At the centre: The role of bonds is shaping the sector in a number of ways

A number of factors suggest Nigeria has all the makings for a vibrant bond market, one that has come a long way since its inception a decade ago. In the last few years a sustained downturn in equities has diverted investment towards money markets and fixed income instruments, while sovereign bond issuance has successfully established a yield curve since 2008. By the end of 2011 Nigeria’s 48 bonds reached a market capitalisation of N2.09trn ($13.38bn) for federal bonds, N1.34trn ($8.58bn) for corporate bonds and N308bn ($1.97bn) for state bonds, according to the Nigerian Stock Exchange (NSE). Yet success in sovereign and subnational bond issuance, alongside high interest rates, has created its own challenges for corporate fixed income financing in 2012.

SOVEREIGN YIELD CURVE: The Federal Ministry of Finance has been successful in establishing a benchmark yield curve over the past decade. Moribund since the 1970s, the fixed income market began to revive in 2003 when the Debt Management Office (DMO) issued a test offer of N150bn ($960m). With only N72.56bn ($464.38m) subscribed at the time, the DMO pursued a diligent development strategy, issuing bonds monthly starting in 2005 and achieving a benchmark curve by 2008. Following debt restructuring by the Paris Club in the middle of the decade, Nigeria’s combined domestic and external debt-to-GDP ratio had fallen to 17.3% by the close of 2011, according to the DMO, leaving room for more debt. The DMO now issues securities every month save December, with three maturities (ranging from three to 20 years) in a single Dutch auction process, whereby winning bids are awarded at the highest yield. The length of average maturities have gone from one year in 2002 to 10.33 years by 2010. Corporations have followed suit, with manufacturers, banks and property companies successfully floating bonds at rates in the mid-teens. By early 2012 there were 42 listed bonds – 36 government and 16 corporate. Federal Government of Nigeria (FGN) bonds dominated the market’s capitalisation in 2011, with a 56% share, followed by corporate bonds (36%) and state and local government bonds (8%). The average tenor of corporate bonds was 5.63 years at the end of 2011, while that for state bonds was 5.15 years. But with some N5.9trn ($37.76bn) in domestic debt, the FGN is conscious of its debt burden and of the danger of crowding out other issuers. Bond issues are nevertheless in high demand in light of high risk-adjusted returns.

ATTRACTIVE YIELDS: The bond market has developed on the back of high growth in domestic demand for fixed income securities. The sustained slowdown in equities markets since 2008 has spurred what Samuel Sule, a senior associate in Stanbic IBTC Bank’s debt capital markets division, told OBG was “a systemic shift of investor appetite to fixed income.” Commercial banks have long dominated bond trading in Nigeria, focusing on short-term paper as another way of investing excess client deposits, but new institutional and retail demand has flocked towards fixed income. Offering high premiums (over 16.5% as of July 2012) compared to emerging markets like Brazil and South Africa, Nigeria sovereign bond yields are attractive to foreign investors. They have grown their bond holdings, a trend expected to continue. Foreign holdings of FGN bonds grew from 5.33% in 2008 to 7.1% in 2010.

REFORMS: Pensions reform in 2004 spurred the rapid accumulation of some N2.45trn ($15.68bn) in assets under management by pension fund administrators (PFAs) at the close of 2011, up from N815bn ($5.22bn) in 2007. Once consolidation begins on the back of higher capital requirements starting in July 2012, PFAs are expected to increasingly exert a role as the country’s largest pool of institutional investors, with an appetite for longer-term bonds issued by firms rated BBB and above by at least two rating agencies. Current Pension Commission rules cap PFA investments in corporate bonds at 35%, money market and commercial paper at 35% and state government bonds at 20%. Nigerian investors have increasingly shifted towards money markets in the aftermath of 2008 and have proven to be a growing source of demand for short-to medium-term bonds. “In the last year, we have seen increased activities in fixed income securities in the Nigerian market,” Wale Agbeyangi, the managing director of Cordros Capital, told OBG. “There has been a significant uptick in both primary issues and secondary market trading.” The high interest rate environment has also contributed to the attractiveness of corporate bond coupon rates, with the Central Bank of Nigeria (CBN) increasing the benchmark policy rate from 9.25% to 12% in October 2011, and no easing in sight given persistent inflation. With yields in the range of 14-16%, fixed income securities have become a less risky and more attractive alternative. “Should we see some stabilisation in inflation, interest rates and the exchange rate by the fourth quarter of 2012, all the conditions would be in place to support a non-sovereign bond market revival,” Sule told OBG.

While institutions have dominated bond trading, the NSE and the DMO plan to create a retail market in government bonds to extend greater retail access to fixed income trading. With the minimum floor for investing in primary bond issues set at N100m ($640,000), the establishment of a secondary bond trading market would lower barriers to entry in the bond market and entice more retail investors. In addition, structural reforms, including the introduction of short selling and securities lending, will be extended to the bond market and could foster more transparency and liquidity. “Prices quoted across trading platforms reflect interactions of market forces better than those in the over the counter markets,” Agbeyangi told OBG.

SUBNATIONAL BONDS: Power and share of public spending for individual states in the country has risen considerably since the advent of democracy, yet contrasts remain in terms of the financing abilities for each of the 36 states. While southern states received the highest per capita share of federal allocations, only a handful of states have built up any significant tax base. Only those states with sizeable internally generated revenue (IGR) have found themselves able to diversify funding sources away from allocations and bank debt. Ultimately backed by the Federal Account Allocation Committee and capped at half of a state’s aggregate total revenue, bond issuance at the state level is fast emerging as a means of funding much-needed infrastructure projects.

The Lagos government was the first to issue N50bn ($320m) in five-year bonds in February 2009, setting a benchmark for other states. This was followed by bonds from Imo (N18.5bn, or $118.4m), Kwara (N17bn, or $108.8m) and Niger (N6bn, or $38.4m) in 2009. Sustaining its bond issuance programme, Lagos issued the second tranche of N57.5bn ($368m) of bonds in April 2010 and will float the third tranche of up to N80bn ($512m) during 2012. While issues by the states of Kaduna, Ebonyi, Edo and Benue have been smaller (below N15bn, or $96m), oil-rich Bayelsa raised N50bn-80bn ($320m-512m) in seven-year bonds in June 2010. Ondo meanwhile raised some N27bn ($173m) in seven-year bonds in February 2012, with three states to follow. Rivers, with the second-highest IGR of 25%, plans to float five-year bonds to total N100bn ($640m) before the end of 2012. This is still less than half its N250bn ($1.6bn) yearly revenue. Osun has planned a hybrid bond float, with N22.5bn ($144m) in conventional bonds and N7.5bn ($48m) in a sharia-compliant sukuk bond at roughly the same rates. Meanwhile the Asset Management Corporation of Nigeria (AMCON) raised N1.7trn ($10.9bn) in three-year bonds in 2011, selling bonds to banks in return for the non-performing loans on their balance sheets. Guaranteed by the Central Bank of Nigeria (CBN), AMCON will return to market to refinance the full amount in maturities of seven to 10 years in 2013.

REDUCTIONS: Added to the FGN’s debt burden of 17% of GDP, these subnational obligations contribute an extra 4%. While below the 25-30% range set by the DMO, the Ministry of Finance is attempting to reduce annual borrowing – from N852bn ($5.45bn) in fiscal year 2011 to N744bn ($4.76bn) in 2012, with plans for further reductions to follow. Recognising that interest rates on its domestic debt remains too high, Ngozi Okonjo-Iweala, the minister of finance and coordinating minister for the economy, proposed the creation of a sinking fund in the next budget to lighten some of the debt burden: “We are going to put a chunk of our money into a sinking fund and retire one or two of the bonds,” she said in July 2012.

While rebalancing fiscal spending towards capital expenditure will be key, reducing the rate of domestic borrowing will also leave more space for corporate issuers. Meanwhile, on the back of Nigeria’s first eurobond issue in January 2011, authorities plan for the launch of a $600m eurobond in early 2013 designed to appeal to the significant number of Nigerians living abroad – in other words, a “diaspora bond”. Relieving some of the pressure on domestic debt markets, this issue could also tap the country’s significant remittances, estimated at around some $10bn a year.

CORPORATE BORROWING: While a number of corporations have tapped the bond markets in recent years, with successful floats from banks and industrialists, significant issuance from the public sector has soaked up much of the liquidity. Corporate bond issuance continued well into 2011, with issues from UBA, Lafarge Cement WAPCO and Nigerian Aviation Handling Co (NAHCO) in the third quarter of that year. Yet the vast majority of corporations have continued to prefer long-term loans or rolling over short-term credit facilities as a means of financing.

“The appropriate yields on any new corporate bond issues would have to be close to 20%, given current market conditions,” Akinsowon Dawodu, the country treasurer of Citibank Nigeria, told OBG. “Unsurprisingly, we really have not seen much interest from potential corporate issuers since the 2.75% policy rate hike that took place in October 2011.”

But with the average yield on a bond for the federal government of Nigeria standing at a decade high of 16.5% in July 2012, there has been some concern that private issues are being crowded out. Large and medium corporates have been deterred in their plans for 2012 because of the high rates that they would have to offer to compete with virtually risk-free government bonds. Blue-chip companies that have the ability to raise bank loans at rates of between 14% and 16% have put plans for bond issuance on hold for the time being. Most other firms with lower credit ratings face commercial interest rates several points higher, closing the gap with bond rates, but they have remained cautious when it comes to locking in high interest rates for longer than may be necessary.

TAKE THE LEAD: Following the lead of the government, with its $500m eurobond in January 2011, a number of corporates have sought to float bonds on offshore markets. The benchmark 5% around which the FGN eurobond is trading has allowed Nigerian blue-chips to raise funds in a range of 5.5% to 8% internationally, far lower than onshore rates.

Banking on the sustainability of the CBN’s exchange rate targeting (at N155/$1 in a band of +/- N3), corporates like GT Bank, Skye Bank and First Bank are hoping to avoid the experience of previous offshore issuers such as Flour Mills of Nigeria and Nigerian Bags Manufacturing, which saw their profits eroded by a depreciation in the local currency.

Another source of corporate funding that could emerge later in 2012 or in early 2013 is commercial paper. In 2009 the CBN suspended the practice of issuing commercial paper, which in the past had played a key role in corporate borrowing. Indeed, Stanbic IBTC estimates that this market was worth N300bn ($1.92bn) a month before it was suspended. The use of commercial paper now looks set to return, with new regulations expected within a year. However, the CBN will likely add additional restrictions, such as requiring each issuer to hold ratings from two agencies.