Like sands through the hourglass: A summary of credit markets in 2019 and what to expect in 2020

1. Introduction

Listed credit offered stable, inflation-beating returns to investors during 2019. Considering the volatility and uncertainty across other asset classes, these characteristics have resulted in growing interest from investors.

As we emerge from the December slumber and before our diaries start to fill up, we have an opportunity to explore some of the developments in listed credit markets during the last twelve months.

In summary, demand for listed credit assets continued to outpace supply during 2019, a dynamic which has been in effect since the second half of 2016. As a result of this trend, we continued to see credit spreads drifting lower over the last year.

The factors driving the continued demand for listed credit remained intact during 2019 (to be discussed below), however, there were some responses in the market on the supply of listed credit, which will also be addressed in more detail below.

2. Demand for listed credit

The ongoing demand for listed credit during 2019 was driven by several factors including:

  • uncertainty and negative investment sentiment which led to a re-allocation by investors to lower risk asset classes;
  • appetite by banks for High Quality Liquid Assets (HQLA); and
  • the search for yield by investors who had not traditionally invested in the listed credit market to offset a muted outlook in more risky asset classes.

Asset re-allocation:

Over the last three years, investors have allocated to asset classes with lower risk and volatility. Given the floating rate nature of most listed credit currently being issued, and South Africa’s history of relatively subdued credit losses, many investors have opted for cash and money market plus (MM+) type portfolios. These mandates account for a material share of the traditional investor base in the South African listed credit market.

Assets under management (AUM) for South African Collective investment schemes (CIS) increased by 7% to R2.143 billion from December 2017 to September 2019 (December 2019 data has not yet been published). During this period fAUM related to the equity component decreased by 8.2% (to R380.5 billion) over the same period while the interest-bearing portion increased by 24.3% (to R648.3 billion).

The investment environment in 2019 did little to arrest this trend. While the Johannesburg Stock Exchange (JSE) All Share Index (ALSI) total return for 2019 exceeded 12%, the returns were driven in large part by historically volatile resources counters. Volatility also remains one of the main attributes of South African government bonds given the uncertain outlook regarding the credit rating of the sovereign, the weak domestic economy and political uncertainty, along with increased uncertainty in the global political and economic environment. With this background and some of the better performing MM+ portfolios providing less risky returns in the region of CPI+4%, investors had little incentive to alter their reallocation tendencies in 2019.

Bank demand for HQLA:

Following the introduction of Basel III, banks are required to hold more capital against the assets they traditionally originated (i.e. term loans to corporates and state-owned companies). The regulations incentivise banks to hold instruments which qualify as HQLA’s as these instruments require lower levels of capital to be held by banks against them. The listed credit market, especially issuance by highly rated corporates, provide the banks with such a source of HQLA. Banks have aggressively bid in auctions by well rated corporates resulting in tightening credit spreads and lower volumes of listed credit available to more traditional market participants, such as MM+ portfolio managers.

Search for yield:

Given the muted equity returns in the years leading up to 2019 and increased volatility in government bonds following the deterioration in the fiscal position of the country, investors which have not traditionally been invested in listed credit have entered the market. Mandates such as multi-asset and balanced funds are increasingly investing in listed credit, given the inflation-beating returns and low volatility on offer.

In addition, these investors are participating in higher yielding instruments such as subordinated debt issued by banks, insurance companies and securitisations in order to replace or supplement the meagre returns that have been a recent feature of traditional growth assets (i.e. equity).

3. Supply of listed credit

 Issuers of credit have not been blind to the demand dynamics and the favourable fund raising environment that it has

created and there have been some notable responses in terms of supply of listed credit including:

  • Total listed credit issuance (excluding the sovereign) for 2019 at c.R169 billion is the highest issuance volume on record and represented a c.46% increase in year-on-year issuance.
  • First-time issuers in the South African listed credit market during 2019 included Equites Property Fund, while Sasol issued its first bond in South Africa since 2003.
  • Several corporates and non-bank financials raised funding in the listed credit market after being absent for at least the entire 2018 such as: Fortress, Northam Platinum, Momentum Metropolitan Life, Old Mutual Life, Lombard Insurance, KAP Industrial Holdings and African Bank (ABIL).
  • There was meaningful issuance from SOCs such as the South African National Roads Agency (SANRAL), Transnet and the Development Bank of Southern Africa (DBSA) after several years of insubstantial or a complete absence of issuance.
  • Issuance by banks and financials during 2019 recovered strongly (in excess of 55%).

The charts below provide additional insights into the listed credit issuance trends of 2019:

Chart 1: Gross issuance volumes

Chart 1_Gross issuance volumes

Source: JSE, RMB Global Markets (data as at 31 December 2019)

Chart 2: Share of gross issuance volumes

Chart 2_ Share of fross issuance volumes

Source: JSE, RMB Global Markets (data as at 31 December 2019)

Charts one and two indicate that issuance growth was strong across all of the major sectors, with the most material increases observed in issuance by SOCs and Banks and Financials. Banks and financials continued to account for the majority of listed credit issuance during 2019, with corporates again providing the second largest source of supply. The share of corporate issuance, however, reduced when compared to 2018 due to strong growth experienced in SOC issuance.

Banks and financials issuance increased by 55.2% to R72.9 billion. This followed a year of subdued domestic issuance by banks in 2018 which was impacted by banks raising material funding in 2017 and banks electing to raise offshore funding rather than in local markets during 2018.

The trends in bank issuance (excluding other financials) are presented below:

Chart 3: Gross bank issuance (excl. financials)

Chart 3_Gross bank issuance (excl. financials)

Source: JSE, RMB Global Markets (data as at 31 December 2019)

Chart 4: Gross corporate issuance


Chart 4_Gross corporate issuance
Source: JSE, RMB Global Markets (data as at 31 December 2019)

Charts three and four above indicate the strong recovery in senior unsecured issuance by banks during 2019. Further, banks continued to take advantage of tightening spreads in Additional Tier one (AT1) instruments, with the highest level of issuance of these types of instruments since it was introduced in the South African market. Of note, African Bank was able to raise senior unsecured funding in the listed credit market for the first time since 2016.

Corporate issuance increased by 31.9% to R44.6 billion, the largest level of issuance on record. The increase follows a slowdown in issuance during 2018. The growth in corporate issuance illustrates the response by issuers to the continued demand and favourable pricing environment for listed credit.

Chart 5: Share gross corporate issuance

Chart 5_Share gross corporate issuance

Source: JSE, RMB Global Markets (data as at 31 December 2019)

Chart 6: Gross SOC issuance

Chart 6_Gross SOC issuance

Source: JSE, RMB Global Markets (data as at 31 December 2019)

Chart six illustrates the improved diversification in corporate issuance during 2019. Mercedes-Benz South Africa (MBSA) continued being the largest issuer, as it has been for the past number of years, but its share of total corporate issuance declined to below 20% for the first time since 2013. Property counters continued to take advantage of the ability to issue senior unsecured bonds, as opposed to the typically secured funding that could have been obtained from banks, accounting for 30% of issuance.

Other than MBSA and the property counters, MTN was the largest issuer during 2019 with eight other corporates raising in excess of R1billion (Northam Platinum, Telkom, Bidvest, Sasol, Toyota Financial Services, KAP Industrial Holdings,Super Group and Exxaro).

In total, there were 25 corporate issuers in 2019 (21 corporate issuers in 2018), the highest number of corporate issuers since 2014.

 State-owned company issuance increased by 72.8% to R35.8 billion. This signaled a continued recovery in issuance volumes for SOCs after growth was also experienced in 2018 and is the highest level of issuance since 2010 (when it exceeded R41 billion). Most of the growth in SOC issuance is attributable to SANRAL (R7.2 billion compared to R500 million raised in 2018) and the DBSA (R6.2 billion raised in 2019 after zero issuance during 2018). Eskom also continued to grow the level of funding raised and Transnet was able to raise term funding in the listed credit markets for the first time since 2017 when it raised R360 million. Transnet’s ability to raise funding in the listed credit market during the fourth quarter of 2019 followed the appointment of a new board of directors and some changes to the executive management team, as well as active actions being taken against previous employees implicated in potential wrongdoing.

Historically, SOC issuance accounted for up to 30% of total annual listed credit issuance and regularly exceeded R30 billion per annum, with the majority being raised by the likes of Eskom, Transnet and SANRAL. This, however, changed from 2017 as concerns around the governance and financial sustainability of these SOCs increased. During this period from 2017, however, the development finance institutions (Land Bank, DBSA and Industrial Development Corporation) continued to raise funding in the listed credit markets.

Following the issuance raised by SANRAL and Transnet during 2019 as well as Eskom’s continued ability to increase funding raised in the listed credit market, these entities accounted for over 60% of SOC issuance for the first time since 2016.

Chart 7: Gross SOC issuance

Chart 7_Gross SOC issuance
 
Source: JSE, RMB Global Markets (data as at 31 December 2019)

Chart 8: Share of gross SOC issuance

Chart 8_Share of gross SOC issuance

Source: JSE, RMB Global Markets (data as at 31 December 2019)

Other issuance, as per Chart one, increased as well with all of the R15.4 billion in issuance being attributable to securitisations. Issuance by securitisation vehicles increased by 28.3% in 2019 and exceeded R15 billion for the first time since 2012. No funding in the listed credit markets was raised via inward listed bonds or by Municipalities during 2019.

4. Pricing dynamics

 The four largest South African banks (Absa, FirstRand Bank, Nedbank and Standard Bank) typically account for the majority of issuance in the listed credit market. These instruments are also the most liquid listed credit instruments in the South African credit market. As a result, senior unsecured bonds issued by these banks generally provide a floor for credit spreads with many other issuers placing instruments at higher spreads.

African Bank being placed under curatorship in August 2014 was one of the most material events to impact the South African listed credit markets. Prior to ABIL’s curatorship, banks were issuing 3-year and 5-year senior unsecured instruments at 80 – 90 basis points and 105 – 110 basis points above the Johannesburg Interbank Average Rate (JIBAR) respectively. Following ABIL’s curatorship during in the third quarter of 2014, banks were issuing senior unsecured instruments at spreads of 110 basis points and 130 basis points for 3-year and 5-year instruments respectively. Spreads continued to widen and eventually peaked in mid-2016 at c.145 basis points (3-year) and c. 180 basis points (5-year) on senior unsecured issuance.

 The increased demand for listed credit issuance has seen credit spreads tightening over the last 36 – 40 months, with spreads on instruments issued by the large banks at 111 basis points and 124 basis points for 3-year and 5-year instruments respectively during quarter four of 2019. Over the last twelve months, the spreads on 3-year senior unsecured bank instruments remained unchanged while spreads on 5-year senior unsecured bank issuance tightened by c.10 basis points.

It does appear that spreads on senior unsecured issuance by the big four banks in the 3-year space have found a floor at current levels, however, the term premium on longer-dated instruments may have some room to tighten as investors opt to benefit from the additional yield offered.

Spread compression also occurred on corporate issuance during 2019, although it was less pronounced than experienced in prior years as illustrated below:

Table 1

Table_1
Source: JSE, RMB Global Markets (data as at 31 December 2019)

Credit spreads also tightened for most corporates which are less frequent issuers (i.e. MTN, Bidvest and Barloworld). In the AAA.za rated corporate space, there was a widening of spreads during 2019. This was mainly driven by these instruments pricing tighter than the senior unsecured instruments issued by the big four South Africa banks. Therefore, traditional investors opted to rather earn spreads offered on bank paper than dilute yield in exchange for higher quality credit.

During 2018, Growthpoint issuance spreads were tighter than the big four South African banks. Our view at the time was that this was unsustainable and would correct over time. This was evidenced by the widening of credit spreads on Growthpoint issuance during 2019. MBSA and Toyota Financial Services continue to issue credit instruments at spreads tighter than the big four South African banks. We believe this is justified for these issuers as their instruments benefit from guarantees by international parent companies with credit ratings superior to the South African sovereign.

The most pronounced tightening of credit spreads was again observed in higher-yielding instruments such as Tier 2 and AT1 subordinated issuance by the banks and subordinated bonds issued by insurance companies (refer below). The ongoing tightening results from continued demand from multi-asset mandates seeking to replace growth assets with yield generating assets, and MM+ mandates attempting to offset some of the spread tightening in senior ranking credit instruments. The higher spreads on Tier 2 and AT1 instruments are due to these ranking below the senior unsecured issuance in the capital structures of the banks. Banks issue these instruments as it provides a source of capital which is cheaper than normal equity capital but still assists the banks in achieving its capitalisation requirements under Basel III regulations.

Table 2

Table_2

Source: JSE, RMB Global Markets (data as at 31 December 2019)

5. Market outlook

The persistent weakness and lack of confidence in the South African economy will continue to increase the demand for listed credit. Until such time sentiment regarding the South African economy improves, investors will be cautious in allocating capital to growth assets (i.e. equity) and the inflation-beating returns along with low volatility of listed credit will remain an attractive alternative.

Following recent declines in economic growth forecasts for South Africa, it is unlikely that a change in sentiment will occur in the short term. Therefore, demand for listed credit assets will continue to exceed supply, with continued spread tightening expected through 2020, although at a slower pace than experienced during the prior three years.

6. Conclusion

Regardless of continued tightening in credit spreads, an investment into credit should remain attractive to investors. Most of the listed credit in South Africa is floating rate in nature, therefore credit spreads are earned in addition to a reference rate. The reference rate in South Africa is 3-month JIBAR, which currently yields 6.6%. Credit spreads on high quality credit portfolio (AA-.za national scale rating and better) should add between 1.5% and 2% to returns resulting in a running yield in excess of 8%. This return compares favourably with the South African inflation outlook which remains subdued (SARB forecasts CPI to average 4.3% in 2020), therefore credit will continue to deliver inflation-beating returns.

The South African listed credit market remains largely “buy-and-hold” in nature. Managers may look to sell a listed credit instrument in the event of spreads tightening to realise mark-to-market gains. However, if spreads widen, investors tend to hold the instruments to maturity. This in turn, limits the realisation of mark-to-market losses as a result of spreads widening. In the current environment, we will continue to be discerning in terms of finding value and we feel it would be prudent to retain exposure to more liquid bank instruments, or shorter-dated instruments (e.g. three-year tenors). As always, we feel it is appropriate to consider both listed and unlisted credit to ensure the widest possible range of credit opportunities in any investment decision.