The resurgence in Nigeria’s domestic sovereign debt instruments dates back to 2000, when the Debt Management Office (DMO) was created to co-ordinate the management of Nigeria’s debt. This was previously performed by several organisations, and the result was disorganised and inefficient. For example, most of Nigeria’s domestic debt instruments were structured into treasury bills with maturities of 91 days and below, creating inconsistencies and irregularities in the federal government’s borrowing costs.
In October 2003, the DMO introduced the sale of Federal Government of Nigeria Bonds. This has affected the markets and investor behaviour in three ways: first, it has restructured Nigeria’s deficit funding from shorter to longer tenored borrowing instruments; second, it has improved and lengthened the yield curve in the domestic money markets; and third, it has encouraged long-term savings.
Nigerian government bonds were sold to the investing public through licensed banks and discount houses in the country. However, most of the investors held their bonds to maturity and few secondary trades were carried out.
Secondary market
In August 2006, the DMO sought to stimulate a secondary market by establishing a primary dealership/market maker network which authorised primary dealers and market makers (PDMMs) to deal directly with the DMO in bond auctions. The PDMMs are expected to play an active role in the issuance, sale and marketing of all bonds, making two-way prices in bonds in all market conditions. This structure has resulted in the creation of a successful secondary market trading in government bonds issued by the DMO.
The DMO has hitherto issued about N770.6bn ($6bn) of bonds and expects to issue about N480bn in 2007.
Access Bank, as a licensed PDMM, has been playing a leading role in disseminating data about the government bond market. It launched a sovereign bond index in December, 2006, detailing price information about local currency denominated fixed rate Federal Government of Nigeria Bonds. In order to qualify for the index, a bond must be publicly issued through the DMO and traded under the PDMM trading guidelines – as these are the liquid bonds that can be readily traded in the secondary market.
Pricing data is obtained from the 15 licensed PDMMs to ensure transparency of the index. It is therefore easy to replicate the index in practice as it includes only traded issues. Bond indices include a wide array of statistical information that provides valuable comparative information to assist strategy development and return attribution.
Access Bank, for example, produces a daily price for government bonds through a straightforward process of averaging. The capital markets team takes market quotes from all the broker dealers and ranks the prices in ascending order. It then eliminates the four prices at the top and the bottom of the list, on the assumption that they are ‘outliers’ and therefore going to distort the subsequent average. It then takes an average price from the surviving 11. The bank publishes the quote for each bond in a newspaper and it is accepted throughout the market as definitive.
Access Bank restricts its averaging process to bonds with at least a year to maturity. It says that bonds with shorter maturities are money market instruments and therefore not eligible.
According to Access Bank, the index serves an important indicator for market assessment of government handling of the economy, and of economic performance. “The bond index shows the market expectation for interest rates. If the monetary authorities come up with a policy, the market interpretation is reflected in the value of the index. If the market thinks that a policy will drive down interest rates, the bond prices will go up and the index goes up. It is like a barometer of the economy.”
Performance measure
Market observers also expect the index to be used as the objective benchmark for assessing the performance of pension fund managers and administrators. “Investors will be able to see if the administrators are generating alfa for them. The index will be an essential component of the country’s nascent but strong pension industry. This will be an objective criteria for assessing their performance.”
International observers are also expected to use the index. For example, Access Bank says that “a hedge fund wanting to invest in Nigeria will have something to work with. If you want to invest in a BB economy or instrument, you can see the return in Nigeria. It helps to make informed economic decisions. Investors should look more closely at the economic fundamentals of the market and pay less attention to politics. This will be of benefit to both their shareholders and to Nigeria.”
Naira-denominated bond investments may not be the optimal investment outlet for the average resident investor, compared with a spectacular domestic stock market that has delivered a compound annual growth rate of 35.22% since democracy was ushered in on May 29, 1999, and a year-to-date return of 22.52%. Official inflation rates are almost at par with bond coupons and the returns on bonds are almost negative. Investors in the bonds have mostly been banks (which benefit from tax breaks) and the newly introduced pension fund administrators (which are constrained by their licences) and foreign investors.
Non-residents – who are taking advantage of the extensive liberalisation of the foreign exchange markets – are starting to recognise the benefits of the domestic bond market. Non-residents can benefit from the continued appreciation of the naira against other major currencies as well as the bond’s yield, which is generally much higher than those of other sovereigns with similar risk profile.
Access Bank says: “Bond yields in Nigeria are impressive. The initial yield was 12%. This can be as much as 13% in dollar terms as the naira has appreciated against the dollar. For a non-resident who wants to invest in Nigeria, this is a good deal. The yield compares favourably with those of Turkey, Chile and Peru, which have the same sort of risk and rating.”
The naira has appreciated by more than 6% against the dollar since 2003, for the first time in the country’s recent history. Market players expect the naira to appreciate further against the dollar before the end of the year, with estimates ranging 1%-3%. Government bonds are not subject to any form of taxation, either on the coupons or on the capital appreciation.
Since 2005, the Central Bank of Nigeria has liberalised exchange controls for foreign investors in local debt and money market instruments. But the monetary authorities remain greatly concerned at the economy’s ability to withstand the speculative inflow and outflow of foreign capital, so investments in Treasury bills must be held for at least one year. However, all restrictions have been lifted on investments in domestic money markets by foreign investors.
Corporate bonds
The corporate bond market has not matched growth in the government bond market, largely for tax reasons. Corporate bonds do not attract the same tax breaks as government bonds. There are still very few instruments as only a few corporates (mostly banks) are rated by international rating agencies. Investors typically adjust the coupon for the 32% tax effect before adding on the risk premium.
From an issuer’s perspective, the expense of issuing a bond tends to be much more expensive than a bank loan. This high interest expense, coupled with the expected strengthening of the naira, is prompting corporates with relevant credit ratings to look towards the Eurodollar markets for their bond flotations. Most banks are expected to follow GTBank’s lead and issue Eurodollar bonds in the next 18 months.
The first and only corporate bond to be issued since the establishment of the DMO was the N13.5bn convertible bond issue by Access Bank in 2006.
