BondsFinancial marketsIs Zambia’s Eurobond Rally Excessive?

Kennnedy MuturiOctober 17, 20218613 min
Source: Bloomberg
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A new leaf has undoubtedly fallen in Zambia, considerably boosting the country’s economic outlook and hopes for a quick resolution to IMF talks and a peaceful restructuring of its debt. We believe it is naive to think that bondholders will not be required to accept haircuts, notwithstanding President Hakainde Hichilema’s assurances.

Source: Bloomberg

The IMF must be convinced that Zambia’s debt is manageable before it agrees to a program. However, even if fiscal consolidation is a priority, bondholders will likely be required to participate on the same conditions as other creditors due to the Common Framework’s concept of comparability.

President Hakainde Hichilema declared earlier this year that “A haircut is required. It’s got to be fair. There should be no cross-subsidization of debt stock by one set of creditors to the detriment of another.” According to him, a Barclays bank analysis forecasting a 20 percent cut was an appropriate beginning point for negotiations.

This means that state debt is equivalent to 124 percent of rolling 12-month GDP at a mid-2021 exchange rate (22.64/US$) (through Q1 21). As a result of the rapid appreciation of the Zambian Kwacha, Zambia’s external debt stock has fallen to 102 percent of GDP at the current exchange rate of 16.2/US$, a significant improvement over previous years. But this does not take into account the concealed debt – which, once disclosed, will likely increase the debt stock and budget deficit

2.5 billion dollars of Zambia’s $12.75 billion external debt is owed to multilaterals countries and is unlikely to be restructured. If the domestic debt is eliminated, this leaves US$10.25bn (or 44 percent of GDP at the present exchange rate) available for restructuring. A substantial amount of debt reduction would be required even with an improved reform prognosis under H.H., as evidenced by the IMF’s impending debt sustainability assessment (DSA). Assuming no more cash flow relief, the ZAMBIN 812 04/14/2024 Eurobonds are currently priced at over 80 cents on the dollar, implying a 25 percent haircut at a 10 percent exit yield. So, we believe that haircuts may have to be higher.

Another US$750mn tranche maturing in nearly one year will be due during the IMF program duration (assuming they have secured one by then). Because the IMF is unlikely to enable this to be paid in full within the framework of an IMF program and Common Framework restructuring, we believe a maturity extension will also be required. Bonds are now pricing in a c9yr maturity extension and grace period, assuming no haircut and stable coupons (with an 8.5 percent coupon rate on the 24s, maturity extensions and grace periods alone have little impact on the bond price).

Eurobonds in Zambia stand to gain a lot if the restructure does not contain any cuts. There is also a solid and well-organized bondholder committee and high hopes for an investor-friendly reorganization (i.e., minimal nominal haircuts and restructuring focused on relatively more NPV-neutral maturity extensions and grace periods). We believe that the markets are underestimating the amount of assistance required from bondholders, even though H.H. has made comforting assurances.

 

Local debt looks attractive.

 

Source: CADTM

ZMW has risen by 40 percent, while 5-year rates have already fallen from 32 percent to 25 percent, so we’ve certainly missed the boat roughly in line with inflation, which slowed from 24.6 percent to 24.4 percent YoY in August. (Zambia Daily Mail). A trade can be initiated regardless of whether you are a latecomer to the game or not if the nominal carry remains appealing.

Although real government bond yields are not currently positive, BOP dynamics are still a significant tailwind for the ZMW. H.H.’s fiscal consolidation would likely impede the comeback in imports, according to preliminary data. The current account surplus shrank in Q2 to US$0.7bn from US$0.8bn (16.8% of GDP) in Q1, as import growth outpaced export growth. (Zambia Daily Mail)

It has grown from US$1.4bn (2.6 months of import) at the end of June to US$2.9bn (5.4 months of import) after the IMF’s US$1.33bn SDR allocation and the BoZ’s US$150mn net purchases in July and August. On September 7 September 7, the G20’s DSSI agreed on an extension of official bilateral debt service relief through the end of 2021, which could further relieve BOP pressures at the margin (although it is unlikely to have a significant impact, with Paris Club relief totaling barely US$7mn in H1 21.

Copper and foreign portfolio inflows have contributed to ZMW appreciation. However, the latest rally has been driven partly by REER depreciation during the past four years, exacerbated in recent months by significantly rising copper prices. However, even after accounting for the 40 percent nominal increase since May, Zambia’s REER is still c5% behind its 10-year average. ZMW appears to have reverted to its fair value because of the recent kwacha weakening, as long as the BOP remains a tailwind.

Despite this, the possibility of capital outflows has increased significantly, with non-residents owning at least ZMW45bn of government bonds in Zimbabwe. When it comes to emerging and frontier markets, 24 percent outpaces the basic average of 16 percent among 24 emerging and frontier markets. With a value of almost $2.75 billion, this represents approximately 100 percent of the country’s reserves. To compensate, Zambia has a substantial current account surplus and IMF support that might unlock alternative finance sources. Furthermore, non-resident bond holdings account for 97.5 percent of non-resident assets; thus, the possibility of a rapid departure is minimized.

An increase in interest rates may affect the price of Zambian bonds. Price growth at the Bank of Zimbabwe was 22.6 percent this year before declining to 15.5 percent next year and 11.9 percent in the first half of 2023 under Christopher Mvungu (Tellimer, 2021) There’s still a chance the next acting governor will raise rates at next month’s meeting if it looks inflation is sticking around a bit longer than expected. This could result in some losses for investors who own long-term bonds because of increased yields, but it will boost the BoZ’s reputation and protect recent currency gains.

ZMW and local debt have lost a lot of their upside potential in recent months, and the market has gotten congested. However, we still find local currency bonds attractive because of their high nominal yields and the expectation of ZMW stability. For US$63.74 (a yield of 25.1 percent as of cob on September 9 on Bloomberg), we initiate a Buy recommendation on the ZAMGB 11 01/25/2026s, favoring shorter-term (5-year) debt versus longer-term (10-year) debt to protect against the risk of higher-than-anticipated inflation leading to rate hikes.

Despite our contrasting views, we believe Zambia is in the midst of a significant positive policy move, but the Eurobond recovery value will likely be below present levels. Being excluded from restructuring may reap the benefits of policy shifts without having to worry about unclear restructuring terms, which are only partially in the government’s and investors’ hands.

Look forward to Musokotwane’s upcoming budget, which will likely shed more light on the actual size of the debt and deficit, layout the fiscal policy plans of H.H.’s administration, and set up IMF negotiations (which we expect will be concluded early next year if all goes well, instead of this year as the government hopes). Aside from the headline figures, it will be crucial to see the stance adopted on FISP subsidies and the mining tax regime.

Kennnedy Muturi

Ken is a Quantitative Trader with experience in investments, quantitative finance, financial modelling and algorithmic trading in Global Investable Markets (GIM). He enjoys using Bayesian Statistics, Time Series and Machine Learning in developing Robust consistent Alphas in Equities Market, FX, ETPs and Derivatives instruments. He enjoys deep dives in understanding High Frequency Trading infrastructures and improving how the African financial markets work. He holds a Bachelor's in Actuarial Science from Strathmore Institute of Mathematical Sciences : An Executive Program in Algorithmic Trading (EPAT) certificate in Algo Trading from QuantInsti : A current MSc student in Financial Engineering at World Quant University.

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