Supply of Fixed Income Securities to Rise as DMO Kickoff Borrowing Plan
In January 2021, supply of government fixed income securities has been projected to rise, thus, reduce current imbalance between demand and supply that has kept yields down.
Analysts at Chapel Hill Denham are expecting supply of government securities to increase substantially, once the Debt Management Office (DMO) begins to implement the 2021 deficit financing plan.
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 explained.
The DMO has raised a record amount in the bond market in the current fiscal year without breaking a sweat, mainly due to large open market operations (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, 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”, Chapel Hill Denham stated.
The firm added that 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.
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The excess liquidity resulting from this imbalance used to be mopped-up by the CBN via OMO issuances, but 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.
Chapel Hill Denham analysts think the CBN has gone a step further to segregate foreign investors from commercial banks.
In September, the CBN began selling non-rediscountable special OMOs directly to foreign portfolio investors (FPIs), which could ultimately lead to banks being shut out of the OMO market, analysts explained.
The investment firm however said that corporate debt issuances have risen to the occasion, as combined issuances of commercial papers and corporate bonds in H1-2020 (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”, analysts reckoned.
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 analysts believe 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, Chapel Hill Denham believes the liquidity backdrop should continue to favour low yields in the fixed income market.
Against this backdrop, the firm 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 stated.
In Q2-2021, 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 stated. It explained that 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.
Analysts projected that this could be freed up at any time if liquidity becomes too tight, thus representing a downside risk to yields.
There is an indication that the CBN is set to take this path, with special bills circular issue recently to free excess cash reserves requirements to banks.
On the other hand, analysts stated that the CBN could eventually concede the point that its dovish monetary policy bias is a risk to macroeconomic stability, at which point we are likely to see an aggressive tightening of monetary policy, thus representing an upside risk to yields.
Strategic implication:
Chapel Hill Denham hinted that sovereign local currency (LCY) 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, analysts believe that local asset managers have to take risks and go out of their traditional comfort zone to generate positive real return.
Consequently, analysts 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 said the biggest institutional investor block in Nigeria, the Pension Fund Administrators (PFAs), are yet to calibrate their asset allocation to reflect this outlook.
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, while 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 at Chapel Hill Denham 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”, analysts explained.
