Credit Insights – We are not there yet

01 November 2018

a) Introduction

Following a subdued second quarter in 2018, the third quarter saw an increase in issuance volume (R30.7 billion) in the listed credit markets to levels more comparable to the first quarter (R31 billion). Second quarter issuance amounted to only R22.5 billion. The third quarter issuance was marginally below the issuance trend over the last 12 months of c.R31.2 billion. The recovery in issuance was mainly attributable to the financial institutions returning to the South African (SA) listed credit markets, following offshore issuance during the second quarter.

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

• Corporate issuance remains concentrated in a small number of highly rated issuers, with some opportunistic entry into the bond market by less frequent issuers.
• Issuers are exploring funding avenues in both the listed and unlisted debt markets in order to achieve the best pricing.
• 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 will continue to exceed supply resulting in spread tightening, especially in higher yielding instruments.
• State-owned companies (SOCs) are re-engaging the listed credit market following an extended absence, with Eskom and Denel accessing the market through government guaranteed issuance.

b) Supply of assets

During quarter three, issuance increased c.27% from c.R22.5 billion to c.R30.7 billion. On a year-to-date basis, issuance during the first three quarters of 2018 amounted to c.R84.2 billion, a c.23% reduction from the issuance volumes of c.R109.5 billion recorded in the first nine months of 2017.

The level of issuance during quarter three is placed in perspective by the below facts:

• Issuance during July 2018 (c.R10.9 billion) was three times more than the issuance during June 2018 (c.R3.6 billion). The July 2018 issuance was marginally higher than the issuance during July 2017, but marginally above the 12-month rolling average, which was trending at c.R10.6 billion per month at the time.
• Momentum in issuance was maintained during August 2018, with issuance increasing to c.R11.6 billion. This was 18% lower than issuance during August 2017, but exceeded the 12-month rolling average, which was trending at c.R10.4 billion per month at the time.
• Issuance during September 2018 declined to c.R8.2 billion, a c.50% decline from September 2017 issuance. The issuance was also below the 12-month rolling average, which was trending at c.R10.4 billion per month at the time.

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

Source: RMB Global Markets Research

During the third quarter of 2018, financial institutions raised c.R12 billion, accounting for approximately 39% of all issuance. This was a strong turnaround from the previous quarter, during which financial institutions raised only c.R2.2 billion in the domestic market, accounting for c.10% of total issuance. The largest issuers of senior unsecured bonds were FirstRand (c.R3.9 billion), Absa (c.R3.6 billion) and Investec (R2 billion), while Nedbank issued c.R1.5 billion of tier two subordinated bonds.

During the quarter, SOC issuance decreased significantly to c.R2.2 billion compared to c.R7.3 billion and c.R7.8 billion during quarter one and quarter two 2018 respectively. SOCs accounted for only 7% of issuance during the third quarter. The decline was mainly attributable to Eskom, which raised c.R9.8 billion of debt during the first six months of 2018, compared to raising only R530 million during quarter three 2018. Further, the Industrial Development Corporation (IDC) was absent from the markets in Q3 (c.R1.3 billion raised during quarter two 2018), while the Land and Agricultural Bank of South Africa (Land Bank) only issued bonds totalling R1.5 billion (c.R3.4 billion issued during quarter two 2018). Finally, Denel returned to the listed credit markets in quarter three issuing R180 million of long-term funding following the finalisation of its new government guarantee.

Eskom has accounted for c.60% of total funding raised by SOCs during the first nine months of 2018, while the Land Bank and IDC accounted for c.28% and c.8% respectively.

During quarter three 2018, corporate issuance increased by c.30% to c.R11.6 billion compared to c.R6.7 billion in quarter one and c.R8.1 billion in quarter two of this year. Corporate issuance accounted for c.38% of total issuance during quarter three 2018. Issuances by Mercedes-Benz SA (c.49%), Toyota Financial Services (c.12%), AECI (c.8%) and Discovery (c.6%) were the largest; accounting for c.75% of total corporate issuance in quarter three. 

Twenty corporates have raised a combined c.R26.5 billion of funding in the first nine months of 2018. However, seven corporates have raised in excess of R1 billion each and accounted for c.73% of total corporate issuance in aggregate. The largest issuers for the first nine months of 2018 include Mercedes-Benz SA (R10.3 billion), Netcare (c.R1.76 billion), MTN (R1.75 billion), Growthpoint (R1.6 billion), Telkom (R1.5 billion), Toyota Financial Services (R1.4 billion) and Hyprop (c.R1.1 billion). 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. Nine of the corporates that have raised funding are property companies and accounted for c.26% of year-to-date issuance in aggregate.

Securitisation issuance decreased by 15% during quarter three 2018 from c.R4.3 billion to c.R3.7 billion to account for c.12% of total issuance during the quarter. Securitisations which raised funding in quarter three include Amber House (SA Home Loans), Thekwini (SA Home Loans), Fox Street (Investec Home loan finance) and Bayport (unsecured lending).

Interestingly, SA Home Loans uses two securitisation vehicles to raise funding. The Thekwini securitisation is used for the majority of the funding of its underlying home loans business and is mainly placed through public auctions, while the Amber House securitisation is used in most cases to refinance some existing Thekwini structures once legal maturity approaches and is typically placed via private placement.

Standard Bank Namibia issued its first inward listed bond during August 2018, raising R536 million.

c) Demand/Supply dynamics and pricing evolution

Auctions have been well supported during quarter three 2018 as investors and banks continue to compete for assets. Ongoing demand for credit assets is evident from auction spreads for most issuers clearing within or below price guidance. Further, the spreads at which auctions have cleared for recent issuance is below the issuance spreads for past auctions.

A comparison of spreads achieved by issuers (on auctions or private placement) during quarter three 2018 and early October 2018 relative to the most relevant comparable periods are presented below:

Source: Ashburton and RMB Global Markets Research

The table indicates a contraction in yields across all issuers. Notable observations from the above table include:

• Pronounced tightening in higher yielding instruments such as additional tier 1 and tier 2 subordinated debt issued by SA banks.
• In addition to tighter spreads on bonds issued by the Land Bank, the term premium between three-year and five-year instruments have tightened by 10 basis points over the last year.
• Woolworths and Liberty achieved tighter spreads on recent issuance despite difficult trading conditions leading to deteriorating financial performance.
• Growthpoint is still issuing five-year debt at spreads tighter than the SA banks.
• BNP Paribas Personal Finance is raising five-year funding at 5bps wider than where it raised three-year funding 12 months ago.
• enX achieved significant spread tightening over five months raising funding at 55bps tighter for funding with an additional term of 12 months.

During the third quarter and the first week of October 2018, there were 24 auctions with 43 instruments being issued. 11 of the instruments cleared at spreads below initial guidance levels, while none of the instruments were issued at spread above guidance levels. This illustrates ongoing demand for credit, while investors have also tempered their expectations in terms of credit spreads.

d) Are we at the bottom yet?

In short, no. The spreads on senior unsecured funding raised by the SA banks are a good indicator in determining the level of credit spreads relative to prior cycles. This is due to the banks typically being the largest issuers during recent times and that credit spreads on bank funding usually presents a floor from which credit spreads on other sectors are determined. 

African Bank (ABIL) being placed under curatorship in August 2014 had the most significant impact on credit spreads in the SA listed credit market in recent years. The impact on issuance volumes and spreads was more pronounced than any other recent market events such as the First Strut default, the Steinhoff crisis, or the removals of any Finance minister.

Prior to ABIL being placed under curatorship, credit spreads on three-year and five-year bank funding were lower than current levels. During 2013, banks issued senior unsecured three-year funding at levels between 74bps and 80bps, while five-year funding was raised at c.90bps. During 2014, leading up to the ABIL curatorship, banks issued senior unsecured three-year funding at levels between 85bps to 90bps, while five-year funding was raised at levels between 94bps and 108bps.

The last issuance during this period was in July 2014, with ABIL being placed under curatorship in August. Banks only started raising funding again towards the end of September 2014, with spreads on three-year and five-year funding at 110bps and 130bps respectively. Following the resumption of issuance, bank three-year and five-year credit spreads continued to rise through to quarter three 2016, whereafter the current cycle of spread tightening commenced. Senior unsecured bank credit spreads for three-year and five-year funding peaked at levels of c.145bps and c.180bps respectively.

The latest senior secured bank issuances indicate that the market is at the levels last seen during the first issuances conducted by banks following ABIL being placed under curatorship. Although it may feel like credit spreads are exceptionally tight, it is clear that there is still further room for credit spread compression.

We believe the current supply/demand mismatch 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, 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

The current market dynamics hold some risks for investors. The strong 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, 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 virtually every issuer in the SA credit market, no matter what their underlying fundamentals,  being assigned an investment grade,  national scale rating. 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 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, 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.

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 still benefit from equity buffers and security further down the capital structure of these entities.