After the reggae, comes the blues: A painful year for bond traders
Yields along the Naira curve broadly increased in 2021 (up by over 500bps) a reversal from the strong declines observed in 2020 when an unorthodox monetary policy stance by the Central Bank of Nigeria (CBN), that allowed a build-up in financial system liquidity, had pushed interest rates to historic lows. Given the inverse relationship between bond yields and bond prices, the S&P FMDQ Nigeria bond index, (a broad index which tracks the performance of bond prices) declined 15% over the year, after the 35% gain posted in 2020. The lift-off in interest rates was roughly parallel across the curve and reflected a unique confluence of factors: CBN’s unexpected upward repricing of OMO bill rates (with the 1-year tenor hiked from 3% to 10%) which worked to fuel speculation about potential interest rate hikes, large pension fund liquidations in the aftermath of revised regulatory guidelines on HTM/MTM classifications for bond holdings and general market unease about the prospect for increased FGN borrowings to finance a record budget deficit. Bearish trends deepened over Q2 2021, when the CBN embarked on an episode of liquidity tightening via a ramp-up in adhoc CRR debits, ostensibly in a bid to manage the fallout from the unwinding of its OMO bill portfolio in Q1 2021.
Figure 1: The Naira Yield Curve in 2021
Pension fund rebalancing and fluid monetary policy underpin up-down trend in interest rates
In terms of timing, the sell-offs were concentrated in Q1 2021 (+400bps) which coincided with the re-pricing of OMO bill yields to 10% and perhaps more importantly, desperate pension fund selling ahead of a regulatory deadline to rebalance MTM/HTM bond positions to meet variable income exposure limits for pension fund portfolios. The Q2 2021 selloffs was driven by tight liquidity conditions across the banking system after the CBN doubled down on CRR debits to offset the impact of fresh naira liquidity from its unwinding its OMO bill portfolio with net redemptions of NGN3trillion. More on this in a bit. This development pushed interbank placement rates for 90-days to 14-16% over the quarter and forced banks to sell-down on bond positions to generate liquidity. Over Q3 2021, a liquidity bulge arising from the redemption of the July 2021 FGN bond (NGN561billion), reduction in the intensity of CRR debits and a cessation of OMO bill auctions drove a moderation in interest rates over the quarter (down 100bps). However, markets halted the declining trend in Q4 amid a pick-up in expectations regarding bond supply following the release of the draft 2022 budget which showed another record deficit on the cards. As against the parallel shifts over the first three quarters, the yield curve steepened in Q4 with the front-end moving lower while the mid-long segments drifted higher.
Record fiscal deficit underpins historic trends in fiscal issuance
In terms of securities supply, large fiscal imbalances with a record NGN5.2trillion deficit underpinned gross domestic bond sales of NGN2.9trillion in 2021 – a record number. Adjusted for bond maturities, net bond issuances are at a record NGN2.4trillion which required higher bond yields to clear (average: 12.2% vs 2020: 9.05%). Worthy of note is that to meet its large borrowing need, the DMO leaned on non-competitive bids (NGN392billion) at bond auctions – highest in five years and aggressively tapped the NTB segment. For context, gross NTB issuance climbed to a four-year high of NGN4.1trillion but interestingly in a departure from the norm of merely rolling over NTB maturities, net NTB sales when adjusted for the maturities was over NGN1trillion – a record. In 2018, the DMO sold USD3billion in Eurobond debt under a plan to reduce rollover risk (i.e. cut down on NTB outstanding) which led to the redemption of nearly NGN1trillion of NTB instruments. Fast forward three years and the Eurobond is yet to mature but the large fiscal deficit has forced the DMO to walk back that plan. The DMO continued to diversify debt instrument availability with the sukuk sales of NGN250billion in December with a new 10-year rental at 13%.
Figure 2: Primary-Secondary market spread
Source: DMO, FMDQ
But CBN quietly switches from OMO to SPEBs to lower liquidity management costs
While the DMO was ripping up its NTB Eurobond plan and borrowing aggressively, the CBN was carrying out a seismic change in its own liquidity management toolkit. In December 2020, the apex bank had announced the creation of a new security for liquidity management – Special Bills which would be accessible to non-bank financial institutions and would be of 90-day tenor. Unlike the hitherto OMO bills whose yield was determined via auctions, the yield on SPEBs would be pre-determined by the CBN and they were set at 0.5% which given the 0-1% NTB yield level in December 2020 appeared normal. However, despite moving the OMO yield higher, the CBN retained the 0.5% level for SPEBs all through the year even as it introduced various tenors stretching up to 6months in four iterations over 2021. Strangely, for banks who traded out of their SPEB positions they would be credited with these positions at the next rollovers, a development which forced some banks to change classification of these instruments from MTM to HTM. Within this context, for the second consecutive year, the CBN shrank its OMO bill portfolio to NGN2.1trillion – the lowest level since 2011 implying net liquidity injections of NGN4.5trillion in 2021 after NGN6trillion redemptions in 2020. Essentially, the CBN has replaced OMO bills (with market determined yields) with SPEBs and their adhoc determined yields at near zero levels foisting the cost of liquidity management on banks. This move is consistent with the CBN’s policy shift towards non-market-based approaches to price determination of key economic variables: FX and, now, interest rates.
Although the central bank continues to justify these anomalies under its heterodox policy framework, the development creates distortions in the Naira fixed income market as for risk free securities under 1-year, a three-way pricing now exists: SPEBs are issued at 0.5-1% but trade at 5-6% in the secondary market, NTBs are issued at 2.5-4/5% but trading at 3-5% and OMO yields (available to banks and offshore investors) trading at 3-6% in secondary market but issued at 7-10%. Instructively, placement rates are now varying between 10-13% during normal periods and 14-16% during tight liquidity episodes. Then you now have bonds which are between 11-13% with the monetary policy rate held at 11.5%. As with the currency market, the CBN has essentially put a knife on the idea of private actors independently responding to signals about likely policy response to economic development and their own liquidity needs in determining interest rates. We are now in an indeterminate interest rate world with really no need for a secondary fixed income market.
But Naira interest rates remain misaligned with fundamentals, T-bills in particular!
From a fundamental perspective, despite the back-up in interest rates and deceleration in headline inflation over 2021, the Naira curve remains over-valued when compared to inflation with negative real yields of 420bps at the end of December (2021 real yield average: -660bps). Given the depressed level of NTB yields, the segment is deeply over-valued with negative real yields of 1080bps and when compared with the secondary market yields of equally abundant SPEBs (5-6%) which is perhaps indicative of the cost of immediate liquidity, the front-end of the curve is fundamentally expensive. That said, relative to Nigeria’s long-run inflation of 12%, the over-valuation on bonds does not appear much with present average nominal rates around 11% while NTBs remain over-valued. Term premiums have widened to elevated levels reflecting the compression in NTB yields implying either a strong pull back in bond yields or a gap-up in NTB yields. I think the latter is more likely than the former.
Figure 3: Average Term Premiums
Source: Author’s computation
Large fiscal imbalances point to bear flattening, but CBN is the unknown unknown
“There are known knowns, things we know that we know; and there are known unknowns, things that we know we don’t know. But there are also unknown unknowns, things we do not know we don’t know.” – Donald Rumsfeld.
Donald Rumsfeld died in 2021 and after poring through the various points, I found this quote as descriptive of 2022’s fixed income outlook. First, we start with the known knowns. After several years of low inflation and easy monetary policies, soaring prices looks set to drive a hawkish pivot across global central banks in 2022. Higher US bond yields and a stronger dollar will likely combine to soften net portfolio flows to Nigeria’s debt market, which was already struggling given negative real interest rates and poor FX market liquidity. On the domestic front, the 2022 budget deficit spells out net domestic borrowings of NGN2.5trillion which given bond maturities of NGN605billion implies gross bond sales potentially north of NGN3trillion. In his budget signature speech at the end of 2021, President Muhammadu Buhari sounded out discontent over the increase in the budget without accompanying revenue measures which would suggest a supplementary budget in 2022 could be on the cards. In terms of maturity preferences, the DMO is likely to continue with the 2037s and 2026s and potentially introduce a new 30-year tenor (2052s) and possibly a new ten-year (2031).
Figure 4: Annual Debt Maturities
On the liquidity front, CBN’s unwinding of its OMO bill position by rolling over only 30-40% of weekly maturities which could see NGN700-800billion addition liquidity into the system in Q1 2022. As in 2021, this liquidity release is unlikely to be remain uncontested with a potential ramp-up in adhoc CRR debits which will support interbank placement rates. However, the non-CBN maturity profile appears front-loaded with FGN 2022 bond maturity in January set to unleash NGN606billion. Given the heavy upfront cash requirements, the DMO cannot credibly redeem NTB instruments over the quarter as this will only store up rollover risk headache further out in 2022. Overall, a liquidity bulge over Q1 2022 could work to keep yields contained in Q1 2022 before thinner liquidity conditions and diminishing marginal utility forces in the face of resolute bond sales by the FGN induces an upward reset over the rest of the year.
Thrown into the mix are newly introduced regulatory costs on secondary market bond trading by the Nigerian Securities and Exchange Commission (SEC), given the poor state of its finances on account of a heavy top-level personal structure. Rather than streamline its longstanding top-level personnel cost issue, the SEC is choosing to impose a regulatory burden on the capital market to survive which is instructive of policy thinking. Added to this is the end of the decade long tax moratorium on income from fixed income securities. Overall, these extra costs will likely drive wider spreads on fixed income trading and marginally higher yields as investors look to offset these costs.
Beyond the fundamental liquidity profile are potential key event risks that could drive potential selling pressures. Sizable pension fund MTM bond positions (NGN360billion) could present downside risks in the event of a disorderly attempt at selling which could work to support bear flattening. Another risk could yet emerge from the downward pressure on Nigeria’s external reserves given a likely resurgence in import demand. Persisting external account imbalances amid limited capital inflows to debt markets will test the resolve of CBN’s import suppression/USD demand management policies. Ahead of the 2023 elections dollar demand is likely to remain robust and renewed weakness in external reserves absent inorganic additions like SDR injections or Eurobond sales will mean something has to give at some point. Indeed, my greatest concern over 2022 is how CBN responds: dig deeper into heterodoxy or come clean with a return to orthodoxy. Either way has profound implications for yield direction beyond Q1 2022. Will Nigeria pull back from the brink as in 2017 or dive deeper into the unknown world of financial repression?
Happy New Year and good luck navigating Nigerian debt markets in 2022!