Bond investors Pitch for higher yield to Compensate Inflation Risk

The recent rise in Nigeria’s headline inflation signals that the purchasing power of the country’s bonds future cash flows has been eroded.

Nigeria’s headline inflation in May, picked up from 8.7 percent year-on-year (yoy) to 9 percent, against most analysts expectation of circa 8.8 percent, yoy.

To hedge against this potent risk occasioned by bond’s worst enemy (inflation), Nigerian bond investors may be fielding for higher yield to compensate inflation risk.

This situation is more realistic, following recent weak demand from offshore investors, since JP Morgan’s ‘threat’ to delist Nigeria from its local currency government bond indices weighs appetite.

“We expect local currency bond yields to rise, in line with the current short-term inflation trend and consequent depreciation on bond prices,” said research analysts at Lagos-based Cowry Asset Managment Limited.

In the bond market, if participants believe that there is higher inflation in the horizon, interest rates and bond yields will rise (and prices will decrease) to compensate for the loss of the purchasing power of future cash flows. Those bonds with the longest cash flows will see their yields rise and prices fall the most.

The Debt Management Office (DMO) will today (Wednesday) hold its next monthly auction of FGN bonds in a targeted raise of N80billion.

At today’s FGN bond auction, the  DMO will issue N40 billion, N15.22 billion and N25 billion worth of 15.54 percent February 2020 (5year), 14.20 percent March 2024 (10year) and 12.149 percent July 2034 (20year) bonds (all re-openings) respectively.

“The liquidity constraints forming the basis of JP Morgan’s threat to delist Nigeria from its local currency government bond indices are a powerful disincentive.

The auction should show the continuing appetite of the Pension Fund Administrators (PFAs) for the 20-year benchmark,” said analysts at Lagos-based investment house, FBN Capital Limited.

The Tola Odukoya led team of bond market analysts at Dunn Loren Merrifield said, “The level of market volatility is expected to reduce as we approach the FGN bond primary auction due on Wednesday (today) during which N80.22billion worth of bonds will be offered”.

The analysts noted that Nigeria’s Over-the-Counter (OTC) fixed income market was last week, influenced by OMO bills auctions and redemptions; the release of June 2015 FGN bond auction offer circular by DMO; net CRR credit; and the news of JPMorgan extending Nigeria’s Government Bond-Emerging Market (GBI-EM) index watch inclusion period, which stimulated initial demand from domestic investors.

However, towards the mid to end of last week, the market became bearish, as diminishing market liquidity spurred increased selling activities, whilst dealers took positions ahead of today’s bond auctions.

“Consequently, bond yields lost 53basis points on the short end but gained about 27 basis points on the mid-long end of the curve,” according to Dunn Loren Merrifield analysts.

The report for May from the National Bureau of Statistics (NBS) reflects the negative impact of both the fuel shortages and the late start of the rains, analysts added.

“The headline rate now sits at the top of the CBN’s range of between 6 percent and 9 percent y/y, and presents a challenge for the MPC when it next meets in July. “ The offering of five, ten and 20-year paper is unchanged from the four previous months,” said FBN Capital analysts.

“The offshore participation next week is likely to be marginal, at best. The liquidity constraints forming the basis of JP Morgan’s “threat” to delist Nigeria from its local currency government bond indices are a powerful disincentive. The auction should show the continuing appetite of the PFAs for the 20-year benchmark”, FBN Capital analysts added.

United Capital analysts expect to see mixed sentiment in the fixed income space this week. “We think activities in the bond market will be stronger this week, though expectation of higher rates in the primary market might spark sell-offs,” United Capital analysts added.