The Mechanics of a Bond Market in Nigeria

Solutions to Liquidity Constraints in Over-the-Counter Bond Trading

By: *Tavershima Adyorough, M.B.A.; M.A
PURPOSE

Nigerias 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 Nigerias 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 Nigerias 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 dont 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, its 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 Nigerias

economy in the past three years have largely been self inflicted by misinformed
CBNs monetary policy and the banking industrys 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 industrys 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 DMOs excellent ground breaking initiatives to manage
governments 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 CBNs monetary policy targets. The liquidity crunch in the
capital markets was caused partly due to the CBNs 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 DMOs 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 Nigerias 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 Nigerias 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 CBNs monetary policy rates for short-term
money market rates and fixed income securities on the other hand. The CBNs
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 Yous, 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
CBNs 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 CBNs 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 OTCs 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 members 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 CBNs 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 SECs 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 CBNs 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 nonfinancial institutions such as municipal governments, large corporations, high networth 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 CBNs 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.

*Tavershima Adyorough, MA Macroeconomics, MBA Intl Mgt, BS Engr., Branch

Manager/ Investment Representative for Edward Jones Investments in Atlanta,
Georgia USA 2005 2008. Previously, he was with Gruntal & Co., the third oldest
member of the New York Stock Exchange and F. N. Wolf & Co., a USA National
Association of Securities Dealers member firm in New York. He is an emerging
market expert and specializes in valuation of growth companies. Email:
adyorough@yahoo.com

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