Low Yields: Asset Managers Must Take Risk to Generate Positive Returns'
Bolaji Balogun - Chapel Hill Denham Chief Executive

‘Low Yields: Asset Managers Must Take Risk to Generate Positive Returns’

With the outlook firmly pointing toward continuation of the financial repression strategy and single-digit fixed income yields, an investment firm, Chapel Hill Denham, has said that local asset managers have been advised to take risks and go out of their traditional comfort zone to generate positive real return.

Chapel Hill Denham made the submission in its fixed income market research note, as the investment firm noted that fixed income market yields hit a record low last month despite growing social unrest.

It said as social unrests dominated headlines over the past month, a landmark event took place in Nigeria’s local currency sovereign bond market, which went largely unnoticed.

Notably, analysts explained that the 19-month long bond rally climaxed in October, as the generic 10-year and 20-year bond yields dropped to 4.22% and 5.45% respectively on Friday 30th October.

This was the lowest level since data became available in 2007, Chapel Hill Denham stated emphatically.

The investment firm stated that as trading rounded up for the month last Friday, bond traders will be looking back at October with much reverence, as the month delivered the strongest return for bonds in at least five years.

Notably, the S&P FMDQ Nigerian bond index advanced by 19.5% month on month as yields collapsed by 260bps month on month, by far the best monthly performance since the inception of the index in 2017.

This further cement the status of the current bond rally as the most rewarding in the history of the Nigerian bond market, analysts added.

Year-to-date, Nigerian bonds, measured by S&P FMDQ bond index are up by 55%, easily outperforming the Bloomberg Barclays Emerging Markets local currency bond index, which is down 1.8% year to date.

What is driving the rally?

“We can trace the beginning of the bond rally to the CBN’s dovish tilt at the March 2019 MPC meeting, when the benchmark policy rate was cut for the first time in four years, by 50bps to 13.50%”, Chapel Hill Denham said.

The firm said rally gained momentum in October 2020 following the CBN’s decision to exclude non-bank local investors from its Open Market Operation (OMO) bills market.

That decision, the firm said, subsequently freed up over N3.5 trillion of liquidity from the open market operations (OMO) market, and into the sovereign bond market and other risk assets.

At the onset of the COVID-19 pandemic in March 2020, which triggered risk aversion, the bond market corrected, but the rally resumed in April as the CBN turned more dovish by substantially reducing issuances of OMO bills, which was followed by two 100bps policy rate cuts.

“What finally threw the market into a frenzy that resulted in the record low yields, was the indication by the DMO that the supply of bonds will reduce considerably in Q4-2020, starting with the October bond auction”, Chapel Hill Denham stated.

Non-bank local investors have finally rotated out of OMO bills:

Chapel Hill Denham said the fixed income market witnessed a regime change on Thursday 22nd October 2020, when non-bank local investors finally exhausted their OMO holdings.

Ordinarily, analysts said this should have ignited an upward reversal in yields, but they expect bonds to remain defensive in the near term due to two factors.

The first consideration according to Chapel Hill Denham is that banks and foreign portfolio investors still have substantial OMO maturities between now and March 2021.

In that case, analysts said yield direction henceforth will depend on CBN’s liquidity tolerance, or otherwise, in the next few months.

By implication, Chapel Hill Denham said investors will be watching the frequency and size of the Apex Bank’s OMO issuances.

“If the CBN ramps up OMO issuances to roll over the FPI-dominated OMO inflows in the coming weeks, it could start to force yield upwards.

“If the reverse occurs, then the liquidity backdrop will remain supportive of low yields in the fixed income market.

“We think the outlook is biased towards the later as the CBN appears convinced that its dovish monetary policy bias (which has led to financial repression) is neither fuelling inflationary pressures (+49bps to 13.71% year on year in September) nor contributing to macroeconomic instability”, the investment firm stated.

Nevertheless, analysts believe that some anecdotal evidences also suggest that monetary, credit and exchange rate policies may have contributed to the macroeconomic instability in recent months.

Explaining further, analysts said the second factor to consider is fiscal policy, particularly the local currency borrowing plan.

Chapel Hill Denham said the Debt Management Office (DMO) has taken advantage of the strong demand for securities to frontload its issuances for 2020, and already sold over 95% of its domestic issuance target as at October 2020, by our estimate.

As a result of this, analysts think that the supply of government securities will remain thin in the short term.

This is supportive for fixed income yields, particularly as there is substantial OMO maturities (N2.4tn), trickle of bond coupons (N23bn) and two outstanding FAAC distributions left for the year.

However, Chapel Hill Denham said it expects supply to increase substantially in January 2021, once the DMO begins to implement the 2021 deficit financing plan.

It explained that the budget proposal submitted to the National Assembly suggests that the Federal Government of Nigeria (FGN) plans to reduce its net domestic borrowing marginally by 3.3% to N2.1tn in 2021.

“Although we expect the actual figure to be higher in anticipation of a debt substitution exercise”, analysts said.

The DMO has raised a record amount in the bond market in the current fiscal year without breaking a sweat, mainly due to large OMO maturities from non-bank local investors searching for investible assets.

With non-bank local investors fully out of OMO bills, and bank maturities to decline substantially from March 2021, Chapel Hill Denham said a credible question could arise as to how the DMO can conveniently fund this deficit without triggering an upward repricing in yields.

“In our view, while deficit financing pressures will be higher relative to 2020, we believe the market can still conveniently fund the deficit from natural growth in banking deposits, monthly FAAC pay-outs to sub-national governments, pension contributions, and bond coupon payments.

“Also, the growth of the Nigerian bond market in the past years has failed to match the growth in the institutional buy-side funds, excluding foreign portfolio investors”, analysts explained.

Chapel Hill Denham stated that the excess liquidity resulting from this imbalance used to be mopped-up by the CBN via OMO issuances.

That is no longer the case since the CBN stopped selling OMOs to non-bank local investors, and also gradually using moral suasion to discourage banks from bidding for OMO bills.

Analysts explained that the CBN has gone a step further to segregate foreign investors from commercial banks.

In September, the firm said the CBN began selling non-rediscountable special OMOs directly to FPIs, which could ultimately lead to banks being shut out of the OMO market.

Corporate debt issuances have risen to the occasion, as combined issuances of commercial papers and corporate bonds in H1-2020 worth N697.4bn have surpassed FY-2019 (N580.6bn) level and tracking at record highs.

“Yet, the market is not deep enough to prevent excess liquidity from building up, in our view”, analysts stated.

Lower for longer

Analysts said with bond yields at record lows amid renewed pressures on oil prices, investors are justifiably likely to become more apprehensive on the sustainability of the historic bond rally.

Nonetheless, Chapel Hill Denham thinks it is too early to call the end of the rally, as it believes that the imbalance between demand and supply of government securities will continue in the near term, except the CBN steps in aggressively to sterilise liquidity via OMO issuance.

However, analysts said odds are in favour of the CBN maintaining the current policy bias, until the economic recovery gains a foothold.

As a result, analysts believe the liquidity backdrop should continue to favour low yields in the fixed income market.

Against this backdrop, Chapel Hill Denham said it expects the bond rally to persist until the DMO begins to implement 2021 borrowing plan in January 2021, at which point yields should stabilise.

“We see a strong scope for further 50-75bps contraction in bond yields towards year-end, with long term bonds likely to find support at 6.5% level”, analysts said.

In Q2-2021, it is expected that OMO maturities will decline substantially, which could trigger an upward repricing in yields.

However, analysts expect inflationary pressures to subside in H2-2021 due to high-base effect, and the liquidity environment should improve due to a bond maturity and substantial bond coupon payments in July 2021, both of which are favourable for bonds in the second half of 2021.

Risks to Outlook

The CBN is a wildcard in the yield outlook, Chapel Hill Denham said.

The apex bank has built up considerable excess bank reserves (N11.3tn in August 2020, up 2.1x) via arbitrary Cash Reserve Requirement (CRR) debits, which could be freed up at any time if liquidity becomes too tight, thus representing a downside risk to yields.

On the other hand, Chapel Hill Denham said the CBN could eventually concede the point that its dovish monetary policy bias is a risk to macroeconomic stability, at which point the market is likely to see an aggressive tightening of monetary policy, thus representing an upside risk to yields. 

Strategic implication:

Sovereign local currency bonds have outperformed every other asset class in 2020, but momentum may shift in favour of other risk assets in the near term.

“With the outlook firmly pointing toward continuation of the financial repression strategy and single-digit fixed income yields, we believe that local asset managers have to take risks and go out of their traditional comfort zone to generate positive real return”, Chapel Hill Denham said.

Consequently, analysts said they expect risk assets to outperform in the near term, including equities, alternative assets such as infrastructure funds and real estate, corporate debt securities and long duration bonds.

The firm explained that the biggest institutional investor block in Nigeria, the Pension Fund Administrators (PFAs), are yet to calibrate their asset allocation to reflect this outlook.

Chapel Hill Denham said industry allocation to equities is down by 61bps year to date to 4.8% as a percentage of Asset Under Management (AUM) in August 2020.

Meanwhile allocation to corporate debt securities and infrastructure have risen only marginally by 1.1% and 0.1% year to date to 6.65% and 0.47% respectively.

At the peak of the last historic bond rally, between Q1-2009 and Q2-2010, analysts said they saw PFAs allocation to equities more than double to 18% of AUM from 7%.

“This has yet to materialise in the ongoing bond rally, but may become inevitable if the low yield environment persists in 2021, as we expect”, Chapel Hill Denham explained.

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Low Yields: Asset Managers Must Take Risk to Generate Positive Returns’