Credit Insights - Demand continues to outpace supply

a) Introduction

The second quarter of 2019 was characterised by strong issuance volumes during April (R17.8 billion) and June (R20.5 billion), with issuance during May (R12.5 billion) being impacted by the lead up to the general elections. Issuance volumes in April 2019 were driven by banks raising funding ahead of the general elections. June 2019 issuance from banks was reasonable, but the main driver in issuance volumes was from the corporate sector, specifically well-rated corporates issuing for the first or second time during 2019.

Total listed credit issuance during the second quarter of 2019 was c.R50.8 billion which exceeded the issuance during the second quarter of 2018 by c.R28.3 billion, and comfortably exceeds the quarterly issuance trend over the last 12 months of
c.R37.0 billion. The strong issuance levels were initially attributable to banks prefunding in light of the upcoming elections. Following the elections, banks returned to the listed credit markets during June to take advantage of the ongoing demand for yield in their subordinated instruments such as tier 2 subordinated (T2) notes and additional tier 1 (AT1) notes. In addition, corporates appear to be taking advantage of the current tightening credit spread environment to raise funding.

Based on the primary and secondary market activity during quarter two, the key themes in credit markets include:

  • Demand for credit continues to exceed supply resulting in spread tightening, especially in higher yielding and longer-term instruments. However, the rate of spread tightening appears to be slowing.

  • Banks are actively bidding in corporate issuances to source high quality liquid assets (HQLA), which is limiting supply to traditional marketb participants and causing a tightening in spreads.

  • Spreads on senior unsecured issuance by banks appear to have bottomed in the 3-year instruments but continue to tighten in the 5- to 10 – year tenors as investors are searching for additional yield by harvesting the term premium on longer-dated credit instruments.

  • Corporate issuers have responded to the favourable supply/demand dynamics in the listed credit markets with 22 corporate issuers during the first half of 2019 compared to 23 issuers during the entire 2018.

  • There has been strong support for less frequent issuers as investors look to diversify credit portfolios. However, there has been some widening in spreads on instruments issued by more regular issuers during the first half of 2019 such as Redefine Properties and Growthpoint Properties.

b) Supply of assets

During quarter two, issuance increased c.126% year-on-year from c.R22.4 billion to c.R50.8 billion. On a quarter-on-quarter basis, issuance increased c.43% from c.R35.5 billion to R50.8 billion.

A summary of the quarter-on-quarter and year-on-year issuance during the second quarter of the year is presented below:

Supply of assets
Source: RMB Global Markets Research

During the second quarter of 2019, banks raised c.R21.1 billion, accounting for approximately 42% of all issuance. The majority of the issuance occurred during April 2019, amounting to c.R10.8 billion. The issuance volumes of banks during the quarter was the highest quarterly issuance since the first quarter of 2015. The bank issuance was split c.50/ 50 between senior unsecured and subordinated funding (T2 and AT1) during the quarter. The high level of issuance during April was mainly due to banks aiming to complete a material portion of their funding requirements prior to the elections during May 2019, while funding increased again during June as banks took advantage of the tightening credit spread environment. The largest issuers of senior unsecured bonds were Standard Bank (c.R4.6 billion) and Investec Bank (c.R2.0 billion) followed by Nedbank (c.R1.7 billion) and FirstRand
(c.R1.2 billion). All the large diversified banks, apart from Investec, issued subordinated instruments during the quarter with Nedbank (c. R3.4 billion) being the largest followed by Absa (c.R3.3 billion), FirstRand (c.R2.8 billion)
and Standard Bank (c.R1 billion).

During the quarter, State-Owned Companies (SOCs) issuance amounted to c.R9.8 billion, the highest quarterly issuance levels since the second quarter of 2016. State-Owned Companies accounted for c.19% of issuance during the second quarter. The increased issuance was by four SOC’s namely Eskom (c.R3.8 billion), the Development Bank of Southern Africa (c.R3.6 billion), the Land and Agricultural Bank (c.R1.6 billion) and the Industrial Development Corporation (c.R800 million). The absence of Transnet and the South African National Roads Agency (SANRAL) from the listed credit markets continues to add to the ongoing shortage of supply in the general market. It was, however, encouraging to see Transnet being able to raise R600 million of commercial paper since March 2019. Finally, SANRAL did enter the listed credit market during July 2019, raising R2.2 billion of government guaranteed funding.

During quarter two 2019, corporate issuance increased by c.95% year-on-year and c.48% quarter-on-quarter to c.R15.9 billion, the highest issuance levels we have on record going back to 2012. Corporate issuance accounted for c.31% of total issuance during quarter two 2019. Issuances by Growthpoint Properties (c.22%), MTN (c.22%), Old Mutual Life (c.21%), Telkom (c.21%) and Bidvest (c.14%) were the largest; accounting for c.59% of total corporate issuance in the second quarter.

During the first half of 2019, 22 corporates have raised funding in the listed credit markets compared to 23 corporates raising funding during the whole of 2018. Further, diversification in issuance volumes has improved. Mercedes-Benz SA retained its position as the largest corporate issuer, however, its share of issuance volume has reduced to c.21% compared to levels in excess of 30% during prior years. Further, eight property REIT’s have raised funding accounting for c.26% of total issuance volume, while the balance (c.53%) is spread across 13 different corporate issuers.

Securitisation issuance was lower year-on-year but increased materially compared to quarter one of 2019. FirstRand’s automotive loan securitisation vehicle, Nitro, was the largest issuer during the quarter raising c.R2.1 billion or c.51% of total securitisation issuance.

c) Demand/supply dynamics and pricing evolution

In general, auctions received strong support during the quarter, with investors and banks supporting most corporate and SOC issuances. In addition,subordinated debt auctions by the South African banks received strong support, while spreads on senior unsecured bank issuance remained flat in the 3-year space but continued to tighten in longer-dated instruments.

South African banks

The tightening of spreads over the last two years on senior unsecured issuance by the big four South African banks
(Absa, FirstRand Bank, Nedbank and Standard Bank) is presented below:

South african banks
Source: Ashburton Investments and RMB Global Markets Research

The table illustrates the following:

  • Credit spreads for three-year senior unsecured bank paper appears to have bottomed and stabilised at J+115 basis points.

  • Credit spreads on the five-year and seven-year senior unsecured issuance have continued to tighten, indicating the willingness of investors to take exposure to longer dated instruments in order to earn a higher yield. This in turn has resulted in the term premiums tightening.

The tightening in credit spreads in subordinated instruments issued by the big four banks over the last two years relative to senior unsecured instruments is presented below:

Tightening in credit spreads
Source: Ashburton Investments and RMB Markets Research

The table illustrates the following:

  • Credit spreads for subordinated instruments continue to tighten at a faster pace than senior unsecured issuance driven by demand from both traditional fixed income and multi-asset investors for higher yielding instruments.

State-owned companies

A high-level overview of the credit spread movements on SOC issuance is presented below:

State owned companies
Source: Ashburton Investments and RMB Global Markets Research

The table indicates that the DBSA and IDC have continued to see tightening credit spreads but at a much slower rate than that of the Land Bank. The ability of all these entities to start issuing longer-dated instruments relative to recent history confirms the willingness of investors to benefit from the higher yield offered by longer-term instruments.

The DBSA and IDC have historically been well supported by listed credit investors due to strong governance structures and sustainable capital structures.

The Land Bank continued to raise funding on tighter spreads due to its improved financial performance and governance.
The tightening is more pronounced for the Land Bank due to it having had higher legacy funding costs compared to the other SOC’s which are now converging.

Corporate auctions

There was strong support for the majority of corporate auctions during the second quarter of 2019. This was most clearly reflected by some of the largest issuances during June 2019 as illustrated in the table below:

Corporate auctions
Source: Ashburton Investments and RMB Global Markets Research


Capitec

Source: Ashburton and RMB Global Markets Research

The table shows that corporate auctions were generally well supported during the quarter, specifically the Bidvest, Exxaro, Capitec and Super Group auctions. This is evidenced by the subscription cover ratios and spreads clearing below or at the lower end of pricing guidance. These strong support levels are most likely due to these corporates not being regular issuers, with investors using the opportunity to diversify portfolios.

The exception to the strong support levels were the auctions by Growthpoint Properties. This is evidenced through the widening of the credit spreads on its five-year and seven-year instruments during the quarter compared to its last issuance in December 2018.

The table further indicates that Growthpoint is no longer issuing paper at tighter spreads than the big four South African banks, as was the case for much of the second half of 2018. The widening of spreads on the Growthpoint issuance is probably due to the large issuance volumes by the company during the fourth quarter of 2018 (R1.1 billion) and the first half of 2019 (R2.35 billion) which may have limited the capacity of investors to take up additional exposure to the issuer.

Change in spreads

d) Where to from here?

To understand the current market dynamics of ongoing tightening in credit spreads, one has to understand the drivers behind supply and demand for credit assets. The demand for credit assets from traditional listed credit investors is mainly driven by positive real interest rates in South Africa. Real rates are a function of the South African economy achieving low real GDP growth rates for a number of years, whilst inflation has been muted resulting in low nominal GDP growth rates. Against the backdrop of low nominal GDP growth, the South African Reserve Bank has remained cautious with interest hiking and cutting cycles being benign. These real interest rates have resulted in a period where money-market and cash-plus mandates are able to deliver inflation-beating returns without taking excessive risk.

Demand for credit assets has been further enhanced due to the requirements of banks to hold HQLA instruments and
multi-asset funds considering higher yielding credit instruments to provide returns during a period of uncertainty and muted performance in the traditional growth asset classes.

Finally, supply of credit assets has remained muted as borrowers are generally cash flush and not embarking on any material capital expansion projects.

Based on Ashburton’s economic outlook, inflation and real GDP growth will continue to remain muted through to the end of 2020. In addition, the current interest rate cutting cycle by the SARB is expected to be shallow, resulting in the positive real interest rate scenario persisting at least until the end of 2020. In that scenario, there is room for further tightening in credit spreads. This applies mainly to corporates or securitisations that issue new instruments with less frequency. Further, investors will continue to have appetite for higher yielding subordinated instruments (issued by banks or securitisations) and will continue to prefer the longer-dated instruments that offer the benefit of the term premium.

The current market dynamics are driven by the ongoing supply/demand mismatch in credit markets which is expected to remain until there is a return of confidence in the South African economy. Increased confidence levels would likely result in the following:

  • Allocation by investors to riskier asset classes than money-market and cash-plus mandates that will result in lower inflows and some outflows from lower risk mandates which in turn will reduce the demand for credit assets.

  • Issuers will be more willing to expand operations which will result in additional supply of credit to the market.

Further, a meaningful return to the listed credit markets by SOCs such as SANRAL, Eskom and Transnet may result in additional supply coming to the market. These SOCs have historically accounted for more than 20% of issuance in the listed credit markets. Should the finances and governance at these entities be restored to levels where portfolio managers gain comfort to start investing in their paper, it may result in a further release of the current tight supply/demand dynamics being experienced in the market.

e) Conclusion

The listed credit markets are expected to continue offering stable inflation-beating returns to investors against a backdrop of positive real interest rates, unpredictable equity market returns and uncertainty in global financial markets. However, risks remain for investors as the ongoing demand for credit driven by continued fixed interest portfolio inflows may result in portfolio managers becoming forced buyers in every auction. This will result in spreads continuing to drift lower and investors taking on longer-term risk to gain additional returns and it may also lead to higher levels of concentration in portfolios both from a single counterparty and industry perspective.

Ashburton Investments is of the view that credit spreads will remain muted in the current environment, however at some point the conditions will change and credit spreads will start to widen. As a result, investors should beware of investing in longer-dated instruments solely for the purposes of picking up an additional term premium which is offering limited value. The risk is that one will be locked into lower yielding instruments at a time when opportunities to take advantage of widening credit spreads may present themselves. Ashburton Investments therefore currently favours a shorter average term in its credit portfolios and we are less enthusiastic about participating in the seven and ten year corporate issues where we see less relative value.

It is important to note that the downgrades of the South African sovereign credit rating resulted in almost all domestic issuers, no matter what their underlying fundamentals, being assigned investment grade ratings, on the national scale. In this environment, investors with conservative mandates must ensure that they are not exposed to outsized bets in risky, higher-yielding assets to offset the tightening in credit spreads.

Ashburton Investments implements a strict credit limit framework across single counterparties, credit rating bands and issuers which is aimed at avoiding unwanted concentrations in portfolios. Further, we assign an international scale rating to every credit exposure and we are therefore governed by the true risk of an investment when adding counterparties to credit portfolios.

In addition, Ashburton Investments has sufficient scale to approach issuers for private placements of listed instruments while also participating in primary auctions. Finally, our clients benefit from the flexibility that we have to access both the listed and private credit markets during periods such as the one currently being experienced as this allows for greater diversification across a wider investible universe.