Tuesday, February 16, 2021 / 7:10 PM / by Meristem Research / Header Image Credit: Getty Images
Issue on Offer/Summary
The Federal Government of Nigeria (FGN), through the Debt Management Office (DMO), will be conducting a bond auction on Wednesday 17th of February 2021. The total amount on offer is expected to amount to be NGN150bn. All instruments on offer are re-opening issues.
16.2884% FGN MAR 2027 NGN50bn
12.5000% FGN MAR 2035 NGN50bn
9.8000% FGN JUL 2045 NGN50bn
Current Yield Analysis
At the last Primary Market Auction (PMA) held in January 2021, marginal rates on offered instruments were higher than they were at the December 2020 auction in line with our expectation. Marginal rates increased on the 2035s and 2045s to 8.74% and 8.95% from 6.9450%, 7.0000% respectively. Against the backdrop of declining real returns, FGN bond investors have been demanding higher rates as observed via the range of bids. So far, the DMO has responded positively to this demand and our near-term expectation is that rates at the PMA will continue to tick up. Our position is supported by the FGN's large budget deficit and the increased scope for domestic borrowing in the recently approved Medium Term Debt Strategy.
In the secondary market, players have been even less favourably disposed to government bonds as selloffs have continued to drive yields upward. Since the last PMA, average bond yield increased to 8.97% (as at 12th February 2021), from 6.76% (recorded on the date of the last auction). In addition to being discouraged by negative returns, investors may be selling off to minimize capital losses due to rising yields, or to take advantage of higher rates at the PMAs.
As the second wave of COVID-19 rages on, the near term outlook for crude oil revenue remains highly uncertain. Although crude oil price has increased significantly since the last auction to about USD60pb from c. USD54pb, demand remains constrained due to persistent lockdowns (of varying degrees) across the world and slow-paced vaccinations. As noted earlier, government plans to increasingly look to the domestic debt market to plug its budget deficit over the medium term. This could result to higher bond yields going forward. Inflation is however expected to maintain its uptrend, thereby keeping real rate of returns negative.
Bond Absolute and Relative Valuation
In valuing the 16.2884% FGN MAR 2027, 12.5000% FGN MAR 2035 and 9.8000% FGN JUL 2045 re-opening offers with the current yield curve as the basis for discounting, we arrived at the following fair value, implied yield and an IRR for the instruments:
Our valuation gives a fair-trading price ex coupon payment, the expected return on the bond considering its periodic interest payments and the expected return on the bond's periodic payments. We analysed the issues on offer given the current yield environment, market liquidity, as well as a review of the recent past auctions, whilst also introducing market sentiment factor into our valuation, on which we advise bid yield ranges for both issues on offer.
A bond is a fixed income debt instrument issued by the government (federal or state government) or corporate institutions with a definite date of maturity and a fixed interest payment (known as coupon) payable either semi-annually or annually. Unlike equities, bonds are issued with a guarantee of the initial investment and can have tenors as long as 20 years.
A treasury note refers to a government bond instrument with a term to maturity of 1 to 10 years while a treasury bond has a maturity of 10 years and above. Bonds issued by state governments of a country are referred to as municipal bonds while those issued by organizations are corporate bonds.
The government usually issue bonds at the primary market to raise domestic funds to meet its fiscal responsibilities. This can be done from time to time as the need arises. Nigerian FGN bond instruments are named by their maturity, coupon, tenor etc. such as 13.05% FGN AUG 2016 instrument.
How is Return Determined?
Bonds are mostly issued with a coupon otherwise known as the periodic interest payable. Bond instruments are usually issued at par; that is, N100 or N1,000 as is the case with Nigerian bonds. A 2-year bond issued at 12% annual coupon with a par value of N1000 implies that the issuer will make 3 semi-annual payments of N60, and a final N1060 on the maturity date.
Bonds can be purchased at both the primary and secondary markets, they are either quoted in price or yields. There is an inverse relationship between the price of a bond and its yield to maturity (YTM). At issuance, the yield on a bond instrument is most likely the coupon on that instrument. At the secondary market therefore, an investor can trade bonds by quoting a yield that reflects the variance between the par value and the current price based on the current market dynamics.
How does the Auction Process work?
Bond instruments are issued through a competitive bidding process at auctions as conducted by the Debt Management Office which serves as the representative of the government. An existing government instrument can be re-issued also at the primary market in which case the DMO re-issues based on the current market yield to maturity.
Bonds are auctioned at established rates which determine the return to investors.
Purchasing these instruments in the primary market and holding it till maturity would mean that the investor gets a fixed interest payment, however, there is a secondary market in which investors can trade these bonds to meet their immediate liquidity needs.