Technical forces and pricing anomalies in the corporate bond market

02 November 2017

In the period between August to October 2017, we have seen a consistent trend of strong corporate bond auction outcomes as evidenced by bond pricing clearing below the guidance provided prior to the auctions on a regular basis.

This has resulted in bond spreads compressing considerably compared to issuances in the first half of 2017. In March, Growthpoint issued a 3-year bond at a spread of JIBAR + 139.5 basis points and a 5-year bond at JIBAR + 170 basis points. Between March and Growthpoint’s latest issuance in October 2017, we have seen gross domestic product (GDP) forecasts for 2017 revised down, cabinet reshuffles and lingering political uncertainty. However, Growthpoint’s latest 5-year issuance was issued at a spread of JIBAR + 144 basis points - 26 basis points below the previous auction and only 4.5 basis points higher than the 3-year issuance in March.

Ashburton Investments’ view is that this compression of credit spreads has been because of technical market forces. These forces include the strong demand for debt instruments as a result of large amounts of liquidity flowing into “cash plus” income funds and bank demand for High Quality Liquid Assets (HQLA) to shore up their Basel III ratios rather than any reflection of fundamentals. This has led to a few anomalies now arising in the South African bond market.

Banks have traditionally set a pricing floor for non-government bond issues. This is due to a number of factors including credit quality and the stable nature of the South African banking market as well as bank paper generally being regarded as a liquid instrument.

Intuitively, banks should also be able to fund at the lower end of the market to be able to on lend to borrowers at profitable margins particularly in a market such as South Africa where banks are the dominant providers of credit with the capital markets providing a more marginal source of funding. In recent auctions, there have now been instances where spreads on bond issuances have pierced this theoretical floor for the first time (see figure 1 and 2 below). Toyota Financial Services SA (TFSA) and Growthpoint have both issued at spreads lower than banks between August and October. This may be justified for the TFSA issuance, which benefits from
a guarantee by The Toyota Motor Corporation (TMC), which is rated AA- by S&P on the international scale, thereby exceeding the sovereign rating of South Africa of BBB-.

Figure 1: 3 year auction outcomes

 Figure 1: 5 year auction outcomes

Banks have traditionally set a pricing floor for non-government bond issues. This is due to a number of factors including credit quality and the stable nature of the South African banking market as well as bank paper generally being regarded as a liquid instrument.

It is harder to use this argument for the Growthpoint issuance. While Growthpoint is a highly rated corporate compared to other South African issuers, its credit rating is not as high as corporates guaranteed by blue chip multinational companies such as TFSA.

Growthpoint is a strong, well-diversified Real Estate Investment Trust (REIT) with a quality property portfolio but is still primarily exposed to the South African economy with 75% of gross property income coming from domestic sources. It therefore remains susceptible to local economic conditions. The capital structure must also be considered when assessing REITs. Growthpoint’s asset base consists largely of fixed property assets. These properties are illiquid long-term assets while the debt used to fund the assets has a weighted average term of three years, of which the banks provide a large portion. This creates a liquidity mismatch between
the liabilities and the assets of a REIT. The liquidity mismatch of REITs is unregulated.

Similar to Growthpoint the large South African banks are also primarily exposed to the South African economy. Banks, as with REITS, also run a liquidity mismatch on their assets and liabilities. However, the process in which banks manage their liquidity mismatches is much more sophisticated and tightly regulated by the South African Reserve Bank (SARB). Various measures such as liquidity coverage ratio and the net stable funding ratio are used to manage a bank’s liquidity within acceptable bounds ensuring the stability of the banking sector. The large banks are also systemically important compared to REITs such as Growthpoint. Due to this systemic importance, implicit support by government and the SARB in the event of a failure, is also considered when assessing thepricing on banks. Based on these factors, we continue to believe that banks should price tighter than corporates such as Growth-point.

While there are issuers that may be able to pierce the theoretical bank pricing floor due to the strength of the guarantors, we believe that the piercing of this floor by corporates who are primarily exposed to the South African economy should be carefully scrutinised.