Searching for assets

Following an eventful first quarter, the second quarter of 2018 was much more subdued in the South African listed credit market, in terms of issuance. While the first quarter issuance exceeded c.R31 billion, marginally below the issuance trend over the last 12 months.

The second quarter was characterised by a sharp reduction in issuance to c.R22 billion. This was mainly attributable to a material reduction in funding raised by financial institutions. Based on the primary and secondary market activity during the second quarter, the key themes in credit markets include:

  • Banks are exploring the development of a global funding base through the issuance of Eurobonds
  • A reduction in issuance is indicative of the weak economy, with businesses not requiring additional funding
  • Issuers are exploring funding avenues in both the listed and unlisted debt markets in order to achieve the best pricing
  • Demand for credit will continue to exceed supply resulting in spread tightening, especially in higher yielding instruments
  • Ongoing appetite for selected state-owned companies (SOCs) including Eskom government guaranteed bonds

1. Supply of assets
During quarter two, issuance reduced from c.R31 billion to c.R22.4 billion. On a year-to-date basis, issuance during the first half of 2018 amounted to c.R53.5 billion, a meaningful reduction from the issuance volumes of c.R68.5 billion recorded in the first half of 2017. The level of issuance during quarter two in 2018 is placed in perspective by the below facts: 

  • Issuance during April, May and June 2018 was lower than the 12-month rolling average in each month, which is currently trending at c.R11.8 billion per month
  • Issuance volumes during June 2018 of c.R3.5 billion was the third-lowest monthly issuance volume over the past five years
  • April 2018 was the first month no funding was raised by the financial services sector in the local debt capital market since December 2013

A summary of the quarter-on-quarter issuance during the first half of the year is presented below:

Source: Rand Merchant Bank

During the quarter, SOC issuance increased marginally to c.R7.8 billion compared to c.R7.3 billion during the first quarter. State-owned companies accounted for a substantial portion of issuance during the second quarter at c.35%. For the first six months of 2018, Eskom has been the largest issuer of debt in the market raising c.R9.8 billion of funding. Other SOCs that raised funding during the second quarter were the Industrial Development Corporation (IDC) and the Land and Agricultural Bank of South Africa (Land Bank). Eskom has accounted for c.65% of total funding raised by SOCs during the first of half of 2018, while Land Bank and IDC accounted for c.22% and c.9% respectively.

During quarter two, corporate issuance increased to c.R8.1 billion compared to c.R6.7 billion in quarter one and  accounted for c.36% of total issuance. Issuance by Mercedes Benz SA (c.43%), MTN (c.21%) and Telkom (c.18%) were the largest accounting for c.82% of total corporate issuance in quarter two in 2018.  

A combined c.R14.9 billion of funding was raised by 16 corporates in the first six months of 2018. However, five corporates have raised in excess of R1 billion each and accounted for c.71% of total corporate issuance in aggregate. The largest issuers during the first half of 2018 include Mercedes Benz SA (R4.5 billion), Netcare (c.R1.76 billion), MTN (R1.75 billion), Telkom (R1.1 billion) and Growthpoint (R1.1 billion). Nine of the corporates that have raised funding are property companies and accounted for c.31% of year-to-date (first six months of 2018) corporate issuance in aggregate.

Further, securitisation issuance increased materially from c.R431 million to c.R4.3 billion during the second quarter in 2018 to account for c.19% of total issuance during the quarter. Securitisations which raised funding during quarter two include Nitro (Wesbank), Thekwini (SA Home Loans), Nqaba (Eskom home loan finance) and Transsec (SA Taxi).
During the first quarter, financial institutions raised c.R16.3 billion, accounting for approximately 53% of all issuance. During the second quarter, financial institutions raised only c.R2.2 billion in the domestic market, accounting for c.10% of total issuance. As mentioned above, financial institutions did not raise any debt funding in domestic capital markets during April 2018, however, FirstRand Group and Barclays Africa raised US$500 million and US$400 million of tier 2 subordinated debt through the corporate issuance of Eurobonds in April 2018. 

2. Demand/Supply dynamics and pricing evolution
Auctions were well supported during the second quarter as investors continue to clamber for assets. The levels of support are evidenced by auction spreads for most issuers clearing within or below price guidance. Further, the spreads at which auctions have cleared are below the spreads earned during quarter one in 2018 and quarter two in 2017.

A comparison of spreads achieved by issuers between the second quarter and the most relevant comparable period is presented below:

Comparison of spreads
Source: Rand Merchant Bank

The table indicates a contraction in yields across all issuers, apart from Calgro. The most pronounced levels of tightening were experienced by the Land Bank and MTN. Further, Vukile Property Fund has been able to raise unsecured funding at tighter spreads than where it raised secured funding a year ago. 

During the second quarter, both the Thekwini and Transsec securitisations tapped the capital markets for the first time since quarter four in 2017. The Thekwini auctions outcome relative to quarter four in 2017 is presented below:

Thekwini and Transsec securitisations
Source: Ashburton Investments

The table indicates that demand for the Thekwini auction conducted in quarter four of 2017 was already strong with the higher yielding tranches clearing below price guidance. As a result, the price guidance for quarter two in 2018 auction was set at lower levels than the 2017 auction. Despite the lower price guidance for the same risk, the auction was more successful with pricing clearing below guidance for all but one tranche. 

The Transsec auction outcome relative to quarter four in 2017 is presented below:

The Transsec auction outcome relative to Q4 in 2017
Source: Ashburton Investments 

The outcome of the two Transsec auctions display similar trends to what was observed in the Thekwini auctions, with strong demand for the higher risk and higher yielding tranches, a reduction in price guidance and clearing spread for the same risk between the two auctions.

3. State-owned companies audit opinions
There have been murmurings of qualified audit opinions for SOCs over the last couple of weeks. This was confirmed on 23 July 2018 with Eskom’s release of its results for the year ended 31 March 2018. Eskom received a qualified audit opinion, mainly as a result of c.R19 billion of irregular expenditure which had been uncovered dating back to as far as 2012. Investors should be aware that there is a high likelihood of this becoming a common occurrence for the financial years ending 2018 and potentially stretching into 2019.

Following the appointment of Mr Cyril Ramaphosa as President of the Republic of South Africa and the appointment of Mr Pravin Gordhan as Minister of Public Enterprises, we have seen a large number of changes at board and executive management level across SOCs. 
The new management teams will aim to wipe the slate clean and expose procurement irregularities under previous management teams and boards in order to set the SOCs on more stable footing.
Although the issuing of qualified audit opinions is always a cause for concern, there will be some silver linings with regards to these developments in the short term, as it will show a willingness by the new management teams to eradicate the practices which may have occurred in the past.

These developments will likely delay the return of some of the SOCs to the listed credit markets in a meaningful manner, as investors will take a wait and see approach to determine if the turnaround strategies at the different SOCs are delivering sustainable results. 

4. National Scale Ratings update
A welcome development was the recalibration by Standard & Poor’s (S&P) of its mapping table for assigning National Scale Ratings (NSR) in South Africa (SA) on 28 June 2018. The recalibration of its mapping table has been expected since S&P downgraded the international scale foreign and local currency sovereign ratings of South Africa (SA) to BB and BB+ respectively in November 2017.
It is important to note, that the NSR of an issuer is not an express indicator of risk in the same manner as an international scale rating is. A NSR is an indication of the credit risk of an issuer relative to the sovereign, whereas the international scale rating is the product of the probability of default  of an issuer. 

A sovereign is typically assigned a NSR of AAA, as it generally reflects the lowest credit risk on offer in a country. Therefore, a mapping table should start at the local currency international scale rating assigned by the relevant rating agency, which then maps to a AAA NSR. Following the sovereign downgrade by S&P, its mapping table was not updated and commenced at BBB- despite the BB+ local currency international scale rating of SA. As a result, the BB+ international scale rating of the sovereign mapped to a AA NSR. The S&P mapping table has now been recalibrated to commence with BB+, resulting in the South African sovereign now mapping to a AAA NSR. This update, has aligned the NSR S&P assigns to the SA government to the other major rating agencies (Fitch Ratings and Moody’s).

A comparison between the previous and updated mapping tables of S&P and the current mapping tables of Fitch Ratings, Moody’s and Global Credit Ratings as at 30 June 2018 are presented below:

Previous and updated mapping tables
Source: S&P, Moody’s, Fitch & Global Credit Ratings

The table indicates that S&P now assigns an investment grade NSR to issuers that are assigned international scale credit ratings of B and higher. The mapping tables of Moody’s and Fitch Ratings are more conservative, with investment grade NSR being assigned to issuers with international scale credit ratings of B+ and higher. Finally, the threshold for entities being assigned AAA NSR’s for Moody’s is higher than for Fitch and S&P due to Moody’s assigning a higher international scale sovereign rating than the other rating agencies.
The recalibration by S&P has resulted in a number of NSR upgrades for South African issuers. It is important to note that the NSR upgrades of the issuers are not due to an improvement in their underlying credit quality but purely as a result of the recalibration of the mapping table. For example, the international scale rating by S&P of the major South African banks have remained unchanged at BB, however, the NSR’s have been upgraded from AA- to AA+. 
The recalibration will result in a number of inconsistencies in the credit markets being resolved such as:

  • The NSR of the SA government and government guaranteed SOC issuance will be assigned AAA NSRs across all rating agencies
  • The senior unsecured NSR for the major SA banks will now be AA+ by all the rating agencies

5. Ashburton Investments’ view
The current market dynamics holds some risk for investors. The strong demand for credit driven by a need to deploy capital could result in portfolio managers becoming forced buyers in every auction. Not only will this result in spreads continuing to drift lower, but it could also result in the build-up of concentration risks in portfolios both from a single counterparty and industry perspective (for example, the property sector which currently accounts for a material portion of corporate issuance). 
In addition, the sovereign rating downgrades over recent years have resulted in very few issuers in the SA credit market who are not assigned an investment grade NSR. In this environment, investors with conservative mandates must ensure that they are not exposed to outsized bets in risky, higher-yielding assets as a means 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, Ashburton Investments assigns an international scale rating to every credit exposure and is therefore governed by the true risk of an investment when adding investments 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, Ashburton Investments benefits from the flexibility of accessing both the listed and private credit markets during periods such as currently being experienced as this allows for greater diversification in the investible universe.

6. Conclusion

Despite the challenging environment, we believe the credit market still offers attractive returns to investors when comparing potential volatility and returns across other asset classes such as equities and government bonds.  We continue to see value in well-governed SOCs, tier 2 subordinated bonds issued by the major SA banks, and second-ranking tranches in securitisations which benefit from equity buffers and security. 
We believe the current status quo in credit markets will remain until there is a return of confidence in the SA economy. Increased confidence levels would likely result in the following:

  • Allocation by investors to riskier asset classes than money-market and cash-plus mandates, which 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 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 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.