In this document, we evaluate fixed income strategy options for long-term investors in Nigeria in the face of a steeply inverted yield curve

1. NIGERIAN PENSION FUND MANAGERS/ADMINISTRATORS: EVALUATING
FIXED INCOME INVESTMENT STRATEGY OPTIONS
Discussion Document
By:
Olaniyi Ogunbayo, CFA, FRM
Managing Director & Chief Investment Officer
Affiniti Capital Management LTD
Email: olaniyi@affiniti-capital.com
September, 2017

2. Outline
2
Summary
•Executive summary
Background Information
•Yield Curve & Shift in Fixed Income Strategy
Evaluating Investment Strategy Options
•Strategy Options, Base Case Assumptions and Results
•Break-Even or Indifference Point Analysis
Additional Sensitivity Analysis
•Break-Even or Indifference Curve
•Impact of Investment Horizon on Strategy Outcomes
Investment Policy Implications
I.
II.
III.
IV.
V.

3. Executive Summary
3
o The prevailing interest rate environment is characterised by a steeply inverted yield curve. In recognition of this, Pensions Funds
have chosen to increase their Fixed-Income (“FI”) Portfolio allocation to short-term securities, particularly 1-year treasury bills
which currently offer 500bps premium over 20-year treasury bond
o In this document, we assess the viability of this tactical shift in FI strategy in favour of short-term securities given the long-term
investment objectives of the pension funds
o Our analyses, based on our capital market expectations, suggest that the strategy shift is to the detriment of the investors
o Specifically, the strategy shift will result in immediate wealth loss estimated to be 12.18% of the allocated capital to short-term
securities
o The strategy shift will only create wealth for the investors if the 20-year yield is above 16.24% in one year’s time. And our own
base estimate of the 20-year yield in one year’s time is 15.50%
o Given the current market conditions, we believe the fair yield for the 20-year bond in today’s market is 15.80%. Therefore, any
offer of the 20-year securities above this level is considered viable for pension funds
o A critical parameter in our analyses is the assumed investment horizon of pension funds, which we take to be 20 years in our base
case analysis. Our analyses indicate that the strategy shift towards short-term securities is only justified if the investment horizon
is 5 years or less
o We believe that if a thorough analysis and simulation is conducted with future expectations of market interest rates, the strategy
shift may not have been implemented
o We therefore recommend a gradual reallocation to long-term securities provided the offered yield on 20-yr bond exceeds 15.80%

4. Outline
4
Summary
•Executive summary
Background Information
•Yield Curve & Shift in Fixed Income Strategy
Evaluating Investment Strategy Options
•Strategy Options, Base Case Assumptions and Results
•Break-Even or Indifference Point Analysis
Additional Sensitivity Analysis
•Break-Even or Indifference Curve
•Impact of Investment Horizon on Strategy Outcomes
Investment Policy Implications
I.
II.
III.
IV.
V.

5. Background Information
5
o The FGN yield curve has been inverted for over a year now, with
the yield spread (20-yr Yield minus 1-yr Yield) currently standing
at -500bps
o The degree of inversion has encouraged PFAs, whose
liabilities/obligations are structurally long term in nature, to shift
funds to short term securities – particularly 1-year treasury bills
with the plan to re-invest in long-dated securities in one year’s
time when the yield curve is expected to have normalised
o Over one year has passed, and the yield curve remains inverted
o Thus, the FI investment strategy dilemma still remains: invest
short term today and re-invest long term later vs. invest long-term
now
o Recent trading activities suggest that most PFAs still favour the
option of investing short term now and re-invest in one year’s
time as shown in the jump in allocation to short-term securities
from 23.4% at the beginning of this year to 27.4% as at April, 2017
o This document primarily aims at exploring the potential financial
implications of the short-term investment strategy
o For our analysis, we have assumed investment horizon of 20 years
FGN Yield Curve as at September 08, 2017
Shift in PFAs’ Fixed Income (FI) Asset Allocation
Source:
YTM - FMDQ
PFA Assets – PENCOM
Yield Curve and Shift in Fixed Income Strategy
Yield Spread = -500bps
13.0
15.0
17.0
19.0
21.0
23.0
- 5 10 15 20
YTM
TTM
24.2
23.6
23.2 23.3
22.9
21.1
21.4
23.8
22.5 22.6
23.7
23.4
24.5
23.2
24.2
27.4
Short-term FI Securities as % Total FI Portfolio 3-Month Moving Avg.
PFAs’ FI Portfolio Allocation
to Short-Term FI Securities (%)

6. Outline
6
Summary
•Executive summary
Background Information
•Yield Curve & Shift in Fixed Income Strategy
Evaluating Investment Strategy Options
•Strategy Options, Base Case Assumptions and Results
•Break-Even or Indifference Point Analysis
Additional Sensitivity Analysis
•Break-Even or Indifference curve
•Impact of Investment Horizon on Strategy Outcomes
Investment Policy Implications
I.
II.
III.
IV.
V.

7. Evaluating Investment Strategy Options
7
Strategy Options
o Option 1: Invest short term now and re-invest later
- This entails investing in 1-year Treasury Bill today
and re-investing in a 20-year bond with TTM of 19
years, one year from now
- This will be subsequently referred to as The Short-
Term Strategy
o Option 2: Invest long term now
- This entails investing in 20-year bond now
- It will be referred to as The Long-Term Strategy
Base Case Scenario
o Investible capital = NGN10bn
o Investment horizon = 20 years
o Current yield on 1-year T-bills = 21.50% (this corresponds
to discount yield of 18.50%)
o Current yield on 20-year FGN Bond = 16.50%
o Target/expected yield on 20-year FGN Bond, one year from
now = 15.50%
Base Case Outcome
Definition of Strategy Options & Base Case Scenario
o Our analysis indicates that, under the base case scenario,
the short-term strategy (Option 1) will result in a shortfall
of NGN29.02bn in portfolio value at the end of the
investment horizon on an invested capital of NGN10.00bn
o This translates to a loss of NGN1.22bn to the investors in
today’s terms. In other words, allocating NGN10bn to 1-
year T-bill now will result in an immediate wealth
destruction of 12.2% of the allocated capital.
o This can be described as the cost of short-sightedness
FV of Option 1, 20 yrs. from today (NGN) 209,266,151,208.90
FV of Option 2, 20 yrs. from today (NGN) 238,295,697,453.62
FV difference (NGN) -29,029,546,244.72
PV difference (Cost of short-sightedness) -1,218,215,291.12
PV Loss as % of Allocated Capital 12.18%
Footnote:
Analysis assumes that intermediate bond cash flows are re-invested at YTM

8. Evaluating Investment Strategy Options
8
o Our base estimate of loss from the short-term strategy assumes that the yield on the 20-year bond will drop by 100bps from 16.50% to
15.50% over the next 12 months
o However, the future outcome may not be exactly in line with our base case. Therefore, the eventual cost of the short-term strategy, if any,
depends on what the 20-year yield will be in one year’s time
o The key question is: how low can the 20-year yield drop over the next 1 year before the short-term strategy results in loss?
o The minimum target/expected 20-year yield in one year’s time that will not result in loss if the short-term strategy is implemented,
otherwise known as the break-even or indifference point, is estimated at 16.24%
o In other words, investors will not suffer any loss of wealth from the short-term strategy if the yield on the 20-year bond is at least 16.24% in
one year’s time
o For every expected basis point drop below this break-even point, the investors suffer immediate wealth loss of 0.18% of the capital
allocated to the short-term strategy
Sensitivity of The Short-Term Strategy Outcome to The Expected 20-yr Yield in One Year’s Time
Break-Even or Indifference Point Analysis
Target 20-yr Yield in 1
year’s time
FV Difference (NGN) PV Difference (NGN)
PV Diff. as % of
Allocated Capital
15.00% - 46,709,581,584.76 - 1,960,152,117.05 -19.60%
15.10% - 43,294,108,246.64 - 1,816,822,909.91 -18.17%
15.20% - 39,819,376,155.76 - 1,671,006,928.84 -16.71%
15.30% - 36,284,385,423.58 - 1,522,662,213.85 -15.23%
15.40% - 32,688,119,766.46 - 1,371,746,116.94 -13.72%
15.50% - 29,029,546,244.72 - 1,218,215,291.12 -12.18%
15.60% - 25,307,614,997.49 - 1,062,025,679.35 -10.62%
15.70% - 21,521,258,973.65 - 903,132,503.17 -9.03%
15.80% - 17,669,393,658.46 - 741,490,251.28 -7.41%
15.90% - 13,750,916,796.09 - 577,052,667.88 -5.77%
16.00% - 9,764,708,107.77 - 409,772,740.85 -4.10%
16.10% - 5,709,629,005.72 - 239,602,689.71 -2.40%
16.20% - 1,584,522,302.55 - 66,493,953.50 -0.66%
16.30% 2,611,788,083.72 109,602,821.69 1.10%
16.40% 6,880,497,429.25 288,737,795.22 2.89%
16.50% 11,222,820,508.54 470,961,944.70 4.71%
16.60% 15,639,991,903.24 656,327,078.93 6.56%
16.70% 20,133,266,315.78 844,885,851.11 8.45%
16.80% 24,703,918,887.73 1,036,691,772.10 10.37%
16.90% 29,353,245,523.14 1,231,799,224.11 12.32%
17.00% 34,082,563,216.76 1,430,263,474.37 14.30%
(2.50)
(2.00)
(1.50)
(1.00)
(0.50)
-
0.50
1.00
1.50
2.00
PV Difference (NGN’bn)
Break-Even or
Indifference Point
Expected 20-yr Yield in 1 year’s time

9. Outline
9
Summary
•Executive summary
Background Information
•Yield Curve & Shift in Fixed Income Strategy
Evaluating Investment Strategy Options
•Strategy Options, Base Case Assumptions and Results
•Break-Even or Indifference Point Analysis
Additional Sensitivity Analysis
•Break-Even or Indifference Curve
•Impact of Investment Horizon on Strategy Outcomes
Investment Policy Implications
I.
II.
III.
IV.
V.

10. Additional Sensitivity Analysis
o The indifference curve indicates the different combinations of
Today’s 20-year yield and expected 20-yr yield in one year’s
time that will give the same performance results for both the
short-term and the long-term strategies
o In other words, along the indifference curve (highlighted in
blue), it does not matter the strategy option that is
implemented as both will result in exact same performance
o For example, a combination of today’s 20-yr yield of 16.50%
and expected future 20-yr yield of 16.24% (as shown in our
base case analysis) gives the investment manager a free choice
between the two strategy options without any consequential
loss to investors. However, any option off the indifference
curve will favour one strategy over the other in terms of
performance outcomes.
o Specifically, any combination in the triangular area above the
indifference curve (i.e. the area bounded by the green broken
lines) will be in favour of the short-term strategy while any
combination in the triangular area below the indifference
curve (i.e. area bounded by red broken lines) will be
detrimental for the short term strategy
Strategy Indifference Curve
Break-Even or Indifference Curve
13.0%
13.5%
14.0%
14.5%
15.0%
15.5%
16.0%
16.5%
17.0%
13.5% 14.0% 14.5% 15.0% 15.5% 16.0% 16.5% 17.0%
Today’s 20-yr Yield (%)
14.0 14.1 14.2 14.3 14.4 14.5 14.6 14.7 14.8 14.9 15.0 15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 16.0 16.1 16.2 16.3 16.4 16.5 16.6 16.7 16.8 16.9 17.0
Break-Even 20-yr Yield in One
Year’s Time (%) 13.6 13.7 13.8 13.9 14.0 14.1 14.2 14.3 14.5 14.6 14.7 14.8 14.9 15.0 15.1 15.2 15.3 15.4 15.5 15.6 15.7 15.8 15.9 16.0 16.1 16.2 16.3 16.4 16.6 16.7 16.8
The Short-term strategy
wins here
The Short-term strategy
loses here
Possible Today’s 20-yr Yields and The Corresponding Break-Even Expected 20-yr Yield in One Year’s Time
Today’s 20-yr Yield
Expected 20-yr Yield in One Year’s Time
o Given our base case target 20-year yield of 15.50% in one year’s time and today’s 1-yr yield of 21.54%, abandoning the short-term
strategy is only viable if the current 20-year yield does not drop below 15.80%. This means that our estimate of the fair yield for 20-yr
bond in today’s market is 15.80%

11. -14.0%
-12.0%
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
0 5 10 15 20
Additional Sensitivity Analysis
o Given that our analysis so far has been done using investment
horizon of 20 years, it is beneficial to see how the short-term
strategy performs under different investment horizons
o For this purpose, we retain the parameters of our base case
scenario except for the investment horizon
o Our analysis reveals the following:
- As it will be expected, the short-term strategy becomes
less viable as the investment horizon increases
- Specifically, the short-term strategy is only viable for
investment horizon of 5 years or below
- For every extra year added to the investment horizon
beyond 5 years, investors will lose approx. 0.87% of their
invested capital in today’s terms
- Also, the longer the investment horizon, the higher the
target future long-term yield that will be required to
maintain the viability of the short-term strategy.
However, the rate of increase in the target future break-
even long-term yield diminishes as investment horizon
increases
Sensitivity of Strategy Gain/Loss to Investment Horizon
Impact of Investment Horizon on Strategy Outcomes
Line Slope est. @ -0.87%
Investment Horizon (yrs.)
PV of Strategy Gain/(Loss) as % of Allocated Capital
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
17.0%
0 5 10 15 20
Target Future Long-term Yield to Break Even
Investment Horizon (yrs.)
Sensitivity of Required LT Yield to Investment Horizon

12. Outline
12
Summary
•Executive summary
Background Information
•Yield Curve & Shift in Fixed Income Strategy
Evaluating Investment Strategy Options
•Strategy Options, Base Case Assumptions and Results
•Break-Even or Indifference Point Analysis
Additional Sensitivity Analysis
•Break-Even or Indifference Curve
•Impact of Investment Horizon on Strategy Outcomes
Investment Policy Implications
I.
II.
III.
IV.
V.

13. Investment Policy Implications
o To improve investment decisions over time, it is important that portfolio performances are evaluated against benchmarks
o While a lot has been said about the difficulties of constructing portfolio benchmarks in Nigeria, a paper portfolio based on the
strategic or long-term asset allocation should be created and maintained to serve as the benchmark for evaluating actual portfolio
performance
o Also, it is important that perceived short-term opportunities, such as the inverted yield curve, are adequately evaluated and
simulated against long-term capital market expectations before any tactical deviation from the long-term asset allocation is
implemented. Put differently, there must be internal consistency between tactical allocation decisions and long-term market
expectations. For example, the tactical decision by PFAs to increase allocation to short-term securities because of the steeply
inverted yield curve will only turn out viable if the yield on 20-year security prints above 16.24% in one year’s time (as noted in
our base case analysis). Therefore, if the fund managers believe that 20-year yield will be lower than 16.24% in one year’s time,
then the tactical decision to increase allocation to short-term securities should not be implemented
o Given the prevailing high interest rate environment and the long-term nature of pension fund obligations, we believe short-term
securities should be used mainly for liquidity management. The high interest rate environment should rather serve as an
opportunity to lock in high yield on long-term securities regardless of the inverted yield curve
o Recognising that market limitations and portfolio size pose major difficulties in portfolio reallocation, we believe the reallocation
process can be gradual. Our recommendation is to invest all fresh funds, after making provision for near-term liquidity
requirement, in long-term securities. This to be followed by reinvesting maturing short-term securities in long-dated securities
o Over time, the pension funds can attain an FI asset allocation that maximises investors’ wealth over the long term

14. Disclaimer
We make no representation in relation to the accuracy, completeness or reliability of the information contained in this document. This
document is only intended to facilitate public discussion on the optimal FI investment strategies of long term investors such as
pension funds under the prevailing interest rate environment in Nigeria; it must not be taken as an investment advice or
recommendation. We will not accept liability for any loss incurred directly or indirectly by relying on the contents of this report.