More of the same, but for how long – what to expect from credit insights in 2019

1) Introduction

The pause in activity in the listed credit markets at the start of the new year provides investors with an opportunity to consider the major market developments over 2018. The overarching theme in the market was the continued excess demand for credit amidst reduced supply and variety.

The demand for listed credit assets has exceeded the supply of listed credit issuance since the second half of 2016 and is a result of a number of developments, both on the supply and demand side of the equation.

2) Supply of assets

Demand for listed credit has increased materially over the last 24 to 30 months. The increased demand was driven by several factors including: re-allocation by investors to lower risk asset classes, appetite by banks for high-quality liquid assets (HQLA), and the search for yield by investors who had not traditionally invested in the listed credit market.

  • Asset re-allocation:

    Over the last two years, investors have allocated to asset classes with lower risk and volatility. Given the floating rate nature of most of listed credit currently being issued, and South Africa’s (SA) history of relatively subdued credit losses, many investors have opted for cash and money market plus (MM+) type portfolios. These mandates account for a material share of the traditional investor base in the SA listed credit market. 

    The re-allocation trend accelerated in 2018 due to the poor performance in the equity market (Johannesburg Stock Exchange All Share Index total return for 2018 was c.-8.5%), volatility in SA government bonds, the weak domestic economy and political uncertainty, along with increased uncertainty in the global political and economic environment. This contrasts with the returns of CPI+4% achieved by some of the better performing MM+ portfolios in 2018.  

    The increased flows to the above mandates raised demand for listed credit, especially issuance by corporates, state-owned companies (SOCs) and securitisations which provided a yield pick-up in comparison to yields offered on bonds issued by the major SA banks.

  • Bank demand for HQLA:

    Following the introduction of Basel III, banks are required to hold more capital against the assets it traditionally originated
    (i.e. unlisted loans). The regulations incentivize banks to hold more instruments which qualify as HQLA as these instruments require lower levels of capital to be held by banks on their balance sheets. The listed credit market, especially issuance by highly rated corporates, provide the banks with such a source of HQLA. Given that it costs less to buy and then hold HQLA assets than it is to originate, banks have aggressively bid in auctions by well rated corporates resulting in tightening credit spreads and lower volumes of listed credit available to more traditional market participants.

  • Search for yield:

    Given the poor equity returns and increased volatility in SA government bonds, a number of investors which have not traditionally been invested in listed credit have entered the market. Mandates such as multi-asset and balanced funds are increasingly investing in listed credit, given the inflation-beating returns and low volatility on offer. In addition, these investors are participating in higher yielding instruments such as subordinated debt issued by banks, insurance companies and securitisations in order to supplement the poor returns from traditional growth assets (i.e. equity).

3) Supply of listed credit

Total listed credit issuance for 2018 amounted to R115.3 billion, representing a c.19% reduction from the R141.7 billion issued during 2017. Further, issuance was at its lowest level since 2014. Given the increased demand for listed credit, the lower levels of supply exacerbated the supply/demand mismatch.

Other than a decline in aggregate issuance, there have been a number of changes in supply of credit driven by factors including banking regulations, delayed capital projects by corporates and governance failures at certain SOCs. The charts below provide some insight into these developments:

Chart 1

Gross issuance volumes

Source: JSE, RMB Global Markets (data as at 31 December 2018

Chart 2

Share gross insuance volumes

Source: JSE, RMB Global Markets (data as at 31 December 2018)

Chart 1 and 2 indicate that the majority of the increase in issuance during 2017 related to issuance by banks (2017: R73.5 billion and 2016: R55.7 billion) and corporates (2017: R37.0 billion and 2016: R21.1billion) while SOC issuance (2017: R15.0 billion and 2016: 30.2 billion) declined materially. During 2018, the majority of the decline in issuance was experienced in bank issuance (2018: R46.9 billion and 2017: R73.5 billion) and a smaller decrease in corporate issuance (2018: R33.8 billion and 2017: R37.0 billion), which was offset to some extent by larger issuance from SOCs (2018: R20.7 billion and 2017: R15.0 billion).

Banks and financials issuance decreased by 36.2% to R46.9 billion following a raised by banks year of exceptionally high issuance during 2017 of R73.5 billion. The main factors causing a reduction in bank issuance included accelerated funding during 2017 in anticipation of the ANC elective conference (December 2017) and the implementation of the net stable funding ratio requirements under Basel III (January 2018). In addition, banks experienced low levels of asset growth during 2018 in a slowing South African economy, therefore requiring lower levels of additional funding. Finally, Absa and FirstRand opted to issue subordinated tier 2 instruments (“T2”) offshore rather than in the domestic market.

The trends in bank issuance (excluding other financials) are presented below: 

Gross bank issuance excl financials

Source: JSE, RMB Global Markets (data as at 31 December 2018)

Chart 4

Share of gross issuance

Source: JSE, RMB Global Markets (data as at 31 December 2018)

Chart 3 and 4 above indicates the material increase and reduction in senior secured issuance by banks during 2017 and 2018 respectively, which confirms the trend of pre-funding during 2017 and a slowdown in funding required due to low asset growth in 2018. Further, banks opted to take advantage of tightening spreads to issue additional tier 1 (AT1) instruments, while opting to issue a portion of its T2 instruments offshore.

Corporate issuance decreased by 8.5% to R33.8 billion following issuance of R37.0 billion during 2017. The slowdown is mainly attributable to the continued weakness in the SA economy with corporates delaying capital expenditure until the economic outlook improves. Despite the decline, the issuance during 2018 is still the second largest corporate issuance on record.
The increased issuance during 2017 and 2018 relative to prior years indicates the response of corporates to growing demand for listed credit both from banks (HQLA) and traditional participants in the market.

Chart 5

Gross corporate issuance

Source: JSE, RMB Global Markets (data as at 31 December 2018)

Chart 6

Share of gross corporate issuance

Source: JSE, RMB Global Markets (data as at 31 December 2018)

As illustrated above, the majority of corporate issuance has remained concentrated, with Mercedes-Benz South Africa (MBSA) being the largest issuer in each of the last seven years. Property counters account for a material share of corporate issuance, with these counters taking advantage of the ability to issue senior unsecured bonds, compared to funding obtained from banks which is typically secured. Other than MBSA and the property counters, Netcare was the largest issuer during 2018 with seven other corporates raising R1 billion or more (Toyota Financial Services (TFS), MTN, AECI, Telkom, Bidvest, Barloworld and Woolworths).

State-owned company’s issuance increased by 37.8% to R20.7 billion following issuance of R15  billion during 2017. Eskom accounted for most of the increase raising R10.9 billion during 2018 (2017: R4.1 billion). The majority of Eskom’s issuance
(R9.8 billion) occurred during the first half of 2018 following the appointment of a new board of directors and executive management team. Eskom’s issuance during the second half of 2018 was impacted by its decision to raise funding in the offshore bond market and increased concerns regarding its financial position. 

Historically, SOC issuance accounted for up to 30% of total annual listed credit issuance and regularly exceeded R30 billion per annum, with the majority being raised by the likes of Eskom, Transnet and SANRAL. This, however, changed from 2017 onwards as concerns around the governance and financial sustainability of these SOCs increased. The development finance institutions (Land Bank, Development Bank of Southern African and Industrial Development Corporation) increased issuance which offset some of the declines, but it was not sufficient to make up for the relatively weak issuance by the major SOCs.

Chart 7

Gross SOC issuance

Source: JSE, RMB Global Markets (data as at 31 December 2018)

Chart 8

Share of gross SOC issuance>

Source: JSE, RMB Global Markets (data as at 31 December 2018)

Other issuance, as per Chart 1, remained flat at R13.8 billion, with securitisations accounting for the bulk of the issuance
(R12 billion) and the balance being inward listed bonds (R1.8 billion). Municipalities were absent from the market in 2018.

4) Pricing dynamics

Historically, the four largest SA banks (Absa, FirstRand, Nedbank and Standard Bank) accounted for the majority of issuance and their instruments have been the most liquid listed credit instruments in the SA credit market. As a result, these instruments typically provide a floor for spreads with the majority of other issuers placing instruments at higher spreads.

One of the most material events in the recent history of the listed credit markets was African Bank (ABIL) being placed under curatorship during August 2014. Immediately prior to this event, the banks were issuing three-year and five-year senior unsecured instruments at 80 – 90 basis points  and 105 – 110 basis points above JIBAR respectively. The issuance by the big four banks subsequent to ABIL’s curatorship during quarter three in 2014 were at spreads of 110 basis points and 130 basis points for three-year and five-year instruments respectively. Thereafter, spreads continued to widen and eventually peaked in mid-2016 at c.145 basis points (three-year) and c. 180 basis points (five-year) on senior unsecured issuance.   

The increased demand for and reduced supply of listed credit issuance has resulted in spreads tightening over the last
24 – 30 months, with spreads on instruments issued by the large banks at 110 basis points and 135 basis points for three-year and five-year instruments respectively in August 2018.

Spreads on senior unsecured issuance by the big four banks now appear to have found a temporary floor at these levels, with issuance during November 2018 being at similar levels to that achieved in August 2018.

Similar levels of spread compression occurred on corporate issuance as illustrated below:

Table 1 corporate issuance

Source: Ashburton and RMB Global Markets Research

The spread tightening has been most pronounced in the highest rated corporates on the back of growing appetite by banks for HQLA. In addition to spreads tightening, these corporates (MBSA, TFS and Growthpoint) are now issuing new three-year and five-year instruments at tighter spreads than the large banks. We believe this is justified for MBSA and TFS as their instruments benefit from guarantees by international parent companies with credit ratings superior to the SA sovereign. However, in the case of Growthpoint, we do not believe this is a sustainable position and it should correct over time.

The spread tightening in higher yielding instruments such as T2 and AT1 issuance and subordinated bonds issued by insurance companies has been more pronounced (refer below), mainly due to increasing demand from multi-asset mandates seeking to replace growth assets with yield generating assets, and interest-bearing short-term mandates attempting to offset some of the spread tightening in senior ranking credit instruments. The higher spreads on T2 and AT1 instruments are due to these ranking below senior unsecured issuance in the capital structures of the banks. Banks issue these instruments as it provides a source of capital which is cheaper than normal equity capital but still assists the banks in achieving its capitalisation requirements under Basel III regulations.

Table 2 corporate issuance

Source: Ashburton and RMB Global Markets Research

 

5) Market outlook

The weak SA economy is the common theme affecting both supply and demand for listed credit. Until the sentiment surrounding the SA economy improves, investors will be cautious in allocating capital to growth assets (i.e. equity) and the inflation-beating returns along with low volatility of listed credit will remain an attractive alternative. In addition, corporates will continue to delay capital projects resulting in limited requirement for new debt. 

This trend has impacted the level of private debt originated by banks. The resultant low asset growth for banks will in turn impact the requirement for banks to issue listed credit instruments.

Given that 2019 is an election year, it is expected that the above sentiments will persist at least until after the general elections (anticipated for May 2019) and a period of time thereafter. Therefore, should the outlook for the economy improve, it is only likely to be during the second half of 2019. 

In light of the above, demand for listed credit assets will continue to exceed supply, resulting in continued spread tightening at least through the first half of 2019.

6) Conclusion

Despite the tightening credit spread environment, a case can still be made for an investment into credit. The SA inflation outlook remains subdued (4.5% year-on-year for January 2019), therefore credit will continue to deliver inflation-beating returns.
High quality credit (AA-.za national scale rating and better) is currently returning a running yield between 8.5% - 9.5%. High yield credit (A+.za national scale rating and lower) is currently returning a running yield between 10% - 12% depending on the risk investors are comfortable to take on.

It is important to understand that credit markets in SA continues to remain largely “buy-and-hold” in nature. There may be some willingness from managers to sell a listed credit instrument in the event of spreads tightening to realise mark-to-market gains. However, if spreads widen, investors tend to hold the instruments to maturity. This in turn, limits the realisation of mark-to-market losses as a result of spreads widening. In the current environment, we will continue to be discerning in terms of finding value and we feel it would be prudent to retain exposure to more liquid bank instruments, or shorter-dated instruments
(e.g. three-year tenors). As always, we feel it is appropriate to consider both listed and unlisted credit to ensure the widest possible range of credit opportunities in any investment decision.

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