorite market in Africa is Ghana,” said L. Bryan Carter, senior vice president and portfolio manager at Acadian Asset Management LLC, Boston. “We were completely out of Ghana six months ago, but there's been a 20% depreciation of the cedi (Ghanaian currency) and there's been a (rise) in yield. Now you're getting a nominal yield of 22% with stable inflation of about 9%.”

With a possible lowering of interest rates in the next 18 months driving further compression, that could mean annual returns of 30%, Mr. Carter said.

Acadian more than doubled its AUM in local currency debt to $102 million in the nine months to Sept. 30, and its three-year annualized outperformance over the GBI-EM was 415 basis points, according to eVestment Alliance.

Heightened appeal

These near-term arguments for buying African local currency debt only heighten the appeal of these countries from a long-term perspective, managers said.

The overall gross domestic product of sub-Saharan economies is expected to rise 5% this year, while a 5.7% increase is targeted for 2013, according to the International Monetary Fund. Political climates are stabilizing with the growth of the middle class, managers say.

Also, while these bond markets are still in their infancy, they are growing in size, liquidity and openness to foreign investors, while the currencies of these countries are protected by growing foreign exchange reserves.

Liquidity remains a concern, one that limits the amount and changes the way they will invest there.

“We still see significant inflows into the asset class and we think it's still coming,” said David Oliver, executive vice president and portfolio manager at Stone Harbor Investment Partners LP, New York, where AUM in local currency emerging markets debt jumped to $21.3 billion as of Sept. 30 from $12.2 billion on Dec. 31, according to eVestment Alliance. Three-year performance was 228 basis points annually ahead of the benchmark.

Kevin Daly, portfolio manager at Aberdeen Asset Management, London, calls it the “Hotel California” effect, after the Eagles' 1977 hit, because investors in illiquid markets can “check out any time” they like, but they “can never leave.” Aberdeen holds Nigerian debt, and Mr. Daly expects Nigeria's position within the BGI-EM to grow to upward of 4%. But “Ghana is too illiquid for us,” he said.

Antoon de Klerk, portfolio manager at Investec Asset Management Ltd., London, said liquidity is “a risk you need to manage,” and that investing in these markets is not only about yield. “There would have to be an immense amount of risk to walk away from a 20% yield in this environment.” Investec's institutional AUM in two local currency strategies was $7.3 billion as of Sept. 30, up from $5 billion at the beginning of the year, according to eVestment Alliance. Three-year performance on both strategies topped the benchmark by about 40 basis points.

Michel Aubenas, director and portfolio manager at BlackRock (BLK) Inc. (BLK), said liquidity is a significant obstacle to investing in sub-Saharan Africa, but one that can — at times be — overcome. “For liquidity reasons, we tend to decrease exposure to these markets when they are very fashionable and increase exposure when investors are overlooking these markets,” because fashionable markets tend to be one-way markets in that the vast majority of investors are looking to either buy or sell at the same time, Mr. Aubenas said, adding that he does hold Nigerian debt, but not the seven- and 10-year bonds that are part of the index.

“Instead of 10-year bonds, we have been buying on the three-year part of the curve” where yields are also between 12% and 13%, he said. “You don't have any advantage to extending the maturity.”

Managers that like Africa also extol its diversification benefits. JPMAM's Mr. Lambert said, “It's a good diversifier; the risk/reward offer for these markets is very good (and) the correlations have been quite low to the rest of our portfolio.”

And Investec's Mr. de Klerk, in a forthcoming white paper titled, “Opportunities in African Fixed Income,” said, “not only do African markets still have very low levels of correlation to global markets, there is significant scope for diversification between individual African markets given the differences in economic structure, exchange rate regimes and global trade profiles.”

Africa isn't the only game in town when it comes to attractive valuations and high yields in local currency emerging markets debt. “Africa has become sexy again after being out of favor a few years,” Acadian's Mr. Carter said. “But you still don't hear people talking about Costa Rica or Belarus.”

Jan Dehn, co-head of research at Ashmore Investment Management Ltd., London, sees the larger local currency emerging bond markets, such as Brazil, being the big winners in coming years, not smaller frontier bond markets like those in sub-Saharan Africa.

His thinking: massive inflows from central banks around the world looking to diversify their holdings away from the U.S. dollar will invariably pick the largest, most-liquid bond markets, driving down yields in those countries.

“Frontier (bond) markets will less likely be the destination of choice for central banks, who have this incredibly pronounced preference for liquidity over yield,” Mr. Dehn said. n

This article originally appeared in the December 10, 2012 print issue as, "Hunt is on for African currency bonds".