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Corneleo Keevy

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The search for yield continues

18 Apr 2018
The first quarter of the year was an eventful one for the listed credit market in South Africa (SA).

Auctions by banks and property companies dominated the markets, while Netcare and the Land Bank also conducted successful auctions. The final auction for the quarter was conducted by Nitro 6, the asset backed securitisation of Wesbank, a division of FirstRand Bank Ltd.

The secondary market also provided some interesting insights, with two major themes being the continued tightening of Tier 2 subordinated debt issued by banks and growing demand for Eskom bonds.

Based on the primary and secondary market activity during the quarter, key themes in credit markets included:
• Ongoing indications of demand for credit exceeding supply, resulting in spread tightening especially in higher yielding instruments
• Pricing anomalies with some issuers achieving spreads tighter than banks
• Increased interest for Eskom government guaranteed bonds
• Credit risk remains due to unforeseen events

1. Demand/supply dynamics and pricing evolution

In general, there has been strong support for auctions during the first quarter of this year. The levels of support are evidenced by auction spreads for most issuers clearing within or below price guidance. Furthermore, the spreads at which auctions have cleared are below the spreads earned during the first quarter of 2017.

 A comparison of spreads achieved by issuers between the first quarter of 2017 and of 2018 is presented below:

Table 1
Source: Ashburton Investments

The table above indicates a contraction in yields across all issuers, with the highest levels of tightening experienced by the Land Bank and the Tier 2 subordinated bonds issued by the major South African banks. 

The other key event was Growthpoint being able to issue five-year senior unsecured paper at tighter spreads than at which the four major SA banks were able to issue five-year bonds. This is an unusual event, given that bank issuances usually provide a floor for spreads in the SA credit markets. This is mainly due to the strong implied sovereign support for the major banks given its systemic importance to the South African economy, along with increased levels of liquidity available on bonds issued by the major banks.

Ashburton Investments is of the view that property companies and banks run mismatched funding structures, where long term assets are funded with sort-term liabilities. These entities, therefore, rely on continued access to the funding markets in order to finance their balance sheets. When assessing the relative risk between the exposures, one should consider that banks are subjected to rigorous regulations and oversight, coupled with the implicit government support as well as benefiting from higher levels of liquidity. Given these matters, our view is that the current spread discount achieved by Growthpoint relative to the banks is not fundamentally justified and may not persist in the future. 

In addition, one of the most telling auctions was the issuance by Nitro 6. The results of the auction are presented below:

Table 2
​Source: ​Ashburton Investments

The above table indicates that demand for the higher risk and higher yielding tranches were stronger in the Nitro 6 auction. The issuer was able to fill its auction in the higher risk notes at a level below the price guidance provided prior to the auction. It also had to accept all bids in the lower risk and lower yielding tranches to fill the book. This resulted in the lower risk tranches clearing above or at the higher end of price guidance. This is a clear indication that the hunt for yield is continuing.

In summary, demand for credit remains elevated, while supply continues to lag. This is likely to continue the tightening trend in credit spreads. Ashburton Investments, however, believes that there is limited room for tightening in spreads to senior debt of higher quality issuers. And we expect more material moves in the riskier instruments such as subordinated debt issued by banks, insurers and securitisations.

2. Growing demand for Eskom issuance

Another key trend in the South African credit market has been a resurgence in appetite for government guaranteed bonds issued by Eskom. According to Standard Bank Credit Research, up to the end of the first week of April 2018, government guaranteed Eskom bonds with a nominal value more than R9.6 billion have been traded in the secondary market. This figure may include book-overs and transfers between internal mandates. However, it is estimated that at least R5 billion of the transactions reflected true trades, with foreign investors being involved in trades accounting for c.R1.6 billion of this value. The majority of the trade occurred in the nominal bonds, while c.R43 million of inflation-linked bonds have been traded.

 Ashburton Investments’ view is that there have been a number of catalysts for the increased investor appetite for Eskom government guaranteed credit risk. The table below provides a timeline of the key catalysts and the trades executed during these respective periods:

Table 5
Source: Standard Bank Credit Research

In addition to the secondary trades, Eskom has also tapped R3 billion in new bonds off its Domestic Medium-Term Note (DMTN) programme during quarter one of 2018 as follows:

Tabsle 6;
Source: Standard Bank Credit Research

It is unclear whether these bonds are being held by Eskom for future distribution or if they were issued directly to third party investors. Regardless, this is an important development given that Eskom last tapped any of its bonds during 2013.

The challenges with Eskom

Demand for Eskom’s bonds will likely continue to increase in the event of further positive news flow from the entity and the sovereign. This demand should, however, be viewed in light of the ongoing challenges faced by the entity, as evidenced by continued credit rating downgrades of Eskom’s stand-alone credit rating. The key challenge remains securing sufficient liquidity to refinance upcoming debt maturities and capital expenditure requirements. In addition, Eskom still faces significant challenges in rooting out corruption at all levels, specifically related to its procurement practices.

Ashburton Investments’ view is that true investor appetite will only be reflected once Eskom approaches local and international debt capital markets in a public auction process. This will then be a true indication of the accurate level of returns the market requires to attract meaningful amounts of additional funding.

3. Market related risks

During quarter one, a number of credit situations have impacted corporate issuers. The main issue carried over from 2017 related to Steinhoff and the accounting irregularities raised at the company. Despite the liquidity constraints of the entity, Steinhoff settled all rand-denominated bonds in issue in early March 2018. This is somewhat reflective of the financial flexibility that exists in larger organisations.

The struggles at Steinhoff stemmed from an announcement by the company that it would be delaying the release of its financial statements. The situation was exacerbated by the report released by Viceroy, a previously unknown equity research provider, that provided possible, damning, reasons for the delay. Viceroy also caused some uncertainty in other South African entities such as Capitec. However, the concerns raised by Viceroy regarding Capitec did not appear to be as material as was the case in Steinhoff and have been largely shrugged off by the market.

In addition, difficulties were experienced by Consolidated Infrastructure Group (CIG), which breached its debt covenants when it reported its August 2017 results. During the first quarter of this year, CIG and its funders (banks and bondholders) agreed on a way forward to ensure value is retained by all stakeholders.

Finally, property companies Resilient and Fortress were impacted by concerns raised in a leaked report from 36One Asset Management regarding cross holdings in a number of different REIT’s and accounting related concerns regarding its Black Economic Empowerment (BEE) trusts. No formal outcome of the investigations by the Johannesburg Stock Exchange (JSE) into Resilient has been announced, however, both Resilient and Fortress have taken a number of steps to address the concerns raised by investors. The entities firstly amended the way loans to its BEE trusts would be accounted for. Furthermore, both entities conducted internal investigations into the trades highlighted in the 36One report. Finally, Resilient recently announced its intention to commence the disposal of its shareholding in Fortress.

Credit investments are subject to event risk, which may result in credit losses. These events reinforce our view that the application of a tried and tested approach to credit investing should be applied regardless of the perceived risk of the issuer. Through the application of these principles, one is likely to secure the most favourable outcome for debt investors and limit capital losses to a large extent.
 
Conclusion 

Despite the consistent grind lower in credit spreads, we believe that certain parts of the credit market still offer attractive returns to investors. While listed spreads have moved primarily due to technical pressures driven by excess liquidity in the market, the spreads on unlisted debt have remained more stable as private lenders take a longer-term view through the cycle. In particular, loans to higher risk companies appear attractive as these companies are highly geared towards the economy and the general sentiment in the country. Bond spreads are expected to tighten marginally over the short-term, with a larger element of tightening in higher risk issuances.
 
One development to consider is the timing of a return for certain State-Owned Companies such as Eskom, Transnet and Sanral to the domestic capital markets. And whether there may be any material mark-to-market movements on existing bonds of the issuers as the market looks to set new pricing levels.
 
Overall, opportunities do remain in the current credit markets. However, it has become increasingly important to be able to differentiate between opportunities given the technical forces that have been evident in the market. This is crucial, both from a fundamental credit quality perspective, as well as structural perspective in deciding which opportunities present the best value for investors.