Political and currency concerns outweigh monetary influence on yields


Wednesday, August 12, 2015 12:42 PM / ARM Research

Today’s portion of the cut-out from ARM’s core strategy document – the Nigeria Strategy Report assesses movements in the fixed income markets, and posits their outlook thereof for the remainder of the year.

Choppy half year for FI markets
The turmoil that trailed the domestic fixed income market on the heels of the precipitous drop in oil prices in H2 2014 lingered into the first half of 2015, forcing the apex bank to step up regulatory oversight in a bid to stabilise the deteriorating currency. From the elimination of the NOP to reinstatement of same shortly after JP Morgan’s “threat” of possible expulsion of FGN bonds from its index, from the change in interbank forex market architecture to eventual closure of the RDAS, investors—foreign and local—were faced with a progressively unstable monetary policy. Amidst heightened apprehension due to the gloomy fiscal picture, the torrid political atmosphere—which in part led to the S&P rating downgrade—climaxed with the sell-off that pushed the yield curve more than 200bps higher to a multi-year summit in the middle of the first quarter. Despite the retracement that trailed the successful conclusion of the election, with yield curve only 20bps higher on average (T-bill: 13.93% and Bond yields: 14.78%) by the end of H1 15, the environment was largely unpredictable over H1 15 as indicated by the elevated rolling 30day yield volatility.  

Figure 1: 30 day rolling volatility (standard deviation) of yields

Political and currency concerns outweigh monetary influence on yields
In line with our expectation, the apex bank extended its hawkish monetary tone from Q4 14 with tweaks to CRR and ramp up in OMO issuance over H1 15 to curtail liquidity influence on the currency. However, aside the occasional spikes in call rates, triggered by the shortening of the CRR debit cycle— from monthly to bi weekly and then weekly—the liquidity mop-up of N1 trillion over the period (relative to N770 billion net repayment in H2 14) resulted in only a 20bps increase in average yields to 14.41% as other events appeared to have dominated investors’ considerations. Top on this list was political risks with the sharpest one day spike in yields (+61bps) in H1 15 coming on the heels of the postponement of the general elections in February. In fact, the sell-off was so severe that rates climbed progressively over the next five trading days (+257bps) to touch a peak of 16% on average. The exchange rate was another key driver of yields with the subsequent pull back in rates post-February coinciding with the closure of the RDAS. While yields trended lower in subsequent months, further buoyed by the peaceful conclusion to the general elections, a re-emergence of forex risk at the tail end of H1 15 triggered another round of selloff with yields jumping 125bps over the last trading days in June. Indeed, currency impact was visible in the trajectory of the non-deliverable forward (NDF). Specifically, the implied yield on 1 month NDF contracted from pre devaluation record levels of 114% to 52% post the devaluation easing further to 10% in April, before rebounding to 45% in June as monetary manoeuvres in late June.

Figure 2: Net Issuance vs. Yield Trends (RHS)

Eurobonds respond to heightened global risks

Investors in Nigeria’s Euro bond also responded to domestic events, particularly political risks, with sell-off driving yields to hit a 1 year peak of 7.05% days after the postponement of the general election in February. Eurobond yields retraced soon thereafter largely in lockstep with local currency bonds, before bucking the trend with another round of ascent from May, though this time in tandem with other emerging market Eurobonds, likely in reaction to the Greece standoff with Eurozone. While the risk of a Greek contagion cannot be ruled out, the risk to Nigeria appears remote, thus we believe the sell-off is a reflection of broader strategy by global portfolio managers to underweight EM markets in view of the possible crises, rather than a deterioration in credit quality of the Nigerian government.

Figure 3: Nigeria’s Eurobond prices and Bloomberg emerging market sovereign bond index (Rebased)

DMO unfazed by fiscal pressures risks

Interestingly, in spite of the fiscal straits, the DMO trimmed bond issuance (-18% YoY) to N450 billion in H1 2015. However, it extended issuance at the long end (10 and 20 year papers), with the switch to the 2020 bond in February apparently triggered by the bulging outstanding volume on the FGN 2017 of ~N600 billion—which appears to be an unwritten cap. The focus on the 2020 thereafter saw it account for a third of total issuance in H1 15. The overall lower issuance is reflective of softer issuance programme as well as rejection of offers by the DMO given exorbitant bid rates--as high as 20%--which forced the DMO to sell only 85% of its February offer at in contrast to its usual practice of 100% sales. The scale of restraint indicated by the DMO’s cutback in issuance is underscored by the fact that the agency had to finance the redemption of the N535 billion that matured in April. On a net basis, the DMO repaid ~N90 billion in H1 15 with the lack of actual borrowing fitting into our view that key agencies were awaiting a clearer political landscape to dictate direction for their activities. The DMO was not the only one taking their cue from the March 28 elections as investor appetite significantly improved in Q2 15 with bid to cover jumping to 2.5x from 1.5x in Q1.

Figure 4: Primary market data for bonds

Unsurprisingly, given the prevailing risks, this renewed appetite was domestic investor led. Combined bond purchases by pension fund and banks were nearly 1.4x the cumulative bond issuance in Q1 15. While the PFAs took advantage of the elevated yield environment, with 76% of their N200 billion Q1 15 bond purchases occurring in February, 85% of bank purchases occurred the following month.  Although overall impact of these purchases on yields trajectory was relatively mute, the bank angle, which incidentally coincided with rebound in FPI, suggests that banks took the advantage of their mediating role for FPI demand to use those flows as a barometer of the fixed income market. However, the simple fact that the dominant domestic demand had a minimal impact on yields not only reinforces our perception of the buy-and-hold inclinations of domestic investors but also underscores the extent of uncertainty that permeated the environment in H1 1.

Figure 5: Bid range at primary auction for 10 year FGN bond

Fixed income market awaiting the fiscal nod
Of all the drivers of yield trajectory in H1 15, political and monetary response to currency risk appeared to have dominated, with global dynamics and fiscal pressures largely on the back burner. In this regard, with political atmosphere calmer, unabating forex pressures suggests monetary manoeuvres will remain key in setting the tone for rates over H2 15 and we expect the apex bank to follow the same tack using a combination of some of monetary tightening via OMO and administrative measures.

However, high costs and limited impact of paper issuance on liquidity, which over the years tilted monetary policy in favour of direct cash sequestration and administrative measures, suggest paper issuance in H2 15 will be softer than in the first half of the year.   Interestingly, despite evident pressures, the tale on the fiscal side appears to be similar. Although, as anticipated, the President affirmed that the treasury was virtually empty, subsequent assurance that the FGN will do its best to recover loot, alongside disbanding of board of NNPC, dims scope of a sizable ramp up in domestic paper. Buttressing this disposition is the recent N700 billion bailout package sourced from NLNG proceeds and CBN. Juxtaposing our expectation for monetary activity to continue to favour direct liquidity-capping tools, with the body language of fiscal authorities, points to overall tamer paper supply over H2 15. However, this could be balanced by weaker demand.

On the global stage, though the prospects for US rate normalisation and Greek crises are important drivers for capital flows to EM, we believe, domestic considerations are likely to dominate investment actions. On this front, subsisting currency pressures, with interbank/parallel forex spread at record levels, should see FPI appetite for naira yields remain dry over the coming months. On the home front, while buying power is set to be weaker due to the step-down (-27% to N2.4 trillion from H1 15) in OMO maturities in H2 15, we see flight to safety in response to wavering macro fundamentals still buoying local demand. Nonetheless, uncertainty on probable economic direction of the new government is likely to keep the expression of that demand cautious. That said, with key fears--political risks—effectively off the table, the upper band for rates appear capped, around pre-postponement levels of under 15.50%, in our view.

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