Ashburton Investments credit insights - Nearing the bottom

a) Introduction

After a slow start to 2019, the listed credit market came to life during February and March. Credit issuance in February was mainly supported by significant issuance by banks, with corporates also accessing the market in a meaningful way during March.

Total listed credit issuance during the first quarter of 2019 was c.R35.5 billion which exceeded the issuance during the first quarter of 2018 by c. R4.5 billion, and comfortably exceeding the quarterly issuance trend over the last 12 months of
c.R29.9 billion. The strong issuance levels are mainly attributable to banks prefunding in light of the upcoming elections and pronouncements by Moody’s on the South African sovereign rating, while also taking advantage of the ongoing demand for yield in their subordinated instruments such as additional tier 1 (AT1) notes. In addition, corporates appear to be taking advantage of the current tight credit spread environment to raise funding.

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

  • Corporate issuance remains concentrated in a small number of highly rated issuers, with opportunistic entry into the bond market by less frequent issuers, mainly via private placement.
  • Banks are actively bidding in corporate issuances to source high quality liquid assets (HQLA), which is limiting supply to traditional market participants and causing a tightening in spreads.
  • Demand for credit continues to exceed supply resulting in spread tightening, especially in higher yielding instruments. However, the rate of spread tightening appears to be slowing.
  • Spreads on senior unsecured issuance by banks appear to have bottomed out over the last nine months since July 2018.
  • State-owned companies (SOCs), especially Eskom, continue accessing the listed credit market following improved access during 2018.

b) Supply of assets

During quarter one, issuance increased c.14% year-on-year from c.R31.0 billion to c.R35.5 billion. On a quarter-on-quarter basis, issuance increased c.15% from c.R30.9 billion to R35.5 billion.

A summary of the quarter-on-quarter and year-on-year issuance during the first three months of the year is presented below:

supply of assets

During the first quarter of 2019, banks raised c.R17.8 billion, accounting for approximately 50% of all issuance. The majority of the issuance occurred during February 2019, amounting to c.R11.5 billion. The issuance volumes of banks during the quarter was the highest issuance levels in a quarter since the third quarter of 2017.

The banks issued mainly senior unsecured (c.R12.6 billion) and AT1 (c.R5.2 billion) paper during the quarter. The high level of issuance is mainly due to banks aiming to complete a material portion of their funding requirements prior to the Moody’s announcement on the sovereign rating of South Africa as well as prior to the elections scheduled for May 2019. The largest issuers of senior unsecured bonds were FirstRand (c.R3.1 billion) and Standard Bank (c.R3.0 billion) followed by Nedbank
(c.R2.9 billion) and Absa (c.R2.8 billion). All the banks, apart from Absa, issued AT1 instruments during the quarter with FirstRand  (c. R2.5 billion) being the largest followed by Standard Bank (c.R1.9 billion) and Nedbank (c.R671 million).

During the quarter, SOC issuance amounted to c.R6.0 billion, the highest issuance levels since the second quarter of 2018.
State owned companies accounted for c.17% of issuance during the first quarter.
The increased issuance was by only three SOCs namely the Industrial Development Corporation (c.R2.65 billion), Eskom (c. R2.3 billion) and the Land and Agricultural Bank     (c.R1 billion). The absence of Transnet and the South African National Roads Agency 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
R200 million of 12-month commercial paper during March 2019.

During quarter one 2019, corporate issuance increased by c.60% year-on-year and c.19% quarter-on-quarter to c.R10.7 billion. Corporate issuance accounted for c.30% of total issuance during quarter one 2019. Issuances by Mercedes-Benz SA (c.42%), Redefine Properties (c.22%), MMI (c.7%) and Investec Property Fund (c.7%) were the largest, accounting for c.77% of total corporate issuance in quarter one.

Thirteen corporates have raised funding in the listed credit markets during the first quarter of 2019. However, issuance remains concentrated among the largest issuers, especially Mercedes-Benz SA. The material issuance volumes by Mercedes-Benz SA is used to fund the vehicle finance requirements of the business. The Mercedes-Benz SA issuance benefits from a group guarantee resulting in a AAA rating, which provides favourable funding rates and accessibility to the markets to term out its funding profile at more favourable rates. Five of the corporates that have raised funding are property companies and accounted for c.36% of year-to-date issuance in aggregate.

Securitisation issuance was subdued during the quarter with only R890 million in funding raised accounting for c.2.5% of total issuance during the quarter. A total of R880 million of the issuance was from Transsec 4, a new securitisation vehicle used by SA Taxi to fund a portion of its loan book. The decline in securtisation issuance is mainly due to the strong issuance levels recorded during the final quarter of 2018, which amounted to c.R3.4 billion.

c) Demand/Supply dynamics and pricing evolution

Auctions experienced mixed support during the quarter, with strong support for most corporate and SOC issuances. In addition, AT1 auctions by the South African banks received strong support, however, spreads on senior unsecured bank issuance either remained flat or increased marginally.

South African banks

A summary of the senior unsecured auctions concluded by the big four South African banks is presented below:

SA Banks

The table illustrates the following:

• Support for senior unsecured bank paper remains strong with all the auctions well supported.

• The market still prices very similarly across the four largest South African banks.

• The margins on three-year (JIBAR + 109.5 basis points) and five-year (JIBAR + 129 basis points) senior unsecured bank issuance appear to have bottomed in July 2018, with slight increases during recent auctions.

• The margins on the seven-year and ten-year senior unsecured issuance have continued to tighten marginally, 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.

A summary of the AT1 auctions concluded by the big four South African banks is presented below:

SA Banks 2

The table confirms the continued demand for higher yielding instruments. Indications are that a number of multi-asset investors have appetite for AT1 assets given the current returns provided by equity.

AT1 instruments have experienced a material contraction in spreads over the last 18 months, with issuance in quarter three of 2017 being at JIBAR+ 565 basis points, indicating the impact of strong demand on credit spreads. During the same period (September 2017), credit spreads on five-year senior unsecured bank instruments were at JIBAR + 145 basis points, indicating a multiple of AT1 to senior unsecured spreads of 3.9x. As at March 2019, this multiple has reduced to 3.1x, indicating the increased contraction in spreads on AT1 instruments relative to senior unsecured instruments over the last eighteen months.

A high-level overview of the largest auctions concluded by corporates, SOC’s and securitisations during the quarter are presented below:

State owned companies auctions

State owned company auctions

State owned auctions 2

State owned auctions 3

The tables illustrate that the IDC and Landbank auctions were well supported, however, the DBSA auction was disappointing as it was unable to issue its targeted amount. The reason for the weaker support of the DBSA auction could be due to a number of factors including tighter spreads relative to the Landbank and IDC despite similar credit ratings, timing of the issuance (at the end of a quarter which had strong issuance levels), as well as lesser support from banks in the auction.

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

The spreads in the IDC and DBSA auctions mainly tightened in the five-year instruments illustrating investors’ search for yield. Investors continue favouring longer-dated instruments in order to harvest a higher term premium. This is further illustrated by the ability of the DBSA to issue a 10-year floating rate instrument.

Corporate auctions

Corporate auctions 2

Corporate auctions 3

Corporate auctions were generally well supported during the quarter with the exception of the second auction by Redefine.
This is probably due to the large issuance volumes by Redefine during the fourth quarter of 2018 and the first quarter of 2019 which may have limited the capacity of investors to take up additional exposure to the issuer.

The Investec Property Fund auction was exceptionally well supported, with spreads being very close to those achieved by Redefine despite the difference in the credit rating. In addition, the MMI subordinated debt auction was also well supported with issuance by this sector continuing to tighten on the back of strong demand.

Other auctions

The outcome of the Transsec 4 auction in comparison to the Transsec 3 pricing levels is presented below:

Other auctions

The Transsec 4 auction was well supported, especially the B class notes which illustrate the ongoing search for yield among investors. This is leading to a continued tightening of spreads on higher risk instruments which include AT1 issuance by the South African banks.

d) Are we at the bottom yet?

This is not an easy question to answer. In certain cases, it appears that a floor has been reached for credit spreads, however, for specific issuers or instruments there is still room for further spread tightening.

In the case of issuers where traditional listed credit investors are the main participants (i.e. bank senior unsecured issuance, certain SOCs and securitisations), a floor may have been reached. This will, however, be tested on an ongoing basis to the extent investors continue to prefer money-market and cash-plus mandates to more aggressive growth mandates. In such a scenario, the strong demand may well result in spreads continuing to tighten.

We expect further credit spread tightening in corporate issuance which will be driven mainly the appetite of the large South African banks for HQLA assets, along with the diversification benefits for traditional listed credit investors in adding additional corporate names to a portfolio.

Finally, spread tightening will continue in higher yielding instruments such as subordinated instruments issued by banks and securitisations, which will be mainly driven by investors searching for additional yield in the current credit spread environment.

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

Overall, the listed credit markets still offer stable inflation-beating returns to investors against a backdrop of unpredictable equity market returns and uncertainty in global financial markets. Despite the value proposition, the dynamics in the credit markets do pose some risks for investors.

The ongoing demand for credit driven by a need to deploy fixed interest flows could result in portfolio managers becoming forced buyers in every auction. Not only will this result in spreads continuing to drift lower and investors taking on longer-term risk to gain additional returns, it may also result in higher levels of concentration in portfolios both from a single counterparty and industry perspective.

Further, the downgrades of the South African sovereign credit rating resulted in almost all issuers in the South African credit market, no matter what their underlying fundamentals, being assigned investment grade, national scale ratings. 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, 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 currently being experienced as this allows for greater diversification in the investible universe.