Pre bond auction analysis: Kwacha curve has 250bps correction latitude

The Bank of Zambia will today offer K1.65-billion in government bonds of varying tenors across the curve spectrum (2,3,5,7,10 and 15yr). This debt sale will be the 5th (05/2018) offering this year. Market expectations is ideally that the kwacha curve has 250bps correction latitude given the current risks to the macro economy.

Rationale for the expectation

Given high risks to inflation which is a bigger concern currently, it is expected that 2.5% latitude exists for the kwacha bond yields to rise. This will allow the term structure of interest rates to reflect current sovereign risk highlighted by the rating agencies (Fitch/S&P: ‘B-‘ and Moody’s: Caa1). The kwacha curve is yielding higher in the short end with 273 day and 1- year money priced at 20.5% and 22.5%. This is slightly higher than the 5 – year point dubbed the sweetest and most liquid point on the kwacha curve. However, the likelihood is high that the central bank in their quest to manage interest rates to keep the yield curve unchanged. With the last rate decision meeting of the year in November, the outcome of today’s auction will be a ‘curtain raiser’ statement of what the markets should expect next month. However, the October CPI print will be a clearer determinant of the BPR the country will close at this year.

This time secondary market pricing for kwacha bonds is vague as offshores are more interested and focused on shorter dated assets (T-bills) paying 25% in the 1-year.

Kwacha treasury bill and bond yield trajectory with data extracted from BOZ website.
Kwacha treasury bill and bond yield trajectory with data extracted from BOZ website.

Market developments in the last 2-months

*Long term issuer rating (LTIR) of the sovereign has been downgraded by Fitch rating agency to ‘B-‘  with negative outlook. This being a notch above Moody’s Caa1 (stable outlook). There exists further latitude for another rating downgrade if authorities do not address debt sustainability concerns. There’s need for an urgent sovereign debt redemption plan to instill waning confidence.

*Currency risk was high with kwacha depreciation experienced in the period on account of asset sell off pressure. This was in addition to decelerated pace of dollar kwacha conversion cycle overridden by instituted measure to shore up foreign exchange reserves by allowing mines to pay mineral royalty taxes in dollars. This has decreased support for kwacha enjoyed monthly in mineral royalty period.

*Financial markets were thin with dollar scarcity coupled with rising green back fetish as the dollar index strengthened. This resulted in increased demand for foreign currency denominated assets a vice systemic across the globe.

*Credit default spreads on Zambia’s 22, 24 and 27’s remains wide above 1,322bps exceeding Mozambique’s 23’s.

*Price discovery of kwacha yield curve in secondary market reveals higher premiums on T-bills to 25-28% in the 1-year as offshore price sovereign risk of high debt distress. Kwacha T-bills are yielding higher than local currency bonds.

*Risks to inflation remain very high with cost push effects from higher crude pricing (USD79.5/bbl.: 07.39am) effects and projected extended dry spell that could push food prices higher. Current inflation of 7.9% is under pressure to soar higher as currency volatility effects price-in in October and November print, threatening the 6-8% target.