Bonds are an interesting financial instrument. An entity lends money to a borrower who in turn agrees to pay back the amount with periodic payments during the tenor known as coupons at an agreed rate. It’s simple right? Well, not so simple as we are beginning to learn from the Eurobonds.
To unpack it, it is important to understand the different players that are in this Eurobond equation. First starters, you have the Zambian Government who issued the non-domestic debt (i.e. the Eurobond), international investors (who put up the money for the 3 Eurobonds and are the bondholders), and prospective investors in bonds (who buy and sell bonds). The latter two are part of a group of investors known as bond traders. Now according to Bloomberg, in their article aptly titled “The pain’s getting worse for Zambia as Eurobond yields hit 10%’ by Paul Wallace, yield rates have been on a gradual ascent over the last couple of months. Compared to Turkey, Ecuador, Urugay among others, Zambia’s Eurobonds have lost the most in emerging markets in 2018. But why have they and what does it mean for Zambians?
Well, the best place to start is looking at the last two statements from the central bank attributed to Governor Dr Denny Kalyalya. According to the February 2018 MPC statement, on the local front, non-resident investor appetite was still high for our longer tenor locally issued bonds (Note to self, these are not Eurobonds but Zambonds). In May 2018, Denny further stated that demand for Government securities had rebounded and he pointed to a further increased appetite for the long term paper (Zambonds again) from non-resident investors.
Now, insofar as bonds are concerned, non-resident investors are driven by what is happening in the macro environment. This is where the regulatory, administration and financial players need to send carefully crafted positions on the state of affairs in order not to raise alarm. In certain jurisdictions, Public Relations (PR) firms are often hired because information that is disbursed has huge ramifications on how the bonds behave. That is why there has been deeper scrutiny of bonds in emerging markets. For example, when investors discovered that Mozambique had what was deemed as “hidden loans” two years ago, this triggered a financial crisis and sovereign default.
So, how come non-resident investors would still fancy local long paper but alarm bells are being raised for externally issued paper? Our view is that because of the behaviour of bonds which at face value can be a bit of an oxymoron, they depend on sentiment. Here is why. In February’s MPC statement, Governor Denny said inflation continued on a declining trend and projected to remain within the target range. In May, Governor Denny said inflation edged up, but projected to remain within the target range. Now, if market interest rates decrease, the value of a bond will increase since the bond’s stated fixed interest payments will be greater than the amounts available in new bonds issued at current market interest rates (there is an inverse relationship between bond yields and their prices). Governor Denny himself admitted that the central bank had observed a gradual reduction in local interest rates following MPC’s southward trajectory over the last 5 MPC statements. This is the reason why non-resident investors continue to fancy our locally issued bonds because they are buying them cheaper (at discount) due to the falling interest rates. However, participation may eventually be capped or decrease if sentiment around the country’s risk ratings head south as no investor wants to be exposed to currency risk associated with the volatility of the local currency.
Now, the story is much different for non-resident investors that are keen on Eurobonds. Owing to the sentiment that IMF discussions have been protracted and gradual increase in local inflation rates, the Eurobond’s yield rates have also increased. With Bank of America Corp. and Nomura International Plc, who are the lenders or bondholders, raising concerns on the true extent of the country’s exposure, this has cause a ripple effect of bondholders not wanting to keep these instruments until expiration of tenure. Bond fund managers will opt to liquidate their shares when sentiment is negative to avoid further losses. When this premature action happens, the fund managers are under pressure to ensure they meet the redemption requests. This action has a destructive effect on the average price of the bond fund (Net Asset Value). Conversely, for those in the bond fund that do not opt out, the Redemption risk exaggerates their pain due to the tumbling of the net asset value.
It’s no secret, inflation is a bond’s worst enemy. When inflation expectations rise, interest rates rise, bond yields rise and bond prices fall. That is why Governor Denny offers what some would argue is analogous to a Chinese wall by stating that projections for inflation will be in the targeted range of 6-8%. According to his statement in May 2018’s MPC, “After trending downwards for seven consecutive quarters, inflation edged up in the first quarter of 2018, rising to 7.1% in March from 6.1% in December 2017, but importantly, remained within the 6-8% target range.” Central Statistical Office published the May 2018 Inflation rate which came in at 7.8% (According to CSO as reported on BOZ website, Food inflation 6.9% and Non-food inflation 8.9%).
The Governor’s emphasis on remaining within the 6-8% target range cannot be understated. This is an important signal to resident and non-resident investors of local and international long term paper. Therefore, it is important to view it in context and more so appreciate the importance of sentiment. That is why it is no surprise that the Ministry of Finance through its PR department issued the statement that Zambia’s $8.7 billion foreign debt has not been understated. They further challenged those saying it is higher to produce evidence.
No doubt, to local business such as the financial players, information is key to the decisions they make. Due to their increased appetite for government paper owing to the protracted disease of non-performing loans, the inflation numbers will make the difference in which treasury team performs or out performs the market. For external investors, they are beginning to show us that trading in instruments continues to be one of the key sources of “value creation” hence why their noses will continue to be in the country’s numbers. As an aside, it also shows that higher liquidity markets trade considerably in comparison to our local financial markets that have been illiquid for sometime.