It’s not often you get outsized returns on external and local currency bonds the year after a country has defaulted. In short, a credit event can provide an attractive investment opportunity. It certainly helps when you have a catalyst for change. Or, in the case of Zambia’s excellent 2021 performance, catalysts. The initial driver was the expectations for a debt restructuring that attracted specialist investors and drove up bond prices. The other key factor was the August presidential election. This saw the long-time opposition leader Hakainde Hichilema, who is commonly referred to as ‘HH’, come out on top. We view the election result as a ‘game changer’ for the country.

A quick recap

Let’s go back in time to explain how Zambia got here. We were one of the initial investors in its Eurobond debut in 2012. The issue had one of the lowest coupons ever for a first-time emerging market government issuer. At that point we believed the growth outlook was sound, the fiscal position was manageable and the debt/GDP ratio, one of the key variables for investors with no past experience investing in the country, was extremely low at around 30%. Nothing to worry about, as the old saying goes.

In 2014, Zambia returned to the Eurobond market. However, at the time there were growing signs of a worsening fiscal and debt picture. A year later Zambia was again back to market and, while the risk premium had increased, the International Monetary Fund (IMF) still viewed the debt burden as sustainable. Five years later, Zambia hit the wall. The then-government defaulted on its Eurobonds in November 2020, citing the Covid-19 pandemic. The reality was that the country was headed for default well before the event due to its unwillingness to address debt sustainability concerns. Many investors were increasingly concerned about Zambia’s borrowing practices in the years following its last foray to the Eurobond market in 2015. This was a slow-moving car crash.

At that point, Zambia had issued some $3 billion of Eurobonds. But, when that well dried up, the government turned to Chinese lenders who were more than happy to fill the gap. The terms of the loans were opaque and the use of proceeds weren’t transparent either &ndandash; an arrangement that apparently suited both sides.

While the Ministry of Finance claimed the amount of Chinese debt was similar to the Eurobonds, there were many media reports that the actual amount was much larger. Efforts by bondholders to get information on the Chinese loans turned out to be fruitless, resulting in further concerns about debt sustainability. Meanwhile, Zambian officials claimed on numerous occasions that they were close to obtaining an IMF agreement on the debt. They had hoped this would address debt sustainability concerns. Alas, that long-awaited IMF agreement never happened. Default was an inevitable consequence.

Zambia comes roaring back

As we noted at the outset, it’s not typical that bond prices can rise sharply when a country is still in default and has yet to have any meaningful restructuring negotiations with creditors. What often happens instead is that bond prices overshoot on the downside when a country defaults. That’s because investors are forced to sell their positions due to restrictions on investing in defaulted securities or if a bond breaches a rating threshold, typically below the B-category. There’s also uncertainty over the restructuring process that can cause a bottoming out in bond prices. This is then followed by a recovery of some sort as distressed funds, also known as ‘vulture’ investors in some circles, get involved.

This partly explains how Zambian Eurobond prices have gone from a low of around 42 cents to the high 70s in 2021. But there’s more to the story. In our view, the surprise August 2021 general election result also supported bond prices.

Having lost the previous five times, including the previous two elections by narrow margins, no one was willing to say ‘sixth-time lucky’.

And what a surprise. Having lost the previous five times, including the previous two elections by narrow margins, no one was willing to say ‘sixth-time lucky’. Most were resigned to the Patriotic Front’s Edgar Lungu winning for a third time, which would’ve violated the constitutional term limit. Such is the power of the incumbent, especially during a pandemic. Nonetheless, ‘HH’ managed to win with a comfortable 59% of the total vote. Which, given the stacked deck, counts as a landslide and ensured peaceful transition of power.

Prior to the vote, the yield on local currency bonds was over 35%. They then fell sharply after the election, before declining to below 20% in December 2021 after Zambia reached a deal with the IMF on a new lending agreement. The Zambian kwacha also surged in value against the US dollar by around 25% during the period. So the market euphoria has been pretty evident.

We can understand why. Having previously met ‘HH’, we were also one of the handful of investors to meet him in London last November as he was in transit from Cop26 in Glasgow. His messaging was extremely powerful. He talked about addressing the rule of law, improving the investment climate and addressing the endemic corruption of the previous government. This was music to the ears of investors. He also told us how he had been arrested 15 times, so you have to admire his perseverance among his other leadership qualities.

Final thoughts…

There are not many frontier countries, or emerging market countries in general, where you can point to an improving credit story and ESG outlook – but Zambia is one of them. We believe the election of ‘HH’ has markedly improved the situation for both Zambia and international investors in the country. That’s why we view his victory as a ‘game changer’.