16, 2018 /3:15 PM / Meristem
Issue on Offer/Summary
The Federal Government of Nigeria (FGN), through the Debt Management Office (DMO), will be conducting a bond auction on Wednesday the 21st of February 2018. A new 10-year instrument, FGN FEB 2028, valued at NGN50bn will be auctioned. Also, there will be a bond reopening of the FGN JUL 2021 (5 years) at an estimated amount of NGN50bn.
FGN FEB 2028 (10-Yr NEW) NGN50bn
14.50% FGN JUL 2021 (5-Yr Re-opening) NGN50bn
Current Yield Analysis
The Treasury bonds market has been largely bearish since the last auction held on the 24th of January, as the average bond yield advanced by 0.26% to close at 13.77% on the 15th of February 2018. All instruments recorded yield advancement save for the MAY-2018 (-1.31%) and JULY-2034 which traded flat. It is pertinent to note that the bullish sentiment on MAY-2018 is expected as the bond reverts to its par value. System liquidity also remained resilient with series of OMO and NTB auctions by the CBN of an amount over NGN800.11bn and NGN428.88bn respectively.
During the same period, the National Bureau of Statistics (NBS) released the January inflation result, which showed reduced inflationary pressures as CPI rate fell to 15.13% from 15.37% in December 2017. We envisage that this, amidst improvement in other macroeconomic variables will incite a rate cut by the MPC in the first half of the year. We therefore expect yields to trend downwards as prices on instruments increase.
On the 25th of January 2018, the DMO communicated its intention to be re-included into the JPMorgan Government Bond Index-Emerging Markets (GBI-EM), which tracks local currency bonds issued by governments in emerging markets. Nigeria was delisted from the index in October 2015, due to FX illiquidity and capital constraints in the economy. Given the significant improvements in the FX space, we are optimistic about the possible re-inclusion in the index and we project that this would lead to increased capital inflow into the market.
At this auction, a new 10-year instrument will be issued. We expect the pricing of the new issue to mirror that of the most recent 10-year bond (16.2884% FGN MAR 2027). However, given the ample improvement in the macroeconomic environment from March 2017 to date and the intent of the government to reduce cost of borrowing by converting domestic debt to foreign loans, we believe that this instrument will be issued at a lower coupon in the range of 13.50-14.00%.
Bond Absolute and Relative Valuation
Valuing the 14.50% FGN JUL 2021 and 16.2884% FGN MAR 2027 re-openings 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 analyzed 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.