Following President Cyril Ramaphosa’s declaration of a national state of disaster on 15 March 2020 to deal with the continuing spread of the Coronavirus (COVID-19) in South Africa, there has been little respite for domestic financial markets. Likewise, markets across the globe have continued to experience significant selling pressure. There has also been a lot of discussion regarding a global debt crisis, which has seen material sell-offs in global credit markets.
The President announced further measures to deal with the outbreak on 23 March 2020, effectively resulting in a 21-day lockdown of the South African economy, effective midnight 26 March 2020. Important to note, however, was the emphasis by the President on the commitment to keep financial markets functioning effectively, while also announcing a number of initiatives to support businesses and people which will be affected by the lockdown.
The international credit sell-off has been steep and ongoing fears of the deteriorating credit metrics of corporates are valid given the potential impact on corporate earnings of a global slowdown and the disruption of trade routes.
There are, however, fundamental differences to the South African credit market compared to more developed credit markets, which will result in local credit markets being less volatile during a period such as this, which include:
- Foreign investment in South African credit markets is almost non-existent.
- Following a protracted economic downturn and underperformance by equities, there have been significant inflows into interest-bearing and money market funds, which in turn resulted in increased demand for listed credit assets. The current volatility in equities could see this trend continue.
- The listed South African credit investment universe is relatively small, both in the number of borrowers and in the number of times that these borrowers tap the market. This has resulted in new supply struggling to keep up with the increased demand for listed credit assets as noted above.
- The majority of listed credit assets in South Africa are floating rate in nature, with duration being limited to 0.25 in most cases.
The above dynamics have led to a stable South African listed credit market where credit spreads have tightened over the last three years. In addition, there has been limited volatility in mark-to-market values of listed corporate bonds despite a number of potential credit events arising. This is mainly due to local investors adopting a “buy-and-hold” approach to listed credit, or because instruments were sold at a premium, or at par, to investors looking to deploy the ongoing inflows into this sector.
Given this backdrop, we continue to see a South African listed credit market that is characterised by lower levels of volatility than developed credit markets internationally. However, we are conscious of the fact that any one of the following factors could result in the supply, and volatility, of credit markets increasing:
- Managers selling credit assets at the expense of equity assets when generating cash so that current paper losses in equity assets do not need to be realised;
- Managers selling credit assets to take advantage of lower equity prices; and
- Investors allocating away from interest-bearing funds to cash in light of the volatility in global markets.
In addition, the impact of the COVID-19 virus will also be felt in the South African economy, as in the rest of the globe.
The key variables in terms of the impact relate to the severity of the measures implemented by the South African government, the period for which the measures are implemented and the larger global growth outlook.
When trying to contextualise the impact of the measures implemented by the South African government and other countries,
we are cognizant of the comments by Mohamed El-Erian (the chief economic adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-chief investment officer (2007–2014)) who recently introduced the concept of “sudden stop” economic dynamics. Although not fully defined as yet, an economic “sudden stop” can be seen as the immediate halt of any economic activity resulting in supply and demand shocks. While this is traumatic, but sometimes manageable, in the short-term,
it causes severe stress when these conditions carry on for a protracted period of time.
Following the initial measures announced on 15 March, there was an almost immediate impact on some South African corporates, especially entities involved in the tourism, hospitality, health and fitness and entertainment sectors as well as entities reliant on imports from markets which have been more severely impacted by the COVID-19 virus.
The latest measures implemented will in all likelihood affect almost all sectors of the economy, including: real estate, unsecured lending, retailers of non-discretionary items and manufacturing amongst others. Sectors we view as more defensive under the current conditions include food retailers and food producers, mobile telecommunications providers (given the increased demand for data and voice services as self-isolation and remote working is applied), along with gold mining companies, given the
safe-haven status of the commodity.
The extent of the impact, however, is dependent on the duration of the “sudden stop” conditions. Given the trying economic conditions in the South African economy over the last number of years, businesses are already strained and have therefore already done what they can to reduce costs. Consequently, a protracted period of slowdown will result in a reduced ability by corporates to service debt obligations in the form of interest and capital payments as they may arise.
Under such a scenario, lenders will have the ability to demand settlement of any debt obligations from borrowers. However, given the extraordinary circumstances of the situation, South African lenders may opt to be more accommodating in terms of allowing for interest to be capitalised or capital repayments to be deferred to some extent. This will most likely only be agreed to if lenders are of the view that the borrower may recover or that the eventual recovery of debt may be enhanced through such actions.
Recent examples of lenders working with distressed corporates to implement solutions where distress occurred include the likes of Tongaat and Steinhoff.
In conclusion, we do expect some deterioration in the financial positions of South African corporates, which may result in negative fair value adjustments or mark-to-market movements on credit exposures. Some of the larger entities may well be able to withstand a protracted shutdown, however, a material number of corporates may be faced with covenant breaches or an inability to service debt. This will result in an increased number of headlines regarding distressed corporates. The only certainty therefore is that the environment will become more trying, however, the extent of the downturn is largely down to the duration of any shutdown. In the event that the spread of the virus is sufficiently contained during the 21-day lockdown, the impact will be more manageable, however, the effectiveness of the 21-day lockdown unfortunately cannot be predicted at this time.
During times such as these, it is important to have exposure to a tried and trusted investment process which includes an ability to restructure distressed exposures with a view to achieving the best outcomes for investors. Ashburton Investments’ team of credit analysts and portfolio managers, complemented by the collective experience of the members of the Ashburton Investments Credit Committee, have such a process and are capable of dealing with the challenging times ahead.