Nigeria’s proposed $5bn total return swap financing arrangement could expose
the country to additional debt-management and liquidity risks despite its
potential benefits, global rating agency Fitch Ratings has warned.
In a special report, Fitch said that while total return swaps can provide
governments with hard-currency liquidity, diversify funding sources, and lower
borrowing costs, the structure could create transparency concerns, increase
exposure to market shocks, and weaken recovery prospects for conventional
creditors if not carefully managed.
The report comes weeks after reports emerged that Nigeria had secured
approval for a $5bn financing arrangement with First Abu Dhabi Bank using a
total return swap structure backed by local-currency government bonds.
Fitch noted that total return swaps have become increasingly popular among
some emerging-market sovereigns seeking alternative sources of financing
outside traditional Eurobond markets.
The rating agency explained that under such arrangements, governments pledge
bonds as collateral in exchange for cash financing, with the pledged securities
typically remaining outside standard debt statistics because they are treated as
contingent liabilities rather than direct debt obligations.
According to Fitch, while the structure can help governments obtain foreign-
currency funding, it may also obscure the true scale of sovereign liabilities. The
report stated, “TRS may be structured under contractual agreements whose
terms and conditions are only partly disclosed, reducing transparency of the true
scale and terms of sovereign borrowing.”
It added that such arrangements could “weaken legislative and market oversight
and make the potential for margin calls harder to assess.” Fitch said Nigeria’s
planned transaction was primarily designed to support liquidity management
and diversify funding sources rather than address an inability to access
international capital markets.
“Nigeria has approved and reportedly executed a TRS. Fitch believes that the
proposed structure, which would pledge naira-denominated bonds against hard-
currency financing, is similarly motivated by funding diversification and
liquidity management rather than market access constraints,” the agency said.
However, the agency warned that the arrangement could expose the country to
additional pressure if domestic interest rates rise or the naira weakens. It stated,
“Margin calls payable in US dollars against naira-denominated collateral could
generate hard-currency pressure either if domestic yields rise or the naira
weakens.”
Fitch further explained that total return swaps carry structural risks because the
value of pledged collateral can decline during periods of economic stress,
potentially triggering additional funding demands at a time when liquidity is
already constrained.
The agency noted that “falling bond prices during a period of stress can
generate unplanned hard-currency demands when external liquidity is already
constrained,” adding that such risks would be factored into its sovereign rating
assessments.
The report also raised concerns about disclosure standards surrounding total
return swap transactions, noting that detailed contractual provisions such as
pricing structures, fees, collateral valuation thresholds and termination clauses
are often not publicly disclosed.
Fitch said reduced transparency was not credit-neutral because it could limit the
ability of lawmakers, investors and markets to properly assess the true cost and
scale of sovereign borrowing.
“Reduced transparency limits the ability of legislators and markets to assess the
true cost, scale and structure of sovereign borrowing, and can weaken
confidence and complicate risk assessment,” the agency stated.
According to a table contained in the report, Nigeria’s planned facility with
First Abu Dhabi Bank has an estimated maturity of 2032 and a value of $5bn.
The transaction would reportedly be backed by about $6.67bn equivalent of
Nigerian local-currency bonds and would include margin-call requirements.
Fitch compared Nigeria’s proposed arrangement with similar transactions
undertaken by Angola and Senegal, noting that African countries have
increasingly explored total return swaps as alternative financing mechanisms.
The report observed that Angola’s experience highlighted the potential dangers
associated with such structures after a previous risk-off market episode
triggered a margin call that the country had to meet using foreign-exchange
reserves.
Although the situation was later stabilised, Fitch said the episode demonstrated
how the financing structure could accelerate liquidity pressures when sovereign
buffers were already under strain.
The agency also warned that there remains significant uncertainty about how
total return swap obligations would be treated during a sovereign debt
restructuring because no established precedent currently exists.
“There is no precedent for how TRSs would be treated in a sovereign
restructuring. Their derivative form and limited disclosure create material
uncertainty,” Fitch stated.
The rating agency further cautioned that as total return swap financing expands
across emerging markets, investors and policymakers would need to closely
monitor its impact on debt sustainability and creditor recoveries.
“The extent to which TRS exposure weakens recovery prospects for
conventional bondholders depends on its size relative to total debt. As TRS
financing grows across emerging markets, monitoring this share becomes an
increasingly important input in the recovery analysis of sovereigns with TRS
exposure,” Fitch said.
Despite the concerns, Fitch acknowledged that total return swaps can offer
genuine financing benefits, including access to external liquidity, lower
borrowing costs and greater flexibility in managing government funding needs,
particularly during periods of tight global financial conditions.