The Mechanics of a Bond Market in Nigeria

Nigeria’s capital markets lack the liquidity needed for a sustainable bond market that can fund growth and development in the public and private sectors. This is a proposal to remedy market illiquidity and provide solution recommendations. The economic environment in Nigeria is sophisticated and suitable to create a sustainable vibrant bond market that can be vital in economic development. The success of the bond market depends on the collaboration between the market operators and financial institutions including the Central Bank of Nigeria (CBN). The Municipal Securities Rulemaking Board (MSRB) , Debt Management Office (DMO), Securities and Exchange Commission (SEC), CBN, and the Nigerian Stock Exchange (NSE) must ensure that regulated bond trading operations in a shadow and little understood repo market (repurchase agreements) is protected against illicit operations.

BACKGROUND

Treasury Notes/Bonds & Municipal Bonds
Nigeria’s sovereign bonds (debt) have been in existence since the 1970s. However, the bonds issued then had been illiquid and redeemable only to the Central Bank of Nigeria (CBN) upon maturity. In 2003, the Federal government returned to the debt market to mobilize funds for long-term capital projects. In the process, the government effectively championed the creation of an Over-the-Counter (OTC) bond market by issuing short-term maturity notes.

Today, the Federal government of Nigeria (FGN) has issued about four trillion naira (N4.0 trillion) worth of bonds that are supposed to be trading in OTC market. The approved budget in 2010 has authorized the CBN to underwrite for the DMO to raise nearly eight hundred and sixty billion naira (NGN868.00 billion). However, these bonds rarely exchange hands and are considered illiquid by most of the institutions that purchase them in the primary market at the Primary Dealer/ Market Maker (PDMM) auctions. Recently, a few municipal governments such as Lagos, Ogun, Rivers, Imo (issued 2016, 18.5b naira @ 15.5%), Bayelsa, and Abia states have either issued or received approval to issue bonds for long-term capital projects. The total amount of bonds or pending issues is less that five hundred billion naira (<N500 billion). There is no indication that these bonds will be marketable in OTC market, either.

Corporate Bonds and Debentures
In the private sector, corporate bonds and debentures are not often or have not been considered as an option by many companies in funding expansion and innovation. Recently, First Bank, Plc has received approval from the SEC to issue or has already issued about five hundred billion naira (N500 billion) worth of bonds dominated in naira currency. Other companies such as GT Bank, Plc, and Access Bank, Plc have issued foreign currency dominated bonds and convertible bonds respectively. The total amount of bonds issued in the private sector is less than one trillion naira (<N1.0 trillion). Considering the size of Nigeria’s economy, this is indeed small and is a reflection on the inability of companies to issue bonds, secured by their assets or debentures issued on the strength of their balance sheets, to mobilize critical funding outside of the banking system.
 

DEVELOPMENTS

In 2006, the DMO introduced a PDMM system to provide at least a two-way quotation or multiple quotations for government bonds in OTC market. This initiative was hailed as a significant development in providing liquidity in the bond market. Further enhancement of this PDMM system would have created opportunities for municipal bond underwritings and eventually, corporate bond underwritings for listing on the NSE. However, lack of repos to help primary market dealers to manage their liquidity and finance inventories became a major set back in trading bonds in the secondary market. Ideally, as envisioned by the DMO, the twenty one (21) registered members of the PDMM syndicate were/ are supposed to support the secondary market for bonds by placing bids as principals (take in the bonds for their inventory) or as brokers (buy and fill orders for clients at a commission/ mark-up) anytime a bond investor tenders bonds for sale. Without repos, an over night or short-term borrowing, to provide liquidity in the market, an active bond market is improbable.    

BOND MARKET LIQUIDITY

The OTC bond market can be as active and liquid as the equity market if the local investment community understands the critical role the market plays in the economy and more importantly, the stability that the investment product provides to a managed portfolio. However, there is a misunderstanding of the product and the market by many investors including big institutional portfolio managers, pension fund managers, endowment administrators, public accountant generals, corporate chief financial officers, and private wealth bankers. Unfortunately, even principals / agents of some PDMMs don’t fully understand the nature of these investment products.

The repo market is the life line of the Treasury securities trading. Repos play a central role in providing liquidity for the vibrant trading and financing of Treasury securities. Without repos, it’s hard for PDMMs to generate enough liquidity to own assets on their books and take advantage on new opportunities in the market place. Repos provide the liquidity for traders to take risk in trading assets from low yielding investments to high yielding opportunities. Lack of repos in the bond market has forced bond investors at the PDMM level to hold bonds in their portfolios, at times, longer than anticipated at the time of purchase in the primary market. Many PDMMs have reported holding FGN bonds in their portfolios for substantially longer periods than planned due to lack of marketability for certain bond series. Others have expressed frustration in holding bond inventories that ordinarily would have been traded for other opportunities in the capital market.

Bond Market Liquidity Constraints
The causes of tightened liquidity in Nigeria’s economy in the past three years have largely been self inflicted by misinformed CBN’s monetary policy and the banking industry’s greed to be dominant capital market operators and formidable commercial banks. The monetary policy rates in the past three years have frozen liquidity in the bond market and created a huge gap in the federal debt management program that even the strongest capitalized banks have been struggling to maintain reserve requirements and liquidity ratios with creative bookkeeping and questionable lending practices as the recent bank audits have demonstrated.

The banking industry’s greed had pushed many banks into bogus underwritings of initial public offerings (IPO) of securities of their own competitors as a way to create wealth for the principals and insiders of the organizations. The banks had liquidity for legitimate business investments that would have recorded the greatest economic expansion of all times in Nigeria, but they chose to extend huge loans to favored customers and clients for pre-IPO share purchases. Since the share purchases were not in companies involved in the real sector of the economy, the loans did not have much impact on the overall economy, except to generate more wealth for the people that were already wealthy.

From 2006 to 2008, the Central Bank focused narrowly on stabilizing the value of the naira relative to foreign currencies and holding down inflation. The inability of the CBN to manage short-term interest rates crowded out private capital in the massive economic expansion that the Nigerian economy had enjoyed in five consecutive years. The DMO’s excellent ground breaking initiatives to manage government’s deficit financing for capital projects, drained the much needed capital in the private sector through debt auctions at coupon rates that were not synchronized with the CBN’s monetary policy targets. The liquidity crunch in the capital markets was caused partly due to the CBN’s monetary policy rates and exchange rate regimes that favored the twelve biggest banks that were also the largest participants in Treasury securities auctions. Actually, it can be argued that the DMO’s ongoing deficit financing initiatives in an uncoordinated monetary policy regime by the CBN overexposed the expanding economy to external shock that led to a panic sell off in the stock market by insiders which led to a market meltdown.

The Price of Capital
The haphazard pricing of capital in the economy has confused and continue to baffle even the most sophisticated investors in Nigeria’s capital market. The idea that capital can best be invested in shares of financial institutions rather than in the real sector of the economy, made many analysts to wonder where the true foundation of the economy lies. Many banks extended margin loans and over leveraged their assets by diverting liquidity from long-term investments that would have been more meaningful for the real sector of the economy to artificially inflated stock prices. Investors in Nigeria’s capital market have not had real alternatives in asset allocation due to lack of investment products in the equity market on the one hand and sloppy CBN’s monetary policy rates for short-term money market rates and fixed income securities on the other hand. The CBN’s interest rate policy has rarely had any impact on the direction of capital movement. The wide discrepancies in interest rates ranging from the Treasury bills to Treasury notes/ bonds auctions, to monetary policy targets, to inter-bank lending offer rates, to prime rates, to consumer lending rates, etc… have made any rational expectations a luxury consideration for serious investors. Simply, economic forecast of leading indicators like inflation, employment, consumer sentiments, and investments are often hard to compute. As a result, investors and traders do not, very often consider allocation of assets based on trends in the economy. The exchange rates and crude oil prices, the only true measurable indicators win consideration at all times in asset allocation.

Just as repos are vital for a vibrant bond market, interest rate policy plays even a more important role in bond trading. Since there is an inverse relationship between bond prices and interest rates, and since bond yields move in opposite direction to prices, bond traders need some signals from the CBN about the direction of interest rates so that they can calculate the risk factors associated with making fixed income investments versus long-term wealth creation and/ or preservation investments.
 

BOND TRADING AND REPOS

One of the most important sources of mobilizing funds for development is by issuing bonds. Bonds are “I Owe You’s,” generally called IOUs (debt) that are issued by the Federal and Municipal governments, and corporations to mobilize funds to manage infrastructural development. Bonds are issued in tenors (maturities) of three, five, ten, and twenty years long. A bond is a debt instrument that must be paid back with interest at a future date by the issuer or borrower. When a borrower issues a bond, they must price it with a coupon rate based on the prevailing interest set by the CBN’s monetary policy rates. In the case of a municipal government, the rating of the municipality also factors in the interest rate pricing of the bond. The longer the tenor of the bond the higher price (interest) the lenders of money to the borrower expect to be paid and vice versa for the shorter maturities. The borrower pays the lender periodic interest, usually every six months, on the bond until the bond matures and at that time, the final interest and principal are paid back to the lender. In reality, no lender (bond investor) of money to the bond issuer (borrower) wants or expects to hold the bonds they have bought for the entire duration to maturity, regardless of how short the tenor is.

Therefore, bond trading becomes an important capital market. Since the bond market is very sensitive to interest rates (the main determinant for prices and yields on bonds) and other economic management factors such as inflation, unemployment, and economic growth the CBN’s policy plays a significant impact on the stability of the bond market. Just as margin trading is important in equity investing, repos are the life line of bond traders. Repos provide opportunities for PDMMs and smaller bond traders to manage liquidity and take risk in portfolio asset allocation.

Repos or Repurchase Agreements
Repurchase Agreements are contracts for the sale and future repurchase of a financial asset, especially Treasury and municipal securities that are used to collateralize the loan. For example, a bond trader can buy Treasury securities and simultaneously collateralized the securities in an overnight repo deal as he looks for someone to sell the securities to at a profit. These assets are bought and sold in hundreds of millions of naira per transaction. Most buyers of these assets do not intend to hold the assets for the entire life to maturity. Many investors buy these assets because they are the safest investments to pack cash at a decent return while waiting for spending budgetary allocations. Others investors choose these assets for tax purposes and as stable fixed income, especially at a time that inflation is not a threat to the erosion of purchasing power. Holding these assets in inventory for trading requires huge amounts of money for bond traders. Therefore, bond traders need repos with such institutions as the CBN, municipal governments, banks, insurance companies, large companies, government corporations, and wealthy individuals to be able to buy and sell bonds as supply and demand detects in the market place.

Overnight or term repos provide liquidity to bond traders to buy and sell hundreds of millions of naira worth of bonds from other dealers or sellers. In a repo deal, the bond trader specifies in the agreement the sale price, the repurchase price, the interest rate, and the termination date. If the agreement is valid for only twenty four hours, it becomes an overnight repo. If it rolls over to another day and several more days, it becomes a term repo, however. On the termination date, the bond trader repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds. 

Repos are short-term interest-bearing collateralized loans for usually high grade interest bearing paper, such as Treasury securities and municipal bonds. The liquidity of the bond market depends on the fluidity of repos. If regulated well, repos provide an opportunity for financial institutions including, banks, thrifts (savings & loans), microfinance, pension fund managers, and insurance companies, to invest their surplus funds in overnight lending just like the inter-bank lending offer rate that is restricted to only banks. Overnight repos provide yield enhancement opportunities to professional asset managers at almost no risk to clients’ assets. 

PROPOSED SOLUTION

The OTC’s Bond Market has challenges that can only be resolved by the CBN because it is the only institution that can provide liquidity and guarantee third party borrowing in financing trading of government securities. The pivotal role of the CBN in the operations of a vibrant bond market compels it to take the following actions to ensure the market exits

Create and support a repo market that allows only PDMMs to participate. Since repos play a vital role in bond trading, the CBN should manage and /or monitor daily repos on collateralized government securities. This initiative can elevate the level of confidence in the market and attract foreign investors such as hedge funds, mutual funds, and foreign governments. Collaborate with the DMO and SEC in the qualification and registration of PDMMs. The registration process must set a ceiling for each member’s transactions in the repo market based on capitalization. This process is important because it helps to establish the upper limit that a PDMM can leverage its assets in bond purchasing and trading. Once a dealer reaches the upper limit for the CBN’s margin rate based on capitalization, the systems monitoring mechanism will send out a red flag if a dealer attempts to effect a repo transaction that has overleveraged its ability to pay even with collateralized high grade assets. Collaborate with the NSE and SEC in the qualification and registration of licensed stockbrokers who are designated by their firms as principal bond traders in the repo market. These individuals must have sufficient training to merit supervisory roles in bond trading and must be willing to submit to the SEC’s periodic review of their licenses for any violation of securities laws and other criminal conduct. Guarantee, regulate, and monitor foreign investments in treasury securities to ensure that the CBN’s foreign exchange rate regimes are strictly adhered to in the massive trading of treasury securities to foreign entities. Guarantee, regulate, and monitor surplus funds invested in the repo market by non-financial institutions such as municipal governments, large corporations, high net-worth individuals, endowments, and the like in the repo market.

The repo market is the engine that powers the bond market and creates equilibrium in the supply and demand for trading government securities and other high grade debt of companies in the private sector. The CBN’s monetary policy determines the supply of funds in the repo market and the overall direction of cash movements in the capital markets. Therefore, a vibrant bond market is possible only with the CBN action.

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