South African credit markets – Will COVID-19 continue to influence spreads?

Introduction

The South African listed credit market experienced a challenging year in 2020. In this note we aim to contextualise the issuance levels relative to prior periods and look to provide some insights on supply/demand dynamics in the credit sector. We will also look at how this is expected to impact credit spreads through the first half of 2021.

Issuance levels

During 2020, issuance levels were the lowest since 2011 due to low economic activity and increased uncertainty during the Coronavirus (COVID19) related lockdowns. The table below provides an indication of issuance levels during 2020 and the first two months of 2021 relative to prior periods:

Issuances levels
Source: RMB Markets Research

Issuance levels of R92.4 billion in 2020 represented a decline of 47% year-on-year. Issuance during the months of April (R1.8 billion), May (R2.4 billion) and December (R2.0 billion) were particularly weak. The weak issuance levels during April and May were due to the most stringent COVID-19 lockdown regulations being in place during this period. It is not uncommon for the South African listed credit markets to “dry up” during times of uncertainty, as evidenced in the past with material market events such as when African Bank was placed under curatorship (August 2014) and when former Minister of Finance Nhlanhla Nene was removed from his post (December 2015).   

From a sector perspective, bank issuance, which usually accounts for the largest share of listed credit issuance declined by c.52% year-on-year, with particularly senior unsecured issuance declining materially by more than 72% year-on-year. In addition, corporate issuance and state-owned company (SOC) issuance declined by c.44% and c.46% respectively year-on-year.

The weak senior issuance by banks was mainly driven by the weak economy and reduced demand for new credit extension in light of the economic contraction as well as risk aversion from corporates regarding capital expenditure amidst the uncertainty. These factors also impacted the demand for new funding from corporates. In addition to limited additional funding, a number of corporates also opted to approach the banks rather than debt capital markets for funding. This is not uncommon in good times but it is exacerbated during economic uncertainty as a large proportion of South African corporates still rely on the South African banks for the majority of their funding needs.

Finally, SOC fundraising was impacted mainly by the default of the Land Bank. This in turn resulted in appetite for most SOCs reducing in the listed credit market. As a result, the SOCs opted to approach international Development Finance Institutions and banks for the majority of their funding requirements.

Issuance during 2021 got off to a slow start, with January issuance only amounting to c.R500 million and February recovering slightly to c.R2.5 billion. Most research houses expect issuance to be flat year-on-year.

Pricing developments

Apart from the period March through July 2020, demand for credit from investors remained elevated during the year, given the uncertain outlook for growth assets. This demand did, however, fluctuate between sectors, with bank senior and subordinated paper initially being favoured above other sectors. The returning demand for credit assets, combined with weak supply, resulted in a challenging environment for the deployment of cash into credit.

The level of credit re-pricing between March and July 2020 was last seen during 2014 when African Bank was placed under curatorship. The graph below sets out the weighted average credit spread of bank issuance across the capital structure which were in issue in March 2020 (pre COVID-19 lockdowns) and which remained in issue as at the end of February 2021.

Non SNR

Source: Standard Bank Research

The graph above indicates that bank issuances re-priced shortly after the COVID-19 related lockdowns were implemented. This was due to instruments issued by banks typically being the most liquid, along with concerns regarding the potential impact of rising non-performing loans on the financial health of the banks. Managers that required liquidity therefore looked to sell bank instruments first to raise the required amounts. The more pronounced spread widening in the subordinated instruments reflects the higher risk on these instruments as they rank lower in the capital structure compared to senior instruments. In addition to liquidity pressures, a number of non-traditional credit investors were holders of the subordinated instruments issued by the banks across multi asset portfolios. The holdings were motivated by the attractive yields that these instruments offered during a time when growth assets were under-performing. When the equity and government bond sectors sold off in mid-March 2020, a number of these investors were forced to liquidate these holdings to ensure portfolios were appropriately rebalanced, hence the upward pressure on spreads.

Spreads on bank instruments peaked towards the end of April as the initial selling pressure abated. The average spreads on bank senior unsecured issuance has subsequently tightened to levels below pre COVID-19 lockdowns. This tightening was mainly due to banks not requiring significant funding, which created a supply/demand mismatch benefitting the banks. More meaningful spread compression in the subordinated instruments commenced from mid-August after banks reported their first results post the COVID-19 lockdowns. Despite elevated provisioning, banks remained well capitalised and liquid, which provided investors with more comfort on these instruments. The tightening trends in these instruments have continued, especially spreads on additional tier 1 instruments trending back towards levels seen pre COVID-19 lockdowns.

The graph below sets out the weighted average credit spread per sector on instruments which were in issue in March 2020 (pre COVID-19 lockdowns) and remained in issue as at the end of February 2021.

Non Bank _vs Bank Snr

Source: Standard Bank Research

Subordinated instruments issued by the major insurers were also impacted in the early sell-off during March/April. The spreads have, however, continued to trend downwards due to the strong capitalisation levels of the issuers despite provisions raised for increased claims. Corporate and SOC spreads were slower to react to the lockdowns, but this is in line with the lower liquidity in these instruments. Spreads on corporate issuance, excluding Real Estate Investment Trusts (REITs), peaked in August and have trended downwards since as investors gained appetite for high quality credit to offset the lower returns on bank senior instruments. The corporate issuers generally consist of large corporates which had low gearing and strong liquidity at the commencement of the lockdowns. Further, corporates implemented a number of cost saving measures to limit the impact of COVID-19 lockdowns on earnings.

The two sectors where spreads have been impacted the most are the REITs and SOCs. Real Estate Investment Trusts generally have higher gearing than corporates and therefore had less financial flexibility. In addition, the valuations of properties have been questioned resulting in REITs such as Redefine and Accelerate requesting investors to amend loan-to-value covenants in order to avoid breaching financial covenants and thereby triggering events of default. The SOC spreads were mainly impacted by the Land Bank default which resulted in increased concerns from investors for other SOCs such as the Industrial Development Corporation and the Development Bank of Southern Africa. SOC and REIT spreads, however, appear to have stabilised but have not retraced to the same extent as other sectors.

Conclusion

We do not expect to see the quantum of flows into short-term interest-bearing mandates that was observed over the last few years. This is due to the declining JIBAR rate during 2020 (in excess of 350 basis points following interest rate cuts by the South African Reserve Bank) reducing the total return on listed credit relative to other asset classes such as government bonds and equities.

Despite the outlook for reduced flows, the assets under management in this category are substantial. Therefore, the low cash returns and ongoing instrument maturities will continue to drive demand for listed credit, at least during the first half of 2021. The muted issuance outlook will result in demand for listed credit continuing to outpace supply. This imbalance will challenge credit managers through; a continued compression in credit spreads; ability to deploy; and achieving sufficient diversification in portfolios.

In an environment such as this, where opportunities are limited and risk remains heightened, we recommend continuing to deploy on a cautious basis where opportunities are attractive on a fundamental basis.  We will continue to apply a cautious approach to deploying credit.  Our aim remains to enhance returns and diversification by sourcing credit through alternative sources such as using our scale to proactively approach issuers for private placements and sourcing unlisted credit through regulatory compliant structures.