Africa

KENYA
Fixed Income dominating, but we
expect a rebound in equities
October 16, 2009

East Africa (EA) has had a number of equity issuances in 2006 and 2007,
but there have been no equity issues in 2009 year to date (YTD). Rather
bond issues dominated the EA capital markets. The Nairobi Stock Exchange
(NSE) has three corporate bond issues YTD. Increased bond turnover
indicates augmented appetite for fixed income assets. Our key idea is:

• Underweight fixed income: investors should avoid Kenyan fixed

income assets. Our main concern is the inflation rate in Kenya which
has been fairly high despite the global disinflation outlook and the
below potential GDP output; and
• Overweight equities: investors should buy Kenyan equities. We
believe that between now and 1H10 the Kenyan equities will bottom
out. Domestic economic recovery uncertainty exacerbates the bear
trend, but in our view, the extent and duration of the downward trend
has matured.

Fig 1: Our major fear for fixed income investors is the high inflation rate.
` 35%
Inflation remain notorisouly high... ...despite an obvious positive output gap, Real GDP growth, %
8%
30% Inflation
Underlying  inflation 7%
25%
6%
20%
5%

15% 4%

10% 3%

5% 2%

1%
0%
Jun‐09
Jul‐08

Aug‐08

Sep‐08

Oct‐08

Nov‐08

Dec‐08

Jan‐09

Feb‐09

Mar‐09

Apr‐09

May‐09

Jul‐09

Aug‐09

0%
2002 2003 2004 2005 2006 2007 2008 2009F

Source: MoF Kenya, Legae Calculations

Peter Mushangwe
Zandisile Mabuya
+27 11 551 3675
peterm@legae.co.za
 1. Fixed Income dominating, but negative 
real returns will persist in our view 
• Bond issues have dominated capital raising activities in EA this year.
In Kenya, there was no IPO or rights issue. Bond issues raised
KES35bn (about US$470mn), which is more than 5X funds raised
through bond issues last year. In Uganda, no equity issuance took
place this year as well. Stanbic Bank raised UGX30bn through a bond
issue (about US$15mn) while PTA issued UGX40bn 7-year bond.
• In Kenya, this year CFC Stanbic, KenGen and Safaricom had bond
issues of KES5bn, KES25bn and KES5bn respectively, at pricing that
provides less than 300bp above the 182-TB rate. Treasury bills
continue to be oversubscribed with the most recent 91-day TB issue
attracting a subscription rate of 145% at a weighted average rate of
7.28%.
• The bond issues have broadly been well received, indicating strong
appetite from investors. We perceive two reasons why investors may
continue to buy Kenyan bonds and other fixed income instruments in
the short-term 1) the fear of Kenyan equities given the fact that the
past two years provide negative returns and have already lost 17.5%
YTD, and 2) potential currency “bets” by foreign investors.
• The supply side could continue to strengthen. From an issuer’s
perspective, 1) locking in relatively cheaper cost of funds for a longer
period is most advantageous given the comparatively higher cost of
funds from banks and 2) equity issuances in such a weak market
would most likely leave some of current shareholders’ money on the
table.
• Our view, however, is that the demand side will begin to weaken on
account of stronger negative real interest rates. Inflation rate in Kenya
has remained relatively high notwithstanding the deflationary outlook
of the world economy. Bond investors have endured negative real
interest rates since CY2003. The major difference, however, is that
real interest rates have worsened from -8.4% in CY2003 to -17.7% in
CY2008. Should interest rates go up (to improve real return), current
bondholders would incur capital losses.

Page 2 of 15
Fig 2 : Bond activity dominates the NSE
Amount raised through bond issues more than quadrupled from last 
year's KES5.6bn 
70,000 

Bonds
60,000 
Rights
IPO
50,000 

40,000 

30,000 

20,000 

10,000 

‐
2007 2008 2009

4 There has been 3 bond issues already this year, with no rights issue or IPO

IPOs
3 Rights Issues
Bond Issues

0
2007 2008 2009

35
Bond trading now dominates the NSE
30

Bonds
25
Equities
20

15

10

0
Sep‐06

Nov‐06

May‐07

Jul‐07

Sep‐07

Nov‐07

May‐08

Jul‐08

Sep‐08

Nov‐08

May‐09

Jul‐09
Jan‐07

Mar‐07

Jan‐08

Mar‐08

Jan‐09

Mar‐09

Source: Kestrel Capital, Central Bank of Kenya, Legae Calculations

Page 3 of 15
 2. Why we think inflation will remain 
higher relative to peers 
In our view, conditions are in place for inflation to remain relatively high in
Kenya, particularly when compared to its peers i.e. regional and Sub Sahara
countries with fairly developed markets. Inflation may fall on base effect but
we expect it to remain high i.e. >6% and thus offering bondholders negative
real returns, particularly on an after tax basis. As the global economy
recover, the positive output gap for Kenya would close, building up more
inflationary pressures. A fall in unemployment rate would remove slack in the
labour markets and wage and demand pressures will build up in our opinion.
Below we specify the reasons that make us less optimistic on the inflation
outlook.

• Strong money supply: Money supply grew aggressively in 2008,

peaking at 25% y-o-y. Early this year, the growth declined to 11%
before starting to pick up again to around 17% by mid-year. Growth in
Money supply as indicated by the M3 will rise from 4.2% in CY2000 to
12.8% that is expected this year. While this could have been
motivated by the need to stimulate the economy during the global
recession, the relationship between high money supply growth and
inflation rate is well documented.
• Widening budget deficit: The budget deficit widened to its worst level
since CY2000, at 6% of GDP. In our view, the deficit could be cyclical,
but we remain concerned with the crowding out effect as government
borrowings in the local market increase notwithstanding the
improvements in domestic debt/GDP ratio that has reduced to 17.3%
from 20.4% in CY2000. Government expenditure continues to grow at
a higher rate (average 34% since CY2000) than revenues (average
18% over the same period).
• The shilling is stable, but not strong: We avoid the fallacy of
forecasting the shilling exchange rate against the US$, but we note
that 1) high inflation rate expectations and 2) lower Treasury yields
would not lend support for a stronger shilling. A weaker shilling often
comes with higher inflation rates. Remittance and portfolio inflows
could pick up as the economy recovers, mitigating the downside risks
though.

Page 4 of 15
 • The oil price is stable but not weak: While current oil price is stable,
it is not weak in our view. In 2005, oil price averaged US$52.6 with a
low of US$37.7. The current price is 38% higher than 2005’s average.
Global economic recovery could result in higher oil prices than the
current, compounding inflationary fears.
• Bank loans remain expensive: In our view, bank loans remain
expensive with lending rates around 17%. The higher costs of working
capital would feed through to higher prices.
• Higher food inflation will persist: Droughts in the region often result
in stronger demand for food from neighbouring countries. Kenya itself
faces inadequate rainfall this year. Pockets of political tensions,
especially in the Western part of the country which is the bread basket
of Kenya, could negatively affect yields and output.

Fig 3: Inflation remained high and rising oil prices aggravate the risk
35%
Inflation remain high despite a reduction in money supply 160
...and oil prices are gaining traction, which could negatively affect inflation
30% 140
M3 Growth
Inflation
25% Nominal rate ‐ 91day TB
120

100
20%
80
15%
60
10%
40
5%
20

0% 0
May‐05

Nov‐05

May‐06

Nov‐06

May‐07

Nov‐07

May‐08

Nov‐08
Jan‐05
Mar‐05

Jul‐05
Sep‐05

Jan‐06
Mar‐06

Jul‐06
Sep‐06

Jan‐07
Mar‐07

Jul‐07
Sep‐07

Jan‐08
Mar‐08

Jul‐08
Sep‐08

Jan‐09
Mar‐09

Feb‐05

May‐05

Aug‐05

Nov‐05

Feb‐06

May‐06

Aug‐06

Nov‐06

Feb‐07

May‐07

Aug‐07

Nov‐07

Feb‐08

May‐08

Aug‐08

Nov‐08

Feb‐09

May‐09

Aug‐09

Source: Central Bank of Kenya, Bloomberg, Legae Calculations

Page 5 of 15
Fig 4 : Real interest has been negative for a while, and local investors should at some point
shift to inflation protective assets
30.0% Money illusion? Real interest rate has been negative since CY2003 Monthly real interest rates have been largely negative
10%
25.0%

20.0% CPI 5%
T.B real interest rate
15.0% 0%

Jan‐05
Mar‐05
May‐05

Jan‐06
Mar‐06
May‐06

Jan‐07
Mar‐07
May‐07

Jan‐08
Mar‐08
May‐08

Jan‐09
Mar‐09
Jul‐05
Sep‐05
Nov‐05

Jul‐06
Sep‐06
Nov‐06

Jul‐07
Sep‐07
Nov‐07

Jul‐08
Sep‐08
Nov‐08
10.0%
6.4% ‐5%
5.0%
5.0% 3.5%
‐3.3% ‐2.2% ‐1.1% ‐10%
0.0%
2000

2001

2002

2003

2004

2005

2006

2007

2008

‐15%
‐5.0%

‐10.0% ‐20%
‐8.4% ‐8.6%

‐15.0% ‐25%

‐20.0% ‐17.7%
‐30%

Fig 5: Expansionary monetary and fiscal policies are supportive of relatively higher inflation
rates
Budget deficit expansion could be technical  (cyclical deficit) due to the 
M3  growth: Money supply has been strong, and could support 
1% global recession, but it still negatively affect inflation
higher inflation among other reasons
25%
0%
2000 2001 2002 2003 2004 2005 2006 2007 2008
20% ‐1%

‐2%
15%
‐3%

10%
‐4%

5% ‐5%

‐6%
0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 ‐7%

Source: MoF Kenya, Legae Calculations

Page 6 of 15
Fig 6: Bank loans remain costly, providing companies motivation to source cheaper funds
through bond issuances
91‐Day TB rates have reduced, and remained fairly low... ...but lending rates remain fairly high
40
35.00 Deposit
Lending 
35 Spread
30.00
30
25.00
25
20.00
20
15.00
15

10 10.00

5 5.00

0 0.00
Jan‐94

Jan‐95

Jan‐96

Jan‐97

Jan‐98

Jan‐99

Jan‐00

Jan‐01

Jan‐02

Jan‐03

Jan‐04

Jan‐05

Jan‐06

Jan‐07

Jan‐08

Jan‐09

Jan‐94

Jan‐95

Jan‐96

Jan‐97

Jan‐98

Jan‐99

Jan‐00

Jan‐01

Jan‐02

Jan‐03

Jan‐04

Jan‐05

Jan‐06

Jan‐07

Jan‐08

Jan‐09
Source: Central Bank of Kenya, Legae Calculations

Page 7 of 15
 3. Why we think equities will rebound. 
We do not see an immediate catalyst for a rebound as risk appetite will not
take a sharp upturn due to expected steady recovery of the global economy.
However, between now and 1H10 we see five major variables influencing
the rebound:

• Money flow: Frittering volatility and uptake in risk appetite should

result in money flows into the Kenyan equities. Kenya is one of the
most important SSA Frontier markets alongside Nigeria. Anecdotally
information indicates that foreign participation on the buy-side which
has virtually dried up during 2008 has resumed to levels around
31.2% of total market turnover. Local investors who have become
stronger on the NSE currently “under-own” the market (see Fig 7).
• Mean reversion process: With the Kenyan equities continuing to go
down to what we perceive as increasingly undervalued territory, some
mean reversion process should ultimately take place, and we expect
the process between now and 1H10. The Kenyan equities which lost
55.4% in CY2008 have shed off 17.5% YTD in local currency. The
MSCI Frontier has gained 21.2% YTD. The underperformance is
more pronounced if one takes into account the fact that Kenya is part
of the MSCI Frontier Index.
• Possible improvements in the cost of equity (CoE) of Kenyan
equities: Risk has reduced as indicated by the slowing volatility. The
50-day standard deviation has reduced to 2005 levels which is around
10% (see Fig 12). The spread between the US Treasury and the SA
10Yr Govnt bond (which we used as a proxy) remain high though, but
better global liquidity and recovering macro-data should compress the
spread, positively moving the CoE. The average spread between
2005 and 2007 was 3.5% while currently the spread is 5.2%. Political
risks are still at unacceptable levels, but indications are that the
Government of National Unity is holding up. As carried by various
media houses, the invitation of the ICC prosecutor to discuss and map
the way forward for the trial of key suspects of the 2007 violence is an
example. In our view, the three variables should lead to improvements
in the Kenyan CoE.

Page 8 of 15
 • Equities should enjoy a stronger benefit from global economic
recovery than bonds: The global economy is expected to recover in
CY2010, with emerging markets lifting up global demand. Confidence
and PMIs have improved across most regions despite lacklustre
industrial performance in the developed world. Most of the Kenyan
companies derive their revenue from the local market, but trade
expansion and GDP growth will support endogenous growth factors
like employment and per capita incomes. By 2010, GDP growth rate is
expected to revert to 4%, (IMF forecast) and profit margins will expand
on economic improvement.
Attractive valuations: Comparing the current market PER to its
historical levels does not make much sense to us as we also admit
that in 2007 the NSE was overvalued. Comparing Kenya against other
EM shows that the NSE’s PER is on the lower end (see Fig 10). Using
IMF forecast for GDP growth in 2010, we note that a number of
countries like Mauritius, South Africa, Argentina, Poland etc trade at
higher PER despite expected lower growth rate than Kenya. We are
unsure whether the difference could be explained by political risks
and/or liquidity risks, but in our view valuations are attractive
especially in light of the clear visibility of profitability (see Fig 11 and
Fig 13). An average dividend yield of 3.9% for the top 20 companies is
fair in our opinion.

Fig 7: Local investors now “under-own” Kenyan equities.

2.5 In our view, the Kenyan market is 
"under‐owned" by  local investors.  
The widening gap between the M2 
money supply and the NSE index 
2 supports our view.

1.5

0.5 NSE Index
Money Supply (M2)

0
May‐05

May‐06

May‐07

May‐08

May‐09
Jan‐05
Mar‐05

Jul‐05
Sep‐05
Nov‐05
Jan‐06
Mar‐06

Jul‐06
Sep‐06
Nov‐06
Jan‐07
Mar‐07

Jul‐07
Sep‐07
Nov‐07
Jan‐08
Mar‐08

Jul‐08
Sep‐08
Nov‐08
Jan‐09
Mar‐09

Jul‐09

Source: Central Bank of Kenya, Legae Calculations

Page 9 of 15
Fig 8 : Money flow should catalyse a rebound in 2010
From its peak of 6125.28 the NSE20 has lost 61.2% to its lowest of 2379.86 in 2007. At current  25
levels the NSE has lost 49.04% from its peak. Equity turnover is below its average since July 2004
6500

20

5500 NSE Equity turnover
Average

15
4500

10
3500

5
2500

0
1500

Jul‐04

Nov‐04

Mar‐05

Jul‐05

Nov‐05

Mar‐06

Jul‐06

Nov‐06

Mar‐07

Jul‐07

Nov‐07

Mar‐08

Jul‐08

Nov‐08

Mar‐09

Jul‐09
3‐Jan‐05

3‐Jul‐05

3‐Jan‐06

3‐Jul‐06

3‐Jan‐07

3‐Jul‐07

3‐Jan‐08

3‐Jul‐08

3‐Jan‐09

3‐Jul‐09

Fig 9:CY2009 will be third consecutive year of negative returns on the NSE. Currently the NSE
underperforms the MSCI Frontier by 38.7pp
Local investors have endured two consecutive years of negative returns, and only a strong  the NSE significantly underperformed other frontier markets in 2007, investors could have started pricing in 
performance would reverse the trend this year risks earlier than in other markets 
80.0% 1.2
71.6%

1
60.0%

0.8
42.1%
38.6%
40.0% 35.7%
0.6

21.2%
20.0% 0.4

0.2
0.0%
2005 2006 2007
‐3.6% 2008 YTD
0
‐10.8%
‐20.0% 2003 2004 2005 2006 2007 2008
‐17.5%
‐0.2
Kenya
‐40.0% ‐35.3%
‐0.4 MSCI Frontier
Kenya MSCI Frontier
Nigeria
‐60.0% ‐55.4% ‐0.6

Source: Bloomberg, Legae Calculations

Page 10 of 15
Fig 10: Attractive risks-reward profile in our view
The higher dividend yield and lower P/E ratio provides an attractive risk‐return 
profile
Poland
India
Slovenia
Mexico
Argentina
Indonesia
Philippines
Chile
Israel Div. Yield
Morocco PER
South Africa
Mauritius
Egypt
Brazil
Kenya
Turkey
Pakistan
Venezuela

0 5 10 15 20 25 30

7.0 P/E ratios versus 2010 GDP growth forecasts. Horizontal axis shows P/E ratio
India
6.0

5.0 Nigeria
Indonesia
Egypt
4.0 Turkey Kenya Chile
Brazil
Philippines
Pakistan Mexico
3.0 Morocco,

Mauritius Poland
2.0 Slovenia
South Africa
Argentina
1.0

0.0
Venezuela
0 5 10 15 20 25 30
‐1.0

Source: Bloomberg, Kestrel Capital, IMF, Legae Calculations

Page 11 of 15
Fig 11: Profitability to improve in CY2010, fairly high dividend yields indicates good entry point
for investors
25 50
Valuation  is no longer excessive in our view. Market PER <15X Profitability is fairly visible, ROEs for companies mkt cap >US$100mn, % 

20 40

30
15

20
10
10
5
0

Equity Bank

NIC Bank

KCB Bank

Barclays Bank
CFC Stanbic

KenGen

Kenya Power

Mumias Sugar

Co‐operative Bank

Athi River

Safaricom

National Media

Standard Chartered

BAT Kenya
Kenya Airways

Diamond Trust 

Bamburi Cement

EA Breweries
0
‐10
NIC Bank

BAT Kenya

KCB Bank

Barclays Bank

Equity Bank

Safaricom
Keny Power

KenGen

Mumias Sugar

Standard Chartered

Diamond Trust 

Co‐operative Bank

National Media

Athi River

CFC Stanbic
Bamburi Cement

EA Breweries

‐20

‐30

12%
Dividend yields are fair in our view But there are no rewards for it yet, YTD performance, local currency 
BAT 34%
10% Safaricom 3%
Athi River 2%
8% Diamond Trust 2%
Mumias ‐2%
Bamburi ‐6%
6% EA Breweries ‐6%
Kenya Power ‐9%
‐11% Barclays
4%
‐12% CFC Stanbic
‐12% StanChart
2% ‐16% KCB Bank
‐17% Nation Media
‐20% Co‐operative
0%
‐24% Equity Bank
Bamburi
CFC Stanbic

Diamond Trust

NIC Bankl

Equity Bank

Safaricom

Barclays

Nation Media

Kenya Airways

KCB Bank

Mumias

Stanchart

KenGen

BAT
Co‐operative

Athi River

Kenya Power

EA Breweries

‐25% Kenya Airways
‐29% NIC Bank
‐31% KenGen

‐40% ‐30% ‐20% ‐10% 0% 10% 20% 30% 40%

Source: Kestrel Capital, Legae Calculations

Page 12 of 15
Fig 12: Falling volatility provides room for improvement of the CoE.
Spread against US Treasury still high, and compression will improve
valuations as well.

NSE 20 Volatility has reduced
Hist Vol(100D)
80
Hist Vol(50D)
70

60

50

40

30

20

10

0
10/17/05
11/24/05
01/04/06
02/13/06
03/23/06
05/05/06
06/15/06
07/25/06
09/01/06
10/12/06
11/23/06
01/05/07
02/14/07
03/26/07
05/08/07
06/15/07
07/25/07
09/03/07
10/12/07
11/21/07
01/04/08
02/13/08
03/26/08
05/06/08
06/16/08
07/24/08
09/02/08
10/13/08
11/21/08
01/05/09
02/12/09
03/24/09
05/06/09
06/16/09
07/24/09
09/03/09
10/13/09
8 There is room for the spread to compress.  CoE would benefit from spread 
7
compression

0
May‐05
Jul‐05
Sep‐05
Nov‐05

May‐06
Jul‐06
Sep‐06
Nov‐06

May‐07
Jul‐07
Sep‐07
Nov‐07

May‐08
Jul‐08
Sep‐08
Nov‐08

May‐09
Jul‐09
Sep‐09
Jan‐05
Mar‐05

Jan‐06
Mar‐06

Jan‐07
Mar‐07

Jan‐08
Mar‐08

Jan‐09
Mar‐09

Source: Bloomberg, Legae Calculations

Page 13 of 15
 Fig 13: Top 20 companies by market capitalisation
Market Price
Company Sector Year End Cap,US$mn KES YTD PER Div.Yield PBV ROE
Safricom Telecom March 1971 3.7 2.8% 14 2.7% 2.9 20.6%
EA Breweries Brewery June 1432 136 -5.6% 14.2 5.9% 5.2 36.6%
Barclays Bank Banking December 809 45 -11.4% 10.6 4.5% 2.8 26.3%
Bamburi Cement Cement December 754 156 -5.5% 12.5 2.4% 3.3 26.4%
Equity Bank Banking December 661 13 -23.9% 14 2.3% 2.4 16.8%
KCB Bank Banking December 582 20 -16.2% 10.5 5.1% 2.1 19.6%
Standard Chartered Banking December 511 141 -11.9% 9.6 7.1% 3 31.6%
Co-operative Bank Banking December 409 8.45 -20.3% 11.9 1.2% 2.1 17.6%
KenGen Power June 322 11 -30.6% 4.5 8.2% 0.4 8.0%
BAT Kenya Tobacco December 234 176 34.4% 9.9 9.7% 3.9 39.3%
Nation Media Media December 226 119 -17.4% 13.2 4.6% 3.9 29.7%
CFC Stanbic Banking December 193 53 -11.7% 19.3 0.5% 0.8 4.1%
Diamond Bank Banking December 152 70 2.2% 10.6 2.0% 1.8 17.4%
Mumias Sugar Sugar June 135 6.65 -1.5% 6.3 6.0% 1 16.0%
NIC Bank Banking December 134 31 -29.3% 9.1 2.1% 1.7 18.6%
Kenya Airways Airline March 132 21.5 -24.6% N/M 4.7% 0.6 -23.8%
Kenya Power & Lighting Power June 131 124 -8.8% 4.3 4.0% 0.4 9.0%
Athi River Mining Cement December 122 93 2.2% 18.5 1.3% 3.5 18.8%
KenelKobil Oil December 97 50 -25.0% 31.4 12.1% 0.8 2.4%
EA Portland Cement Cement June 96 80 0.6% 3.9 1.6% 1.2 30.0%

Source: Kestrel Capital as at cob 12.10.09

Page 14 of 15
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