Nigerian bonds have sold off sharply this year, with the spread on the Bloomberg EM Sovereign Nigeria Index rising by 327bps ytd through 17 June versus a 105bps rise in the Aggregate Index.
Nigeria’s sell-off has been surpassed only by Tunisia, El Salvador, Pakistan, Ethiopia, Ghana, Honduras and Kenya among index constituents that are not in default or directly impacted by the Ukraine war, and the NGERIA 7 ⅞ 02/16/32s now yields a whopping 13.13% (1,004bps z-spread) and have a cash price of just US$71.7 at the time of writing, implying a high degree of default risk.
This has occurred despite a sharp rise in oil prices, which comprises c5% of GDP, c45% of revenue and c85% of exports. However, chronic mismanagement of Nigeria’s exchange rate regime has limited the improvement of Nigeria’s current account and weighed severely on its financial account, with gross reserves actually declining to below US$39bn from US$40.5bn at the beginning of the year, despite the oil price environment and the naira trading at a c45% premium on the parallel market.
Further, refusal to remove Nigeria’s costly petrol subsidy means that every US$10 increase in oil prices increases the budgetary cost of subsidies by 0.5% of GDP, according to our estimates. As such, a rise in oil prices is a mixed blessing, helping to improve Nigeria’s external position but weighing on its budget. Further, a sharp decline in production (from 1.88mbpd in 2019 to 1.49mbpd over the first five months of the year and 1.28mbpd in May, well below the 1.8mbpd OPEC quota) has limited the overall benefit from higher prices, so its underperformance relative to other oil producers is justified.
However, the extent of the sell-off is surprising, with bonds now pricing a high risk of distress despite a public debt stock of just 35.3% of GDP at the end of 2021 (or 39.3% of GDP if external debt is valued at the parallel exchange rate). That said, public debt is projected to rise to 44% of GDP by 2027, according to IMF estimates, and debt service absorbed an eye-watering 96% of federally retained revenue in 2021 (or 47% of total government revenue), pointing to severe liquidity problems (although a negligible primary deficit, which reached 0.3% of GDP in 2021, should limit fiscal financing needs).
Nigeria's debt service problem stems from its weak revenue collection, with total government revenue reaching just 5.2% of GDP in 2021 and federally retained revenue reaching a meagre 2.5% of GDP, so the key to preserving debt sustainability is to boost revenue collection rather than restructure its debt service profile. But, while the government aims to triple revenue collection to 15% of GDP by 2025, which doesn't stand out as being particularly high relative to EM or African peers, there are few concrete measures to achieve such a target and non-oil revenue will likely remain subdued, absent major reforms.
Nigeria’s external liquidity position, however, is less concerning, with just US$1.6bn of external amortisations due annually from 2022-26, per World Bank IDS data (and less than US$2bn of eurobond amortisations due from 2022-25 before the US$5bn maturity hump in 2026). Adding an estimated current account deficit of c1% of GDP (US$6.2bn) over this period, and Nigeria’s gross external financing needs are negligible compared with its US$39bn reserve stock (although a sharp decline in oil prices would leave Nigeria vulnerable, with reserves just barely treading water with Brent oil of cUS$115/bbl).
So, while we remain quite negative on Nigeria’s fundamental story as a whole (see here for a detailed analysis), Nigeria’s risk of debt distress is quite low in the coming years, at least based on consensus oil price projections (indeed, Nigeria scores highly on both our debt sustainability and external liquidity indexes). Further, with elections looming in February 2023, there is potentially some upside risk if a more reform-minded government emerges (although it is too early to tell whether either candidate has clear economic policy preferences, and we are cautious not to succumb to the blind optimism that often accompanies regime changes on the continent).
Relatively limited default risk does not seem to mesh with the 13.13% yield and US$71.7 cash price on the NGERIA 7 ⅞ 02/16/2032s. With Zambia’s defaulted 2027 eurobond trading at US$63 (albeit with nearly US$18 of past-due interest) and Ethiopia’s 2024 bond trading at US$59 (which may or may not be restructured under the Common Framework), this would seem to imply a floor of cUS$60 for Nigeria’s bonds in the unlikely event of default. This is especially the case since Nigeria’s 35% debt/GDP level is much lower than Zambia's 123% and Ethiopia’s 53%, which should justify higher recovery values, all else equal.
However, Nigeria's long-term growth prospects are much worse than Zambia's and Ethiopia's, which could weigh on recovery values. Further, Zambia's and Ethiopia's bond prices could be held up by a small and robust creditor base given relatively small bond stocks. Nigeria’s bond stock is much bigger and probably more diffuse, so it may prove harder to coordinate a restructuring across such a big group of holders. Nonetheless, we think Zambia's and Ethiopia's bond prices represent the likely floor for Nigeria in the event of default.
Using US$60 as our downside scenario for Nigeria, there are just cUS$12pts of downside from current prices. This compares with cUS18pts of upside if spreads contract by 365bps, which would bring spreads in line with the average spread over the Bloomberg EM Sovereign Aggregate from 2018-19 and broadly in line with levels seen in April before the recent sell-off. For illustrative purposes, we also model the NGERIA 7 ⅞ 02/16/2032s under a range of restructuring assumptions and exit yields to illustrate potential downside scenarios:
While bonds seem to be pricing in an inordinately high risk of distress, many of Nigeria’s peers have also sold off sharply in recent weeks, so we also compare Nigeria to a set of peers across a range of key economic variables to see if its bonds are attractive from a relative value perspective. Nigeria’s spreads are currently c170bps above the peer median, with a worse growth and inflation outlook and wider projected budget deficits than its peer group but a lower debt stock and current account deficits:
We also compare Nigeria’s Bloomberg EM Sovereign Index spread to its peer group over time, and find that it has widened by 110bps relative to pre-Covid levels (based on 2018-19 average spread) relative to the median of its peer group (from -3bps to 107bps) and by 364bps relative to the Bloomberg EM Sovereign Aggregate (from a +122bps to +486bps).
While a widening relative to its oil-producing peers is justified, such a sharp widening seems excessive, and Nigeria has sold off roughly in line with peers like Kenya and Egypt which are much more vulnerable to the weak external backdrop (albeit with better long-term growth prospects).
Given the outsized sell-off both relative to its own default risk and the performance of its peers, we initiate a Buy recommendation on the NGERIA 7 ⅞ 02/16/32s at US$71.7 (13.13% YTM) at the time of writing on Bloomberg, with a conservative target of spreads narrowing by 100bps relative to the Bloomberg EM Sovereign Aggregate.
This would put Nigeria's OAS 386bps wide of the Bloomberg EM Aggregate, which would still be well wide of the 122bps average pre-Covid, and would imply 4.5pts and 6.2% of upside if the Aggregate index is unchanged.
Nigerian central bank surprises with symbolic 150bps rate hike, May 2022 (Curran, Ogunkoya & Omole)
Nigeria annual macro overview: The song remains the same, February 2022 (Curran and Malik)
Nigeria: Stealth devaluation possibly underway, November 2021 (Curran, Ogunkoya & Omole)
Nigeria: FX overhaul promised post-Dangote refinery, October 2021
Nigeria: Ban of abokiFX furthers FX folly, September 2021
Central Bank of Nigeria adds fuel to the fire by banning BDCs, July 2021 (Curran & Ogunkoya)
Our discussion with Nigeria’s IMF Mission Chief, April 2021
Nigeria policy rate and FX regime left intact, March 2021