NIGERIAN BOND MARKET STATISTICS

Transcription

1 January 2010 Fixed Income Nigeria Bond Rush NIGERIAN BOND MARKET STATISTICS Market Share (%): FGN: Sub-National: 4.76 Corporate: 0.48 Value Outstanding (N trillions): 2007: : (till Oct): 1.89 Value Traded (N trillions): 2007: : (till Oct): Market Cap (N trillions): 2008: : 2.30 Vetiva Equity Research Oluwakemi Owonubi Head, Research Division Gbadebo Bammeke Senior Analyst Adedoyin Adelakun Analyst Adesoji Solanke Analyst Uduakobong Equere Analyst Oluwaseun Oyegunle Analyst Vetiva Capital Management Limited Plot 266B Kofo Abayomi Street Victoria Island, Lagos Tel: Fax: A strong growth story: The Nigerian Bond market has witnessed significant growth and activity in the last three years, as the value of transactions has increased almost four fold since 2006, reaching a value of about N14.7 trillion as at October 2009 YTD. Over last 3 years, the FGN Bond Market has recorded a cumulative gain of 49%, compared to the stock market s loss of 38% over the same period. Despite the rally in bond prices, the bond market still represents less than half of the stock market, in capitalization terms. Dominated by FGN Bonds: It is also interesting to note that though the ratio of Nigeria s bond market to stock market capitalization remains higher than those obtainable in other emerging markets such as South Africa, India, Singapore and Russia, the market still remains a laggard, both in terms of market depth and product diversity, with FGN bonds comprising about 95% of the total domestic market as at November Effects of Liquidity Tightening: Difficulty in accessing funds from conventional sources in recent times has constrained State Governments and Corporates to exploring other financing means, thus resulting in a rush towards debt issuances via bonds. In 2009, at least four States (Lagos, Kwara, Imo and Niger) raised a total of N91.5 billion from the market, with more of such issuances scheduled for this year. For the corporates, the Banks have taken the lead, with GTBank, UBA, FirstBank, Access, Diamond Bank, amongst others, proposing bond offerings and seeking to raise up to N1.8 trillion over the next few years. GTBank recently concluded a N billion ($90 million) bond placement, Nigeria s first corporate issue in many years. We believe that the GTBank experience will serve as a defining measure of the market s appetite and disposition, yield preferences, as well as its capacity for corporate issuances. Domestic Capacity May Be Insufficient: Our estimate of demand for Corporate bonds, led mainly by PFAs, insurance companies and mutual funds, lies at about N500 billion, leaving a 75% shortfall relative to the c. N2 trillion pipeline of bond issuances anticipated over the next two to three years. However, we note that pension funds are forecast to grow at a 40% CAGR over the next 3-5 years. Plans To Issue International Debt...At What Price Benchmark? Nigeria is among many emerging economies that intend to access the international bond market this year, via the proposed issuance of a $500 million five-year Eurobond, as part of measures to fund a projected 4.8% GDP budget deficit. Judging by recent issuances in the international market by countries of similar rating, and following an assessment of the risks inherent in the Nigerian economy at present, we opine that the required yields for a successful international offering may be more expensive than those obtainable locally. However, a justification for the issuance of Nigerian government paper internationally, could be the need to create a reference rate for sovereign Nigerian debt that would serve as a benchmark for subsequent corporate or sub-national issuances on the international market. Inherent Risks In Risk Free : Though, as convention suggests, we consider Nigerian government bonds risk free in terms of default, we highlight that these securities are still subject to other risk classes which presently appear to have been overlooked by many market participants, especially given the recent heavy inflow of funds into the bond market, as well as the relatively low yields being offered and accepted, even as investors continue to seek safer investment alternatives. Some of these risks include inflation, interest rate, currency and liquidity risks. We believe that a keener evaluation of the fundamentals would show the need for and justify higher yields than presently obtain. Challenges lie ahead: While our outlook remains positive, a lot still has to be done with respect to price discovery, the use of repos to facilitate funding and liquidity, employing derivatives to manage portfolio exposure to risks, product innovation and diversity, robust trading platform and data availability amongst other issues. In addition, a major challenge remains the lack of a secondary market trading platform for most State and corporate bond issues. 1

2 Fig 1: FGN BOND MARKET vs. NSE ALSI (YTD) 100% 80% 75% FGN BOND In search of safety In the last eighteen months a slowdown in economic growth combined with liquidity constraints has put downward pressure on the prices of traditional asset classes in the Nigerian market such as stocks and real estate. However, in contrast, the bond market has remained buoyant, the FGN bond market returning 7% in 2008, significantly outperforming the equity market by over 53 percentage points; and while the equity market has continued to record losses in the current year, dropping 33% as at the end of November, bond prices have rallied with 22% in gains over the same period. NSE ALSI Fig 2: FGN BOND MARKET vs. NSE ALSI (2007-DATE) Rebased 31/12/06 =1 FGN BOND NSE ALSI 60% % 40% 20% 14% 7% 22% % % % -40% -60% *as at November end -46% * BID/COVER RATIO FGN BOND ISSUANCES Average Bid/Cover ratio Source: FDHL; Vetiva Research -33% Source: NSE, FDHL, Vetiva Research Rapid growth witnessed Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Fig 3: FGN BOND MARKET GROWTH Source: NSE, Access Bond Index, Vetiva Research Since the reopening of the FGN Bond market in 2003, the Debt Management Office (DMO) has offered FGN bonds worth N2.51 trillion which have attracted subscriptions of N4.55 trillion while N2.52 trillion had been allotted (average bid to cover of 1.81x). In 2009 alone, the DMO successfully raised N billion from the market - over 31% increase relative to N515 billion raised in 2008, and more than the combined amount of N billion raised between 2003 and Value of trades in the FGN bond market has increased almost four times the amount recorded in 2006, mainly influenced by the introduction of Primary Dealers/Market Makers (PDMM) in 2006, playing an active role in the issuance, sale and marketing of FGN Bonds. Between January and October 2009, turnover in the FGN bond market was N14.68 trillion (NSE - N0.57 trillion) up from N3.95 trillion in 2006 (NSE - N0.46 trillion). Amount in Naira Trillions Value Outstanding Market Cap Value Traded *as at October * 2 Source:FDHL, Vetiva Research

3 NEW ISSUANCES (Naira'Billions) YEAR FGN BOND EQUITY (NSE) N/A , ,894.1 Source: NSE, FDHL Bonds still behind equities Despite the phenomenal growth recently witnessed in bond market, the Nigerian bond market continues to lag the stock market in terms of size. As at the end of November 2009, the FGN bond market capitalisation stood at N2.3 trillion, which represents only about 46% of the stock market s capitalisation of N5.0 trillion 1. As a result of a persistent drop in the prices of equities, surge in bond prices and new issuances of bonds, the ratio of bond market to equity market capitalisation has been on the rise especially in the last eighteen months, up to 46% from 11% in March 2008 at the peak of the stock market. Fig 4: NIGERIAN BOND + EQUITY MARKET (CAPITALISATION) Equity Bonds 89% 90% 89% 88% 83% 74% 77% 72% 68% 11% 10% 11% 12% 17% 26% 23% 28% 32% Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09Nov-09 Source: FDHL, NSE, Vetiva Research The situation in Nigeria and other developing countries is in direct contrast to the global norm, as the world bond market exceeds the world stock market in size by a factor of 2 to 1. As at June 2009, the value of global stocks stood at $44.2 trillion compared to global bond market value of $88.9 trillion. This has been largely influenced by the size of bond markets in developed countries like the US, UK, Japan and in the Euro zone. Like Nigeria, many developing countries generally have a larger equity market, relative to their bond markets. Though there is no clear indicator of the extent to which economic development affects the size of bond markets relative to equity markets, there is an arguable case that significant development of the financial system and capital markets is largely evidenced by similar developments in the bond market in terms of capacity and innovation. 1 Nigerian Equity Market Capitalisation is down from peak levels of about N12 trillion as at March

4 Table 1: Values of the World Stock and Bond Markets, 2009 (USD' Billions) Market Stocks % of World Bond % of World U.S. 14, % 31, % Euro area 6, % 23, % China (incl Hong Kong, excl Taiwan) 4, % 2, % Japan 3, % 10, % UK 2, % 4, % Canada 1, % 1, % Australia 1, % 1, % India 1, % % Brazil 1, % 1, % Switzerland 1, % % Nordic area 1, % 1, % South Korea % % South Africa % % Taiwan % % Singapore % % Russia % % Mexico % % Malaysia % % Other 1, % 2, % Total 44, % 82, % Source: The Asset Allocation Advisor Nov 2009; Bank for International Settlements Stock Market Cap as at 30 Sep 2009; Bond market Data as at 31 Mar 2009 Fig 5: BREAKDOWN OF GLOBAL BOND + EQUITY MARKETS (CAPITALISATION) Equity Bond 31% 22% 25% 39% 35% 51% 53% 54% 47% 44% 54% 68% 71% 75% 73% 68% 85% 98% 69% 78% 75% 61% 49% 47% 46% 53% 32% 29% 15% 2% 65% 56% 46% 25% 27% 32% U.S. Euro area China Japan UK Canada Australia India Brazil South Korea South Africa Taiwan Singapore Russia Mexico Malaysia Nigeria Global Market dominated by Federal Government Bonds Source: The Asset Allocation Advisor Nov 2009, Vetiva Research While the ratio of the size of the Nigerian bond market compared to the equity market suggests an increasingly robust market, the skewness of the outstanding issuances towards government issued paper, highlights the underdevelopment of other segments of the market. As at November 2009, FGN bonds comprised 95% of the total domestic Nigerian bond market; prior to 2009 the market for sub-national bonds, agency bonds and corporate bonds had been almost dormant, partly due to the ease of raising money from the equity market and banks, high implied cost of borrowing via bonds, multiple taxes and regulatory bottlenecks. 4

5 The high level of government debt in relation to total domestic debt has been also observed in other developing markets such as Indonesia (94.3%), Singapore (94.5%) and Thailand (90.3%). Though domestic government debt predominance is in itself not a bad phenomenon or exclusive to less developed markets, in Nigeria the effect has been lack of development of other segments of the market and limited awareness and knowledge among the broad spectrum of investors. Fig 6: NIGERIA vs EMER. EAST ASIA (DOMESTIC DEBT BREAKDOWN) 0.5% 15% 9% 54% 44% 11% 40% Corporate 21% Government 4% 28% 99.5% 85% 91% 46% 56% 89% 60% 79% 96% 72% Nigeria China people's Rep. Indonesia Korea Malaysia Philippines Singapore Thailand Viet Nam Total Emerging East Asia Fig 7: PROPOSED BOND ISSUANCES N Billions First Bank UBA Zenith Bank GTBank Diamond Bank FCMB Access Bank Source: Company Financials, EGM Notices, Vetiva Research *Sub National bonds are included among Government bonds for Nigeria. Bond Rush Source: Asian Bond Monitor Sep 2009, Vetiva Research Difficulty in accessing funds from conventional sources has constrained State Governments and Corporates to exploring other financing means, thus resulting in a rush towards debt issuances via bonds in recent times. In 2009, alone we have seen at least four states including Lagos, Kwara, Imo and Niger raise a total of N91.5 billion from the market with many other issuances scheduled to happen this year. On the corporate side, the Banks have taken the lead with GTBank, UBA, FirstBank, Access, Diamond Bank amongst others proposing bond offerings, seeking to raise up to N1.8 trillion over the next few years. For the non-financials, the National Aviation Holding Company (NAHCO) has hinted at N5 billion bond offering, while Oando also has a N200 billion bond/equity programme scheduled. Table 2: STATE GOVERNMENT BONDS ISSUED (2009) Nomenclature Issue Date Tenor (yrs) Coupon (%) Amt (N'Billions) Lagos State Fixed Rate Bond, 13.00% February 9, 2014 [Series 1] 9-Feb Imo State Fixed Rate Redeemable Callable Bond,15.50% June 30, 2016 [Series 1] 30-Jun Kwara State Fixed Rate Redeemable Callable Bond,14.00% August 5, 2014 [Series 1] 5-Aug Niger State Fixed Rate Redeemable Callable Bond,14.00% October 7, 2014 [Series 1] 7-Oct Total

6 How deep is the market for Corporate bonds? While the bond market appears set for major inflows from a strong pipeline of more issuances by sub-nationals and corporates, our key concern remains the lack of capacity of the market to absorb the circa N2 trillion in ex-fgn bonds, expected to come through in the next 2 3 years, where current plans are to serve as indicators. We look at the current profile of investors in the FGN bond market and use this as a base to assess/estimate the sources and size of funding potentially available to fund the sub-national and corporate bonds. Fig 8: FGN BOND INVESTOR PROFILE 23% April % April % 6% 8% Banks & Discount Houses Pension Funds 1% 15% 60% 25% 61% Government Agencies Foreign Investors Others 6 Source: FDHL, Vetiva Research Currently, Banks & Discount Houses dominate the FGN market demand space, comprising 61% of the market as at April 2009, this due partly to their functions as primary dealers and markets makers. On the other hand, pension funds and government institutions have increased their presence in the market relative to 2008, together accounting for 33% of the market as at April 2009, even as the composition of foreign investors has declined to under 6% as at April 2009 from 23% in April From the current universe of investors in FGN bonds, we believe that except for cases of underwriting commitments, Banks are unlikely to be major players on the demand side for the corporate bond market in the near future. Near term, we believe the focus of banks will be on returning back to profitability while managing risks, rather than being exposed to counter party risks without any form of guaranty. Thus, we believe pension funds, insurance companies and mutual funds will be the dominant investors in the corporate bond market. Pension funds are estimated to have N1.3 trillion (Nov 2009) worth of Assets Under Management (AUM) while the 30% maximum permissible pension fund investment in corporate bonds by the National Pension Commission (PENCOM) results in an estimated total pool of N390 billion available to corporate bonds. Estimating AUM for insurance companies at N300 billion, an optimistic 20% allocation in corporate bonds results in N60 billion while Mutual Funds and proprietary accounts of brokerage houses, given the hit on their portfolios as a result of the downturn in the equities market, are expected to be less upbeat as regards corporate bonds (we estimate about N30 billion in total).

7 In all, our estimates shows that the local market, ex Banks, barely has the capacity to absorb up to N500 billion or 25% of the proposed supply within the next two to three years. Fig 9: EVALUATION OF DOMESTIC MARKET CAPACITY FOR CORPORATE BONDS Estimates in Naira Billions Our demand estimates have not considered expected growth in the size of funds. We expect Pension funds to grow by c. 40% over the next 3 years, with corporate bond allocation increasing to N1 trillion, which could reduce the estimated demand gap to around N0.9 trillion. Estimated demand gap 1,520 2, Bond Pipeline PFA Capacity Insurance Firms' Capacity Mutual Funds' Capacity Demand shortfall Source: Vetiva Estimates That said, foreign investors will thus appear to be prime targets for many issuers. However political risks, exchange rate risks, liquidity risks and default risks are likely to be deterrents to these investors especially with the recent downgrade of the ratings of many Nigerian banks by international rating agencies. Consequently if the equity market remains dull, we see a potential demand shortfall which we believe can have both positive and negative consequences on the Nigerian fixed income market. On the positive side, we expect the demand gap will lead to the development of the market and spur innovation in the market with the introduction of securities such as zero-coupon bonds, step-up notes and floating rate securities that will attract investors by catering to the needs of different market parties, and clients with varying risk/liquidity profiles and return expectations. Transparency should also increase, as investors are expected to be highly selective of the securities in which they place funds, based on the strength of the institution s investment case and its lack of ambiguity. In addition, in order to eliminate the foreign exchange risk concerns of foreign investors, some local issuers might explore the option of foreign denominated bonds, which we believe will give Nigerian corporates international exposure and increase confidence in the local market. On the negative side, scarcity of demand might push some corporates to issue bonds at coupons which will be unattractive for asset/liability management purposes, in a bid to raise some much needed capital. This, we believe, will consequently increase default risks with accompanying increase in credit spreads. 7

8 A Realistic Cost of Issuance for Corporate Debt As we mentioned earlier, the Nigerian Corporate debt market has prior to now been largely non-existent. The regulatory and cost bottlenecks from the issuance perspective, non-availability of adequate benchmarks for pricing and the lack of demand by investors, all contributed to the dormant status of corporate bonds. Lately however, with the rapid growth and development of the FGN market, successful bond issues by state government, concessions on the regulatory side, as well as investor aversion towards the equity market in recent times, seems to have fuelled an increased appetite for the corporate debt market. An arising concern is however the ascertainment of a realistic pricing for these securities, which will benefit the issuer in terms of reasonable costs over the horizon as well as satisfy the risk/return balance required by investors. With the Banks set to be the main issuers of corporate bonds, at least in the near term, we expect that their key focus will be not only to secure long term funds but also ensure the funds are raised at costs comparable with their current liabilities cost base, placing them in good position with respect to their Asset/liability management activities. We note that as at November 2009, according to a CBN circular, the average cost of deposits for eight banks which have indicated plans to issue bonds (First bank, UBA, Zenith, GTB, Access, Diamond, Skye and FCMB) was 10.79%. With tax-exempt 5-yr tenured sub-national bonds backed by strong internally generated revenue flows and irredeemable standing payment orders (ISPO) recently issued at between 13% and 14% (coupons on recently issued state bonds: Lagos - 13%, Niger-14%, Kwara-14%), it will be difficult to defend lower issuance yields for banks in light of the relative and apparent risks, except by possibly making a case for diversification. Fig 10: RISK AND PRICING MISMATCH 20% 18% 16% 14% 12% GTB seems to able to raise money for its bond cheaper than a State government with an ISPO structure and tax waiver. We think this is an anomaly. 12.7% GTB Bond 13.0% Kwara State Bond: 14.0% 14.0% 13.5% Imo State Bond: 15.5% 15.5% 16.3% 18.4% 10% 8% 6% 7.0% 7.4% 8.3% 8.6% 7.9% 8.5% 4% 2% FGN Bond Benchmark Yield Curve* State Bonds Proposed GTB Corporate Bond 2-Year 3-Year 5-Year 7-Year 10-Year 20-Year Source: Vetiva Research 8

9 The GTBank Experience - Testing the Nigerian Corporate Bond Market Guaranty Trust Bank recently concluded the first tranche of a two-year N200 billion debt issuance programme, raising N billion ($90 million) through 5-year tenured bonds issued at par with 13.5 percent annual coupon. Considering the long dearth of corporate bond issuances in the Nigeria market prior to this, we believe the GTBank issuance means success in some respects for the corporate bond market but more importantly it lends some clarity to the state of the market, mindset of participants and the future of other corporate issues. Key takeaways include the following: Market appetite might be overestimated. We believe the relatively low level of subscription, N billion, out of an initially proposed aggregate principal amount of up to N100 billion, (representing 6.58% of GTBank s total planned N200 billion 2-yr bond programme) in the first tranche, already gives indications that except market conditions change or more attractive issue terms are offered, the bank may not successfully raise the needed capital within the time frame of its 2-yr programme. In the same vein, we believe that other ambitious programmes as have been announced by other corporates (some of which are up to N500 billion bond) might be overestimating the market s appetite and are likely to suffer shortfalls within the planned time ranges, where issue terms do not adequately factor in market s expectations. The market expects to be paid higher yields for the taking on the risks of a Corporate Bond. Given the strong GT Bank brand and management, the Bank s comparatively excellent performance in the turbulent 2009 financial season, its strong rating ( Aa - Agusto), as well as the first mover advantage it enjoyed with the launching its bond programme well ahead of its peers, the level of subscription achieved suggests that it will be relatively more difficult for any other Bank or Corporate to secure cheaper funding for similar bond structures (5-yr senior, unsecured, non-convertible) in present market conditions. Thus the anomaly of corporates issuing unsecured bonds at coupons lower than ISPO guaranteed state governments is not expected to subsist. Other considerations are factored in for corporate bonds: Apart from the implied yields and credit spread considerations, demand for corporate bonds might be affected by the present lack of liquidity and difficulty in secondary trading; thus institutions with strong liquidity needs will have little incentive to invest. Also, corporate bonds are presently taxable unlike Federal and state government bonds - a factor which may be a discouraging to non-tax exempt investors. Table 3: RECENT DEVELOPMENTS TO PROMOTE CORPORATE BOND MARKET Minimum rating for Corporate Bonds that Pension Funds can invest in, reduced from "AAA" to "A". Per-issue/ issuer limit for pension funds increased from 2.5 per cent to 5 per cent. Maximum % of Pension assets that can be invested in Corporate Bonds now set at 30 per cent. Plans by the Federal Government to grant 10 years tax holiday to investors in Corporate Bonds. SEC has finalized arrangements with the IFC for a resident Adviser on Bond Issues. Book building issuance system introduced. 9 Source: Vetiva Research

10 The FGN debt Market - From external to domestic; short to long term As at 2004, Nigeria s public debt outstanding was $46.26 billion, comprising 77.7% external debt and 22.3% domestic debt. However with the country s exit from the Paris Club and London Club debts in 2006 and early 2007 respectively, combined with a continued access of the domestic debt market by the government, the tables have turned, with external debt comprising 17.4% of total debt relative to domestic s debt s 82.6% as at the end of Fig 11: NIGERIA s DOMESTIC DEBT BY MATURITY 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 36% 64% 44% 56% 60% 40% Short term 74% 26% Long Term 80% 20% Source:DMO; Vetiva Research Table 4: PUBLIC DEBT OUTSTANDING (US $ MILLION) TYPE External 35,945 20,478 3,544 3,654 3,720 Domestic 10,315 11,829 13,805 18,576 17,679 Total 46,259 32,307 17,350 22,230 21,399 Source: DMO, Vetiva Research From a position of mostly short term liabilities in 2003 held predominantly by the Central Bank of Nigeria (CBN), the Nigerian government has been able to restructure its domestic debt portfolio to consist 79.67% long term securities. This has come on the back of increasing issuance of FGN bonds of long tenors, notably the 20-year bond first issued in November In 2009, 20-yr bonds constituted 33% of the total long term bonds issued by the debt management office (DMO) and about N230 billion has been raised by the issuance of 20- year paper in the space of one year since its introduction. Fig 12: DOMESTIC DEBT BY MATURITY JUNE 2009 Short Term Long term 37% 51% 66% 62% 63% 73% 77% 74% 73% 73% 80% 86% 85% 63% 56% 61% 69% 78% 83% 89% 96% 63% 49% 34% 38% 37% 27% 23% 26% 27% 27% 20% 14% 15% 37% 44% 39% 31% 22% 18% 11% 4% All Countries United State Euro area France Germany Italy Spain canada Japan United Kingdom Emerging Markets Nigeria Brazil China czech Republic India Malaysia Mexico South Africa South Korea Turkey Source: Bank for international settlements ; Vetiva Research 10

11 Table 6: Proposed Emerging Market Issues (2010) Country Size Rating (S&P) Czech Republic $16.3 billion A Russia $8-10 billion BBB Turkey N/A BB- Indonesia N/A BB- Kazakstan $500 million BB- Phillippines $2 billion BB- Vietnam $1 billion BB Belarus N/A B+ Hungary $1.5 billion BBB- Latvia N/A BB Lithuania N/A BBB Poland N/A A- Romania $2.2 billion BB+ Slovania N/A AA Angola $4 billion unrated Colombia $504 Million BBB- Mexico N/A BBB+ Venezuela $5 billion BB- Source: Bloomberg Nigeria s debt profile As a percentage of GDP, Nigeria s total public debt stood at 11.48% (13.40% according to CIA estimates) as at the end of 2008 and was 110 th out of 126 countries profiled by the Central Intelligence Agency (CIA). Compared to other emerging markets and the Debt relief International threshold of 45%, Nigeria s overall debt profile also seems very comfortable. Nigeria s domestic bond market as a percentage of GDP 2 stands at an estimated 9.5%, remaining one of the lowest in the world. Compared to emerging East Asian countries, Indonesia (19.3%), Malaysia (81.3%), Philippines (36.5%), Singapore (74.1%) and Thailand (60.6%) which have comparable GDP with Nigeria, Nigeria s bond market still has a lot of catching up to do. For Nigeria s bond market to grow to the level of East Asia s by 2014 (domestic bond market as a percentage of GDP at 58.2)%; assuming GDP grows 6% a year, Nigeria s domestic bond market will have to grow at a CAGR of 52.4% for the next five years. We note that Nigeria s FGN bond market grew 66% in market cap between November 2008 and 2009 and the expected proliferation of state bonds and corporate bond issues is expected to further boost growth in the next few years. Table 5: Domestic Debt as % of GDP- Nigeria vs. Emerging East Asia (June 09). Nigeria China Indonesia Korea, Rep. of Malaysia Total Government Corporate Philippines Singapore Thailand VietNam Total Emer. East Asia Total Government Corporate Source: Asian Bond Monitor; DMO; Vetiva Research Fig 7: EMERGING MARKET BOND YIELDS (DEC '09) Country 5-yr Yield % 10-yr Yield% COLOMBIA N/A PANAMA 4.06 N/A HUNGARY POLAND SLOVAKIA TURKEY N/A S AFRICA ISRAEL 3.89 N/A CHINA HONG KONG INDIA MALAYSIA PAKISTAN PHILIPPINE SINGAPORE INDONESIA N/A PERU N/A VENEZUELA N/A CZECH N/A ` THAILAND Source: Bloomberg Plans to issue international debt Nigeria s budget deficit is projected to hit N1.56 trillion ($10.4 billion) in 2010 or 4.8 percent of gross domestic product and the Nigerian government has indicated plans to issue a $500 million (N75 billion) Eurobond as part of the means to finance the deficit. The international market for bonds is going to be competitive this year as other emerging market economies also have plans to take advantage of the expected economic recovery this year. Emerging market countries which have indicated interest in issuing international bonds this year include Turkey, Indonesia, Kazakhstan, the Philippines, Romania and Brazil amongst others. The Debt Management Office (DMO) has given indications that it will raise up to N700 billion ($4.7 billion) for the government in the domestic market this year. The planned issue is almost 10 times the planned foreign bond offering, highlighting the fact that the foreign offering will represent a relatively minor source of capital raising this year. Secondly, going by yields on recent bond offerings, it may be more expensive for the Nigerian government to issue a foreign bond, while government paper of equivalent tenures can be issued at relatively cheaper rates in the domestic bond market. At the most recent November 2009 FGN auction, issuances of 3, 10 and 20-year bonds respectively were oversubscribed at marginal yields of 6.75 per cent, 8.32 per cent and 8.50 per cent. Going by Sri lanka s (B+ Fitch rating vs BB- for Nigeria) five year international offering which was recently concluded at 7.75% yield in October 2009, including issuance costs, there is the likelihood of similar costs if the Nigerian Government chooses to issue debt internationally. 2 Market capitalization of bond market and 2008 annual GDP was used for the calculation of bonds outstanding as a percentage of GDP. 11

12 However despite our cost concerns, we opine that there could be other justifications for the issuance of Nigerian government paper internationally. One of them is the need to create a reference rate for sovereign Nigerian debt that would serve as a benchmark for subsequent planned issuances in the international markets by Nigerian companies and sub-nationals, one which is currently non-existent. This benchmark rate will help local companies better price these bonds. Inherent risks in risk free Evaluating the fundamentals of FGN bonds Government securities are always considered to be risk free and the safest form of investments. Risk referred to in this case is primarily credit or default risk (risk of the issuer failing to meet its payment obligations). However government securities as with other fixed income securities are exposed to a series of other market risks including inflation risks, interest rates risks, volatility, currency risks and liquidity risks. Below we examine these risks as they relate to the Nigerian bond market context Inflation Risks: Firstly, inflation has historically been (and still is) a major concern in Nigeria. Based on November 2009 figures, inflation stands at percent, remaining in double-digit range. Based on recent auctions, the marginal yields on issue 10 and 20 year government bonds have consistently come in below the inflation rate(by more than 300 basis points in the case of the last issued 20 year bonds, which cleared at a yield of 8.5%). Where inflation remains above bond yields, investors stand the risk of loss in real value, if the investments are held to maturity and coupons received cannot be reinvested at higher rates. By buying at such low yields, relative to inflation, investors are implicitly betting on a reduction in inflation, one which we think has a low probability of occurrence, at least in the near to medium term, given deregulation plans, recent increases in oil prices, proposed increased government spending and spending associated with the upcoming elections in Fig 13: INFLATION vs. FGN 10-YR BOND YIELDS 16% 14% Inflation 10 yr Bond Yield 12% 10% 8% 6% 4% 2% 0% Nov-09 Oct-09 Sep-09 Aug-09 Jul-09 Jun-09 May-09 Apr-09 Mar-09 Feb-09 Jan-09 Dec-08 Nov Source: FDHL; Bureau of Statistics; Vetiva Research Interest Rate Risks: Until recently interest rates in market had been on a rapid rise with the overnight Nibor (O/N) reaching as high as 29% in March Though there has also been a steep drop since the injection of N620 billion by the CBN to bailout stressed banks, rates have remained volatile on the back of the release and withdrawal of FAAC allocations for the three tiers of government. Also there are chances that rates might not be sustainable at current low levels when lending to the private sector is revived.

13 For the fixed income market to grow there needs to be reduced volatility in interest rates movements, as well as greater clarity on the monetary policy direction for the rates. Furthermore, rates need to be maintained at moderate and stable levels, given that a resurge in rates could cause a significant crash in prices of bonds. Fig 14: INTEREST RATES (OVERNIGHT NIBOR) 30% 25% 20% 15% 10% 5% 0% Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Source: FDHL; Vetiva Research Volatility Risks: Traditionally, one of the reasons local pension funds and fund managers have been lured to the bond market has been due of apparent lower volatility relative to other asset classes like equities and real estate. However, volatility in the market has increased in recent times; using the three year FGN bond as proxy, volatility increased to 26.55x in 2009 from 18.43x as at 2007, while a similar phenomena has been observed across all bond tenors. Unlike conventional finance theory which suggests that increased risks be accompanied with returns, the current low level of yields do not point that high returns will be sustained in the market despite the accompanying volatility. Table 8: FGN BOND YIELD VOLATILITY 2Y 3Y 5Y 7Y 10Y 20Y Oct Dec Dec Source: FDHL Exchange Rate Risks: From November 2008 till date, the Naira has witnessed instability, depreciating from $118/USD to over $165/USD before coming down to its present level of $150/USD. The implication is that even though bonds have rallied by over 22% in 2009, a dollar-based investor would have experienced a marginal appreciation at best due to the over 21% fall in the Naira. We believe this is one of the factors which have led to a decline in foreign activity in both the equity and bond markets. As long as the exchange rate remains volatile, there is a limit to the level of depth that can be witnessed in the market. 13

14 Fig 15: USD/NGN OFFICIAL EXCHANGE RATE MOVEMENT Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Source: CBN; Vetiva Research Though the market has continued to improve in overall liquidity, the low volume outstanding of some bond issues has resulted in illiquidity in such bonds issues, leaving room for price manipulation and also high costs of execution and rebalancing for players in the market. The effect has been a reduction in market efficiency. For the 15.00% 28/11/2028 FGN BOND shown below, one of the reasons for the abnormal price surge (over +60% in one year) has been the relative illiquidity of the issue as the bond has only N50 billion outstanding. Illiquidity could also pose intense downward pressure on prices in the case of a panic sell-off. Fig 16: PRICE MOVEMENT OF 15.00% 28/11/2028 FGN BOND Yield% 14% 13% 12% 11% Yield Price (Naira) 200 Price % 9% 8% 7% 6% Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec Source: CBN; Vetiva Research 14

15 The Challenges, the Future and implication for the markets As noted above the market has grown significantly especially in the last two years; however it is not without its challenges as there is still a lot to be done with respect to price discovery, the use of repos to facilitate funding and liquidity, employing derivatives in order to manage portfolio exposure to risks, product innovation and diversity, a robust trading platform & secondary market activity and data availability amongst other issues. While the regulators have also have a key part to play we believe the evolution of the market will be largely driven by market participants as witnessed in other developed markets. Further to this, ICAP Plc the world's largest inter-dealer broker has applied to provide a secondary bond trading platform in Nigeria. Key to watch this year will be the direction of inflation and interest rates and how yields will react to these indicators. After a strong rally in prices and decline in yields in 2009, a key concern is whether the current low yields are sustainable especially in the face of inflation which we expect to remain high. We believe that as the market becomes less risk averse, bond prices will come under pressure as market players will pay more attention to fundamentals and money will gravitate towards relatively underpriced asset classes. Adopting the Fed model which postulates that the bond market is overvalued if the yield on the 10-year bond is less than earnings yield of the stock market, the FGN bond market seems overvalued as yield on the on-the run 10-yr FGN bond stands at 8% compared to our forward earnings yield of 13% for listed equities. Where the Asset Management Company is successfully created, as is being proposed by the CBN, we believe there will be a positive impact on the stock market and stock prices. Thus, there are chances that corporates who have previously indicated bond issuance programmes will choose to exploit the equity route due to demand shortfalls in the bond market, as well as the expected hike in yields. If rates do rise as expected, we believe the best bonds to hold will be the intermediate tenured bonds (3/5 year bonds) due the larger duration (sensitivity to change in interest rates) of the longer maturity bond. In conclusion, though there might be some near term volatility we have an optimistic outlook for the bond market and expect the market to continue to develop rapidly with growth in market size expected to average 45% over the next three years. 15

16 INVESTMENT RECOMMENDATIONS Vetiva uses a 5-tier recommendation system for stocks under coverage: Buy, Accumulate, Neutral, Reduce and Sell. Buy/Overweight +20% expected absolute price performance Accumulate +10% to +20% expected absolute price performance Neutral/Hold +/-10% range expected absolute price performance Reduce -10% to -20% expected absolute price performance Sell/Underweight -20% expected absolute price performance Definition of Ratings Buy/Overweight recommendation refers to stocks that are highly undervalued but with strong fundamentals and where potential return in excess of or equal to 20% is expected to be realized between the current price and analysts target price. Accumulate recommendation refers to stocks that are undervalued but with good fundamentals and where potential return of between 10% and 20% is expected to be realized between the current price and analysts target price. Neutral/Hold recommendation refers to stocks that are correctly valued with little upside or downside where potential return of between +/- 10% is expected to be realized between current price and analysts target price. Reduce recommendation refers to stocks that are overvalued but with good or weakening fundamentals and where potential return of between -10% and -20% is expected to be realized between current price and analysts target price. Sell/Underweight recommendation refers to stocks that are highly overvalued but with weak fundamentals and where potential return in excess of or equal to -20% is expected to be realized between current price and analysts target price. 16

17 DISCLOSURES SECTION Analyst Certification All of the views expressed in this report articulate the research analyst(s) opinions/views regarding the companies, securities, industries or markets discussed in this report. The analyst(s) compensation or remuneration is in no way connected (either directly or indirectly) to the specific recommendations, estimates or opinions expressed in this report. Other Disclosures A reference to a particular investment or security in this report should not be deemed an investment proposition nor should it be interpreted as a recommendation to buy, sell or hold such an instrument. It is noteworthy to mention that Vetiva Capital Management Limited does and seeks to do business with companies covered in its research reports. Consequently, a conflict of interest may arise that could affect the objectivity of this report. Disclaimer Whilst reasonable care has been taken in preparing this document to ensure the accuracy of facts stated herein and that the ratings, forecasts, estimates and opinions also contained herein are objective, reasonable and fair, no responsibility or liability is accepted either by Vetiva Capital Management Limited or any of its employees for any error of fact or opinion expressed herein. No reliance should be placed on the accuracy, fairness or completeness of the information contained in this report as it has not been verified by the research analyst(s) involved or the companies whose securities have been referred to except as otherwise disclosed. Any ratings, forecasts, estimates and opinions set forth in this document constitute the analyst(s) position as at the date of the report and may not necessarily be so after the report date as they are subject to change without notice. It is also instructive to note that a Company s past performance is not necessarily indicative of its future performance as estimates are based on assumptions that may or may not be realized. The value, price or income from investments mentioned in this report may fall as well as rise due to economic conditions, industry cycles, market indices, operational or financial conditions of companies or other factors. Thus, Vetiva Capital Management Limited and its employees shall not accept liability for any loss arising from the use of this document or its contents in making investment decisions or recommendations. All investors are solely responsible for their investment decisions. Any investments discussed may not be suitable for all investors and the reader(s) should independently determine their suitability and evaluate the investment risks associated with such investments. Vetiva Capital Management Limited is a Dealing Member of the Nigerian Stock Exchange and is registered with the Securities & Exchange Commission to conduct Financial Advisory, Fund/Portfolio Management, Brokerage & Dealing and Trusteeship business in Nigeria. This document is for information purposes only and for private circulation. No portion of this document may be reprinted, sold or redistributed without the written consent of Vetiva Capital Management Limited. Vetiva Research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request Vetiva Capital Management Limited. All rights reserved. 17