Fixed income investors, from retail to institutional buyers like the banks and pension funds, can look forward to a rewarding year in 2019.
After a record breaking 2017 for government bond yields which peaked at 18 percent, 2018 saw yields fall to 14 percent on average amid lower inflation rate and reduced bond supply from the federal government which tweaked its debt strategy to borrow less domestically in favour of external debt.
However, there are signs of a higher yield environment in 2019 and those signs started flashing as early as late 2018.
Rising global interest rates which sparked sell-offs in emerging markets and political uncertainty that coloured the second half of the year, saw the Central Bank of Nigeria push yields higher in the fourth quarter of 2018 using Open Market Operations (OMO) auctions, to attract foreign portfolio investors and tame inflation ahead of the system liquidity that accompanies campaign spending in an election year.
The OMO auctions laid down a marker for fixed income yields, with one-year government Treasury Bills rising as high as 17 percent while average bond yields rose nearly 200 basis points to 15 percent.
Enter 2019 and there are atleast three key reasons why fixed income yields will sustain the upward momentum that started late last year.
First is the expectation for higher inflation this year. Consensus forecasts point to an uptick in inflation to 12.8 percent from 12.2 percent average in 2018. The factors that will drive inflation higher in 2019 include the implementation of a minimum wage hike; expectations for pre-election spending, which will trigger increased system liquidity, and a likely increase in food prices as the lasting effects of flooding and violence in the middle belt take a toll on prices.
Yields typically need to stay above inflation if investors must make real returns. Therefore, the higher inflation rate goes the higher fixed income yields climb and vice versa.
The second reason why bond investors can expect higher yields this year rides on the back of increased CBN monetary tightening. The price stability mandate of the CBN means if inflation rises, interest rates are likely to be raised. The apex bank relied heavily on raising interest rates in the latter part of 2016 when inflation soared to a high of 18 percent. The CBN hiked benchmark rates to 14 percent from 11 percent over that period and that’s where it has stayed for nearly two years now.
The outlook for higher interest rates in the United States and sustained foreign capital outflow this year will only pile more pressure to the CBN to tighten even further.
The consensus forecast for interest rates in 2019 is a 50-basis hike to 14.5 percent. The Monetary Policy Committee is scheduled to hold their first meeting of 2019 this January.
The last reason why yields look set to jump in 2019 is the Federal government’s widening budget financing gap which would only boost local bond supply and bid yields higher.
The Federal government’s 2019 budget has a N2.3 trillion deficit and is predicated on revenues of N7 trillion.
Both scenarios are threatened by disappointing revenues which naturally feeds into a wider deficit that will leave the government with limited options than to borrow.
Capital expenditure bore the brunt of disappointing revenues in the past two years but 2019 will give the government less wriggle room given the spike in recurrent expenditure which cannot be easily made away with like capital spending.
Non-debt recurrent expenditure alone will hit N4 trillion this year. If government revenue is to perform as it did in 2017 or 2018 where only 50 percent of the target was met, then worker salaries, overhead costs and statutory transfers will be higher than total revenue, before considering capital expenditure and debt servicing.
The total non-debt recurrent expenditure will equate to 128 percent of the government’s projected N3.5 trillion revenue for the year. N3.5 trillion is half of the N7 trillion 2019 revenue projection.
What that implies is that the government would have to borrow just to maintain an over bloated bureaucracy. Add capital expenditure as well as debt servicing obligations and there could be a fiscal crisis on the cards for the government in 2019.
The fear of a fiscal crisis is why the government will be keeping a keen eye on oil prices which has recently slumped to $55 per barrel, $5 higher than the budget predication of $60 per barrel. Although most oil price forecasts, as off the mark as they have been over the years, point to an average of $70 per barrel, if prices remain sticky at $55 then there is a fair chance of the government missing the oil revenue target.
The oil production benchmark gives even more cause for worry.
The budget benchmark is N2.3 trillion, but an OPEC-induced cut threatens to restrict production to 1.6 million barrels daily, 30 percent lower than the target. This implies that the expected revenue from oil could be 30 percent lower only from a production perspective. Non-oil revenue will rely largely on company profitability at a time when economic growth has stalled and average incomes are shrinking.
When revenues failed to meet up to expectations, the government turned to borrowing, with the debt stock more than doubling since 2014 to N24 trillion as of the end of 2018, according to the Debt Management Office (DMO).
Rising debt service cost as a percentage of revenue which hit a record high of 60 percent last year didn’t deter the government last year, with bond investors emerging big beneficiaries of attractive yields on money lent to the government.