Edition: November 2018/January 2019
Access to capital enables growth
There are opportunities in the SA credit markets. Ashburton managing director for institutional business Rudigor Kleyn explains how they help stimulate the economy and investors’ portfolios.
Over the past 20 years, there’s been profound change in the SA and global debt markets. Much of it can be attributed to American financier Michael Milken. He revolutionised the way that companies involved in corporate transactions were financed.
From an investment perspective, Milken's innovation in the late 1980s was to realise that investors could make more money on a risk-adjusted basis from buying bonds issued by companies with lower credit ratings than investing in the bonds of AAA-rated companies. The reality at the time was that an extremely limited supply of lower-rated bonds existed.
Hence there was a need to create a new supply of these so-called high-yield bonds by persuading often ignored companies to issue bonds underwritten by financial firms such as Drexel Burnham and Salomon Brothers. In essence, this provided a means for companies to raise capital to which they otherwise would not have had access. In turn, it facilitated economic growth and wealth creation.
These themes are highly relevant in SA today.
The SA fixed-income markets have developed tremendously to the benefit of investors. Recall the complexities of a certain state-owned company’s Electrification Participation Notes structured in the late 1990s. Soon after, SA institutions also started investing more heavily into innovative securitisations (with the first having been completed almost a decade earlier). There was also, for example, financing of public road upgrades and development of green energy projects.
During the 2008 global financial crisis (GFC), much was written about collateralised debt obligations, credit default swaps, credit-linked notes and other financial terms. They all describe structuring techniques to enhance yield and they all found their way into the financial system.
Fortunately for the SA system, it wasn’t really exposed to mortgage-backed securities ostensibly supported by non-performing United States home loans during the GFC. The negatives of certain financial innovations have all been well publicized. But it’s worth mentioning some positives that came from these innovations and the lessons learnt.
A major learning is that no amount of fancy structuring can act as a cure if you are exposed to a portfolio of poor-quality collateral. Bad remains bad, even if it is sometimes disguised by supposedly sound “guarantees”. Credit is an asymmetric asset class. Therefore the investor’s return has limited upside (capped to the spread of the bond/loan) coupled to a lot of potential downside.
The only way to negate this downside is through portfolio diversification, strong covenants and strict loan documentation. The successful inclusion of credit in portfolios also requires detailed bottom-up research complemented by a macro-economic driven top-down approach to identify appropriate risk-adjusted returns.
Historically, the SA credit market has been structurally similar to Europe. It has always been dominated by bank lending with high bank balance sheet utilisation (which is the opposite to American developments where bond issuance dominates). This in turn meant that SA investors had less access to diversified sources of credit returns in their fixed-income portfolios until regulations forced post-GFC reforms.
The SA credit landscape has changed a lot in recent years, with Basel III being a contributing factor. And even though there are still roughly 430 corporate exposures on SA bank balance sheets versus approximately 46 corporate bonds, investors are now able to access the broader credit market through innovation.
Further, until 2011, Regulation 28 of the Pension Funds Act restricted pension funds to investing a maximum 25% of their assets into credit. This led to development of a deep and liquid local equity and government bond market. At the same time, corporate credit was extended by the banking sector due to a lack of substantial demand from institutional investors.
The 2011 amendments to Regulation 28 significantly relaxed these rules. The changes highly incentivise pension funds to invest into listed bonds. This has led to the growth in corporate bond issuance. However, the absolute size of the listed credit market remains small compared to the loan market.
The SA institutional investor, and to a large extent the retail investor, can now access an array of fixed-income and credit funds that cater for various risk-adjusted return and liquidity parameters.
Specialist funds are also available. They include portfolios that focus for example on sustainable job creation, development finance, renewable energy, infrastructure and mezzanine finance.
This all bodes well for investors as they offer more sources of uncorrelated return, choice and diversification. These specialist funds are also often used to target growth opportunities in areas of our economy where access to capital has historically been limited.
SA investors are currently faced with a low-growth domestic environment. In recent years the performance of our equity markets has been both volatile and disappointing. At the same time, largely unnoticed is that conservative corporate credit portfolios have been providing real returns of 4% and higher.
This asset class deserves closer attention.