South African government bonds denominated in US dollars currently yield 2.8% more than US Treasury bonds to compensate investors for well-known South Africa specific risks, according to Mark Dunley-Owen of Allan Gray.

Dunley-Owen, who manages the Allan Gray Africa ex-SA Bond Fund, said that the yield spread between two similar maturity fixed interest instruments denominated in the same currency represents the relative credit risk between them.

“Three years ago the yield spreads between African sovereign Eurobonds and the US 10-year Treasury bond were 2.2%, 3.6% and 4.6% for Nigeria, Zambia and Ghana respectively,” he said.

“Investors were willing to accept relatively low reward for taking on the risk of these developing African economies. In hindsight this was a mistake. These yield spreads have since increased to 6%, 8.9% and 9.8% for Nigeria, Zambia and Ghana respectively,” he added.

Dunley-Owen said that lower commodity prices, questionable macroeconomic policies and lower global liquidity are possible reasons, but the most likely explanation is that risk was mispriced three years ago and the yield spread is now more appropriate.

He believes that the increase in African spreads represents an opportunity for long-term investors such as the Fund.

“The annual income from a Zambian Eurobond is four times more than that from a US Treasury bond, providing significant downside protection within a diversified portfolio. The risk is that Zambia, or similar African governments, default on their foreign currency obligations,” he said.

“We think such a default is unlikely due to the probable consequence of foreign capital exodus. However, it is possible and we are cognisant that some African governments may lack the political will to make necessary but unpopular macroeconomic adjustments,” he said.

“A sovereign default would be disappointing, but should be kept in context. Provided all coupons are paid, an equally weighted basket of five African Eurobonds yielding 10% per annum over 10 years would outperform a US Treasury bond yielding 2.2% per annum, even if four of the five African Eurobonds repaid zero bond capital,” he said.

“This scenario of four African sovereign defaults is unlikely, and as such the risk-reward on the Fund’s portfolio is attractive,” he added.

The $155m Allan Gray Africa ex-SA Bond Fund has showed a negative return of 1.8% in 2015, and a negative return of 4.8% since its inception in 2013.

The Fund invests in a focused portfolio of African (excluding South Africa) interest bearing assets that are selected for their perceived superior fundamental value and expected risk and return profile.

There was limited Fund activity during the fourth quarter of 2015, according to Dunley-Owen.

"Small investments were made in Kenyan, Rwandan and Tanzanian sovereign dollar-denominated debt. We remain cautious on the outlook for African economies,” he said.