Monday, February 01, 2016 11:08 PM / ARM Research
Today, we assess movements in fixed income markets over 2015, and posit our outlook for 2016.
Whilst yields on FI instruments initially responded to increased risk perception on a combination of extended decline in oil prices, delayed cabinet appointments, exclusion of FGN bonds from the JP Morgan Emerging Market Bond Index and prospect of a US rate lift-off, it was the switch in monetary policy to a dovish tone that ultimately underpinned yields trajectory over H2 15 Specifically, the impact of CBN’s accommodative policy induced a 9.5pps contraction the short end of the curve to ~4% (vs. 5.5pps contraction at the long end). Consequently, the treasury yield curve now has a positive slope, having essentially being flat in the last few years.
Going forward, developments with fiscal balances will be central to yield trajectory, given the FG’s plan to ramp up borrowings. In the same vein, having established the influence of monetary policy on yield direction (and shape) over H2 15, the CBN’s posture in this regard, will continue to play a key role in determining level of the yield curve over 2016.
Overall, whilst we anticipate higher bond issuance, we believe the impact will be blunted by monetary easing and, should our expectation for additional cut in key rate pan out, could even drive the treasury yield curve lower.
The contraction of the treasury yield curve over Q2 15, as investors ramped up purchases on diminished political risk proved short-lived. Further downleg in oil prices as OPEC held status quo at its June meeting and Iran sealed a historic nuclear deal in July, reminded investors of subsisting macroeconomic risks.
Beyond the negative implications of the depressed oil price environment on internal and external balances as well as the apex bank’s response to same, investors also had to grapple with the lull on the fiscal scene, with no cabinet formed till the final quarter of 2015. Added to these, the market was also faced with external factors, from the exclusion of FGN bonds from the JP Morgan Emerging Market Bond Index to the US rate lift-off which eventually happened in December. However, after being largely dominated by political considerations in H1 15, it was the switch in monetary policy to a dovish tone that ultimately underpinned
yields trajectory over H2 15.
Excess liquidity forces yields to multi-year lows
Unsurprisingly, coming into Q3 15, the CBN responded to headwinds by extending its 5-year monetary tightening regime, with step-up in net OMO issuance in July (N400 billion)even as it introduced additional forex demand management measures which further drained liquidity. With market expectation stoked for further tightening at the July MPC, the committee then disappointed by leaving key variables unchanged resulting in a 30bps pullback in bond yields.
However, August brought additional admin measures by the CBN—the 48 hour forex prefunding requirements halved system liquidity to N70 billion within days—even as the ‘vacuum’ on the fiscal side, with cabinet not yet formed more than 2 months after inauguration, became a cause for concern. Responding to these events, as well as the then-looming 15th September1 deadline for the implementation of TSA, the yield curve shifted 130bps higher to 15.71% by the end of August, despite net OMO repayment that month, as investors’ unwound long positions across the yield curve.
The selloff was more severe at the short end which jumped (+200bps to 15.64%) nearly twice the change at the long end of the curve. Curiously, the impact of the exclusion of FGN bonds from JP Morgan Index, announced on the 8th September, on bond yields was short-lived as yields closed only 15bps higher at 16.09% on average the next day, after touching intra-day summit of 17.5%. This somewhat muted yield response reflects the net short position of FPIs, with flows into the bond market ~70% lower YoY in the first 10 months of 2015, and increased purchases by domestic players who deployed additional liquidity—due to cut back in OMO sales and CRR cut—to take advantage of the elevated yields. Consequently, the yield curve reversed earlier upswings to end Q3 15 100bps lower at 13.28%.
Figure 1: Trends in FPI flows into bond market
The downturn in the yield curve persisted over Q4 15 as commencement of monetary easing by the apex bank forced deposit money banks, already grappling with deteriorating credit quality in the corporate space, increased purchases across the curve. Specifically, liquidity levels doubled to N600 billion as additional net inflow of N1.2 trillion hit the banking system. Awash with excess cash, at a time of slow paper issuance by the monetary authorities2, investors’ ramp-up of purchases subsumed the DMO’s Q4 15 issuance (N240 billion: +50% QoQ, driven by N60 billion non-competitive allotment) and resulted in the yield curve tightening another 640bps on average over Q4 15 to multi-year lows of 6.8% (H2 15: 750bps). Unsurprisingly, given the liquidity-driven stimulus, the short end of the curve fell significantly sharper (-9.5pps) to ~4% (vs. 5.5pps contraction at the long end). Consequently, the treasury yield curve now has a positive slope, having essentially being flat in the last few years.
Figure 2: Treasury yield curve
Credit spreads widen as Eurobond yields respond to further down-leg in oil prices
In usual fashion, Nigerian Eurobond yields continued to react to the gyration in the oil markets. As oil prices dipped to multi-year lows over H2 ’15, yields of each of the three outstanding issues climbed to record peaks, with the 7 and 10 year notes crossing the 8% (+270bps over H2 15) mark for the first time since issuance.
Consequent upon the spike, and with benchmark US note relatively flat, credit spread on the 10 year Eurobond widened as much as 6.5pps (from 3.9pps from the end of H1 15). That said, we think the sell-off might be overdone as Nigeria’s ability to meet these obligations remain intact. The quantum of annual interest ($0.2 billion) is only about 2% of forex receipts even at sub $40bbl but more importantly, average duration on the outstanding bonds ($1.5 billion) is fairly long (~4 years), giving enough time for improvement in forex receipts. Perhaps, the highlight of the period is that the contrasting movements for the local currency, bonds and dollar denominated sovereign notes in H2 15 have seen borrowing costs’ differential between domestic and foreign capital market narrow significantly, for the FG. Specifically, the differential between the FGN 2024 and Eurobond 2023 is now 2.5pps (vs. 6.5pps in H1 15) and an extension of this trend could be an important consideration in determining the source of borrowing for the 2016 budget.
Figure 3: Nigerian local & foreign currency bonds and US 10 year Treasury note
Bailout of State Governments forces FG to halt supply of 20 year paper…
In the primary market, the DMO issued N399 billion worth of bonds in H2 2015, 11% lower than preceding half-year. Perhaps more importantly, this is 4% above the proposed issuance calendar for the period with the DMO taking advantage of the lower rate environment over the fourth quarter (avg. -400bps QoQ) to raise additional ~N60 billion on a non-competitive basis. In all, H2 15 bond issuance brings cumulative 2015 bond sales to N850.72 billion, 19% lower than 2014.
Pertinently, on a net basis, the DMO borrowed only about half (N315 billion) of projections as the FG relied heavily on credit facility (over N600 billion) from the central bank to fund its budget shortfall. The reliance on CBN facility and ramp-up in borrowing when rates were significantly lower, re-affirms our earlier prognosis on the FG’s resolve to cap the fast climbing domestic borrowing cost which is projected at 15.5% for 2016 (+40bp higher YoY). That said, the tenors of issues were somewhat dictated by the fiscal strait facing the state governments. Although the DMO extended its issuance of the 5 year paper into H2 15 (~50% of total bond sales), it switched to the 10 year paper in Q4 15 from the 20 year paper over the prior quarter. This switch was necessitated by the elevated maturity profile in 2034 which crossed N1.1 trillion after the FG refinanced nearly N600 billion worth of state government loans into 20 year FGN bonds in Q3 15.
Figure 4: Outstanding FGN Bond (N billion) and maturity gaps
...as investors position for increased paper supply
Curiously, the improvement in investors’ appetite since conclusion of the elections in Q2 15 persisted into H2 15, with bid to cover at the bond auction fairly stable at 2.5x each quarter. Whilst, standalone, this does not mean much, putting it side by side with increased interest at the T-bill auction where bid-cover doubled to 3.3x in Q4 15 shows inventors’ continue to stay short. Given the quantum of liquidity over the final quarter, this posture—which partly explains the relatively steep nature of the yield curve—imply the market expects widening of yields or at least require a higher premium for taking tenor risk today, perhaps in view of fiscal headwinds.
Figure 5: Bid-cover ratio and system liquidity (N’ billion
Figure 6: Primary market data for bonds
...but monetary influence could undercut impact of paper supply on yields
Going forward, developments with fiscal balances will be central to yield trajectory, given the FG’s plans to ramp up borrowings. In the same vein, having established the influence of monetary policy on yield direction (and shape) over H2 15, the CBN’s posture in this regard, will continue to play a key role in determining level of the yield curve over 2016. On the fiscal balance, the FG’s expansionary budget projects a N2.2 trillion deficit, with N1 trillion to be sourced from the domestic credit market (vs. N900 billion external).
The quantum of domestic issuance is double estimates for 2015, but crucially, nearly three times actual bond sales over2015, as the FG relied on the CBN and cutback on implementation of the capex budget. However, as we noted earlier, after the historic victory at the 2015 general elections, the current government is under pressure to deliver on campaign promises. This suggests that implementation of the 2016 budget, including the often neglected capex portion, will be significantly higher, raising scope for stronger paper supply over 2016. Added to this, our analysis that 2016 deficit could be wider than projected—due to aggressive projections—as well as narrowing local/foreign borrowing cost differentials could further boost domestic issuance.
Specifically, using estimate for fiscal deficit, domestic borrowing could hit N1.3 trillion in 2016—assuming fixed financing ratio. Based on the foregoing, we expect the FG’s bond sales to be significantly higher in 2016. On the other hand, like H2 15, the tale of demand is likely to be mixed. We expect foreign investment into the bond markets to remain weak on lower FGN rates, subsisting currency restrictions and prospects of further hikes in US interest rates even as monetary thrust likely underpins strong local participation. On the latter, hinged the need to stimulate output growth, we expect the current monetary easing to persist and the net inflow in December (N150 billion), despite the surprise resumption of OMO sales, appears to reaffirm this posture. Crucially, it appears the CBN has both the comfort and sufficient legroom to sustain this stance with average daily system liquidity of N700 billion since October 2015, CRR still elevated (20%) and ample OMO maturity (H1 16: N1.8 trillion). This suggests system liquidity will stay elevated, at least over the first half of 2016, exerting downward pressure on the treasury yield curve.
Specifically, H1 2016 OMO maturities which translates into average monthly inflow of N300 billion, is more than twice the expected gross monthly bond issuance (N130 billion). Indeed, further cut in CRR could potentially increase liquidity, likely offsetting potential upward pressure from additional supply if our prognosis on wider deficit pans out. Overall, whilst we anticipate higher paper supply, we believe the impact will be blunted by easing and, should our expectation for additional cut in key rate pan out, could even drive the treasury yield curve lower.
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