- It can be challenging to assess the credit risk of African borrowers because there is less historical data available.
- Additionally, assessing African risk is difficult because of the inherently complex political, legal, and regulatory environment.
- Given the current high-interest rate environment, investors don’t need to come to Africa to find higher returns.
Yield-chasing investors have poured money into Africa, but an emerging, recent challenge for the continent is that in a now higher interest rate environment, investors don’t need to come to Africa to find higher returns.
Even US treasuries are now yielding far more attractive yields than just a month ago: three-month government bonds offer 5.32 per cent, while 2-year bonds offer a yield above five per cent. Yields have risen in part in response to Fitch’s recent downgrade of the US from AAA to AA+, echoing S&P’s move in 2011.
African bond issuers, spooked by the high-interest rate environment and refusing to issue bonds above the psychological barrier of double-digit yields for Sub-Saharan African bonds, continue to wait it out on the sidelines.
African governments should bring forward set borrowing
But with interest rates continuing to climb, the wait-and-see strategy no longer looks like a sensible approach. Issuers are running out of cash, and the more stable and resilient syndicated loan market – with its heavily relationship-driven pricing, is increasingly proving to be an alluring alternative to the bond market.
African governments should, therefore, bring forward planned borrowing before the capital shifts away, as it is already starting to do, and the cost of borrowing rises further.
Relationship banks will consciously and willingly price a loan at meagre yields to secure a lead mandate and lock in the ancillary opportunities and revenues that come with being a core relationship bank, dominating the syndicated loan market.
Banks do this knowing that they will also be able to persuade other relationship banks to join the deal. This is why syndicated loans always tend to price at a subsidized level compared to bonds – where investors are more agnostic and less loyal – focusing instead on the relative value of opportunities across the market.
However, while bond prices have skyrocketed, the loan market has hardly moved in pricing. Yes, base rates are higher, resulting in higher all-in costs for borrowers, but on an all-in basis, when compared to bonds, issuing a syndicated loan is the cheaper option for borrowers.
Why African issuers price debt attractively
But why have African issuers priced debt at such attractive levels for so long?
There are three main reasons:
- Finite supply: Africa has a limited supply of investable assets. Those banks with an African focus remain eager to support their key clients and to get exposure to the African market, which has strong growth potential.
- Difficulties in assessing risk: It can be challenging to assess the credit risk of African borrowers. This is because there is less historical data available, and the political, legal and regulatory environment is often complex. Joining a syndicated loan or bond that has been oversubscribed and carries the stamp of endorsement from the market can be an attractive solution to this challenge.
- Those issuers that are active in the loan market tend to bring with them an array of other ancillary opportunities, for instance, IPO, Eurobond, and Advisory mandates, in a region where businesses that are succeeding are usually experiencing high growth.
So, finite supply leads to fierce competition for these prestigious African clients, and the fact that these credits are complex and challenging to understand exacerbates the problem.
As a result of these factors, African risk is often not priced reasonably. South Africa is an excellent example of how African risk can be underpriced. Despite losing its investment grade rating in 2017, South African corporates and State-Owned Enterprises (SOEs) continue to price their debt like they are in Western Europe. This is because there is a limited pool of opportunities for those banks that prefer to lend in ZAR to invest in.
Relationship pricing for banks
Relationship pricing works for the banks because they can use the revenues from ancillary business to subsidise their commitment to the loan, but regular investors (typically looking on an asset play basis) can end up short-changed. This means that investors may take on more risk than they realise for a relatively low return.
However, instead of adjusting pricing upwards, the imbalance is being addressed another way – by adjusting risk. Reducing the risk keeps pricing low and addresses issuers’ concerns about paying double-digit yields.
Risk mitigation tools (in the form of ECA wraps, DFI guarantees or insurance wraps) are being embedded into loans, and so while pricing remains low, investors improve their returns by adjusting the risk.
These credit risk-mitigated deals result in investment-grade ratings with a substantial African premium. In the EUR 1bn Bank of Industry deal, BOI/AFC pays a yield of about 200bps versus an average yield of 75ps for an A3-rated credit in Europe. It is the only way for many international and European banks – who typically shy away from low BB or single B African risk – to fill their African buckets.
These investors have a whole world of investment opportunities available to them, from AAA through to single B risk, usually across the globe, so that they can pick and choose their deals. Consequently, to attract their investment into Africa, pricing on these credit-enhanced deals has to be highly attractive relative to similar opportunities globally.
African opportunities that represent African risk
However, for those emerging market investors or African banks focused on Africa, their return hurdle requirements mean that the credit-enhanced deals do not work for them.
Instead, they must find African opportunities that represent authentic, uncovered African risk. However, the market paralysis created by a challenging credit environment, combined with the fact that a large proportion of those deals that do come to market include some form of credit enhancement, means that the pool of deals offering pure, uncovered African risk is now much smaller.
And this is where supply and demand dynamics take over. African banks and investors are desperate for assets and are comfortable assessing and understanding sub-investment-grade African risk. However, this dynamic of fewer deals but strong investor demand has led to plentiful pent-up liquidity down the credit curve.
Ironically, once African investors get over the hurdle of higher return requirements (often driven by higher cost of funding), there is such relief that pricing works from a returns perspective that they can end up effectively under-pricing the actual credit risk. So we end up with BB- loans paying only 450bps versus BB average bond yields of 12 per cent.
Investors in Africa are a finite pool who know and understand African risk. They deserve fair compensation for the risk they take.
The author, Miranda Abraham, is the Head of Loan Syndications at Rand Merchant Bank in London.