Monday, October 9, 2017 8:39 AM/ ARM Research
Different treatise and varying views greeted the astonishing letter. The message taped up our earlier views on policy direction in the short term. This week, the Debt Management office (DMO) released its bond issuance calendar for the fourth quarter of 2017 which points to a lighter borrowing pattern with FG intending to borrow all-out N330 billion, split across the 5-year (2021) and the 10-year (2027) of N165 billion apiece. The calendar also saw the removal of the 20-year bond (April 2037).
The issuance, which is 19% lower than the offer and allotted in the prior quarter, reflects growing sensitivity to rising debt service cost (H1 17: 62% of revenue) and sits well with a recently announced plan to issue $5.5 billion worth of Eurobonds in this quarter for budget support ($2.5 billion) and refinancing naira denominated debt ($3 billion).
A transition like no other
It is hard to fathom a path that took a sharper turn than that of fixed income market in Q3 2017. Even though the MPC left its policy stance unchanged at the July meeting, it had already struck a dovish tone after it allowed the build-up in naira liquidity by net repaying OMO bills into the financial system at the end of Q2 17. In addition to this, the MPC also went ahead to cease issuance of the one-year bills at its OMO auctions at the end of August.
The cumulative impact of CBN actions cascaded into massive demand at the primary market auction (PMA) which eventually resulted in collapse of marginal clearing rates. Importantly, the switch in CBN’s stance followed a failed bond auction in August, then the FG was only able to fill 41% of its offer. Though the CBN retained its policy stance in September, we note that the follow-up communique was less hawkish (relative to earlier MPC meetings). Aided by the downtrend in inflation, CBN’s increasing tolerance for naira liquidity underpinned a slide in the yield curve to 16.45% (-199bps from the start of the September).
In framing our outlook, our fiscal call projects actual retained revenues to lag FG’s projection in the coming months with our base case scenario1 suggesting an implied fiscal deficit of N3.4 trillion in 2017E (vs. N2.4 trillion stipulated in the budget). For clarity, given deficit of N1.8 trillion over the first five months of 2017, we assume a fiscal deficit of N1.6 trillion for the second half of the year on the back of improved revenue. Precisely, excluding N824 billion issued in Q3 2017 (Net Treasury bill issuances: N318 billion, Bond Issuance: N406 billion, Sukuk: N100 billion), the FG would need to borrow circa. N800 billion over the rest of this year.
Given the foregoing, we assume a successful Eurobond issuance of $2.5billion, translating to N900billion to fully cover our proposed borrowings by the F G and displacing the need for domestic borrowings. We go on to provide for a further N450billion (Q4 17 Bond issuance: N300billion and Net T-bills issuances: N150billion). To add, we believe concerns over mounting debt service burden will keep the FG mindful of borrowing cost in the near term. On balance, this would mean moderated domestic borrowings for the remainder of the year and, by extension, sustained yield downtrend at the long end.
At the short end of the curve, we expect the CBN to assume a less aggressive stance at its OMO windows to continue to drive rates lower. Farther out, our call for decelerating inflation and currency stability in the face of fragile growth picture should drive monetary policy shift towards easing. On the strength of the mentioned, we expect T-bill yields to decline to sub 18% levels in Q4 2017, with a more sizable decline (100-150bps) projected for H1 2018.
Going long is the only way to go
There is much that can be read into the slope of the yield curve. It reflects the anticipation of imminent rates, and at any given time a good bit of that reading by the markets can be over or under dramatized. Nonetheless, given the sharp turn in rates, it is useful to look at what this trend in the spread between short and longer-term rates could mean for investors. In our opinion, this sharp drop—not just in terms of absolute rates, but also the yield curve—reflects growing expectations of a downshift in rates. We feel the environment will be one in which short-term yields will drop and long-term yields will drop faster.
We recommend going long on the curve, against the natural leaning to stay short under the guise of playing defense. Overall, we recommend building duration with emphasis on midtenured bonds on the downward slope of the naira curve in a bid to ‘run-down the curve’ as dovish influences kick into gear.