The size of the local currency debt market is skewed towards Nigeria and Egypt, but many smaller markets are readily accessible to foreign investors, according to Nick Ndiritu, Portfolio Manager at Allan Gray.

“Local currency markets attract a captive pool of domestic capital from pension funds and banking sector deposits. For example, 68% of Nigeria’s $18.5bn pension fund assets are invested in government securities, with only 11% allocated to domestic and foreign equities,” he said. 

“Foreign investor participation is low and, unlike in most developed sovereign debt markets, there is little evidence that global capital flows are distorting prices in Africa’s local currency markets,” he added.

Allan Gray manages the $237m Allan Gray Africa ex-SA Bond Fund, which returned 19.1% YTD.

The Fund invests in a focused portfolio of African (excluding South African) securities that are selected for their expected risk and return profile. 

About 24% of the Fund is invested in local currency government securities; 20% in sovereign debt denominated in US dollars; and 50% in corporate debt (of which 43% is in US dollars and 4% in Canadian dollars). 

Government debt accounts for 95% of the universe and the remaining 5% is corporate debt. 

Ndiritu said that investors are often concerned about the liquidity constraints in Africa’s capital markets, but it is worth noting that debt markets are about 2.5x larger and more liquid than the listed equities market. 

“In Nigeria the daily value traded for local currency debt alone is more than 20 times the daily liquidity in the equity market,” he said.

According to Ndiritu, the universe of dollar-denominated corporate bonds is about $12bn and the issuers are mainly financial institutions and commodity-related companies. 

“Our higher allocation to this niche segment is informed by our research experience as equity investors and market inefficiencies. For example, we have invested in dollar-denominated bonds issued by publicly-listed Nigerian banks, which we also own in our equity funds, with market-leading positions and established franchises in their domestic market,” he explained.

“There is a limited pool of investors specialising in Africa-ex SA corporate bonds. In turn, these bonds are less liquid than Africa’s sovereign bonds. Further, tighter prudential requirements for financial intermediaries have curtailed their ability to hold corporate bonds on their balance sheets and facilitate efficient trading. These factors create a good recipe for finding valuation discrepancies in Africa ex-SA corporate bonds,” he added.

Ndiritu said that at Allan Gray they “explicitly evaluate currency risks” in assessing local currency debt, but do not have an edge in forecasting currency movements over the short-term. 

“Rather, we hope to identify structural imbalances and anticipate major trends. Consequently, we prefer to limit our currency exposures to instances where yields offer a significant margin of safety or when market dislocations create attractive opportunities,” he said.

“We believe the Fund’s diversified credits can generate superior returns with reduced risk of loss. Over the long run, a region where patient capital is scarce and market dislocations are more frequent is ideal for long-term investors with a value-oriented approach. This approach has worked well for our clients for over 40 years and is well suited to Africa’s ex-SA debt markets,” he added.