Towers Watson Asset Manager Review
Credit instruments (lending to banks, parastatals and other corporate borrowers) have become a much larger part of bond portfolios over the last 10 years or so. What are the current drivers of the non-government bond market, and what is your current view of the investment case for credit? Has the failure of African Bank had an effect on the market?
says over the last 15 years the non-government bond market has grown to over R700-billion, with a diverse base of issuers across various sectors.
“There are both demand and supply dynamics that have driven this growth. On the demand side, investors initially embraced credit as an essential building block in fixed income portfolios, offering yield enhancement with relatively low volatility.
“More recently, credit has emerged as a distinct asset class that warrants a separate allocation within a multi-asset portfolio, either as traditional bond alternative or as a cash plus strategy. The growth in multi-asset funds has also increased the demand for credit, with the higher yield particularly attractive in an environment where cash rates are below inflation.
“Supply is being largely driven by regulatory challenges affecting banks. Increased regulations are increasing banks’ regulatory costs and cost of funding and they can no longer offer cheap funding to corporates.
“Corporates are thus turning to the bond markets as a cost-effective alternative. Further pressure is coming from large exposure limits, as banks face regulatory pressure to reduce concentration.
“Larger state-owned enterprises and corporates thus require the bond market to supplement bank funding. This supply pressure is expected to increase as general market activity increases and the current high levels of liquidity reduce.”
Howie believes African Bank’s demise has heightened concerns around the health of the consumer and entities with exposure to unsecured lending and retail.
“It is also a stark reminder that defaults, although infrequent, can and do occur. The market remains disrupted and new issuance is at historic lows. But the case for credit remains intact with good supply and demand dynamics, elevated credit spreads and longer-term returns that have more than compensated for the African Bank default,” says Howie.
says pension funds have an investment requirement to deliver inflation plus returns. Portfolios typically consist of a combination of growth assets such as equities and property and income bearing assets such as money market and bond investments.
“The allocation between the different asset classes is usually valuationdriven with the investment objective in mind. In early 2008 the market offered inflation plus 3% returns in money market and short-dated bonds while equities were historically expensive. The risk here was being invested heavily in equities,” says Toms.
“Currently money markets yield close to 0% in real terms and bonds no more than 1% to 2% and are not sufficient to meet a typical pension fund’s investment objective. Equities provide growth potential and an opportunity to deliver inflation plus returns. Right now a fund has to have equity upside exposure to have a chance of delivering inflation plus returns.”
Toms says bond prices are less volatile than equities and when they are priced at good positive real yields, offer an attractive investment in a pension fund. As has been highlighted recently with the demise of African Bank it is not just about the yield one locks in but also about the quality of the credit one takes on.
“At Prescient we adopt a cautious approach to credit. Credit can be very attractive and can provide significant yield enhancement to government bonds. However there are times to hold credit and times to sell it and liquidity is crucially important. The decision to hold credit is a function of the quality of the credit and the price of the credit and has to be monitored continuously.
“Post 2009, credit emerged as an alternative asset class to investors who were nervous of equity markets. This was opportune at the time as credit spreads were wide and as a result many investment houses had taken on a lot of credit. Having a process to understand and evaluate credit is crucial. Holding long-dated illiquid credit is dangerous. When something goes wrong as with African Bank, one can’t sell and that is exactly what happened with investors this year.
“We identified a decline in African Bank’s credit from as early as 2012 and the yield enhancement earned form holding African Bank bonds was not sufficient to compensate for the risk. We were also aware that this was a one way market in which it was very difficult to on-sell African Bank credit if one wanted to. As a result we took on zero exposure to African Bank bonds.
“The more widespread problem resulting from the fail of African Bank is the contagion risk. Investors start to question other banks and lenders and there were significant redemptions from money market funds. Corporates who relied on funding from investors have suddenly found it more difficult to borrow at attractive rates and are now having to pay up to obtain funding, or hold back on borrowing. That is not good news in an economy battling to grow and although on a much smaller scale than in Europe, is the same issue.
“After a credit event, liquidity dries up and lending is at risk of falling. This is where the central bank has to be vigilant and our view is that the SARB has reacted commendably in this event,” says Toms.
He says moving beyond credit there are obviously different types of bonds: those that are linked to cash rates (floating rate bonds); those that pay fixed coupon bonds and those that are linked to inflation.
“Inflation linked bonds are an ideal asset class as unexpected inflation risk is eliminated. However the yield must be sufficient to meet future liabilities and at current levels of inflation, +1.5% to 2% do not offer sufficient yield to meet future pension fund obligations. Floating rate bonds that are linked to cash rates are attractive if one believes interest rates are going up. Fixed rate bonds are attractive if you believe interest rates will fall because you have locked in a higher yield for a long period of time.
“Globally bonds offer alternative yield opportunities for local investors and asset managers will scour the markets to look for yields that are higher than domestically. Obviously there is currency risk here and this must be factored in.
“Overall though we have multi-century-low bond yields and locking into these levels now for an extended time going forward is high risk. Developed world bonds do not offer sufficient real yields to meet pension fund obligations currently. In China there is an arbitrage opportunity that results as a function of exchange control regulations and we see this as providing a singularly good fixed income opportunity,” says Toms. says the big drivers of the credit market are supply and the market's willingness to absorb the growing supply at reasonable prices.
“Corporates are happy to issue bonds as it diversifies their funding and is often cheaper than borrowing from banks. In turn, banks want to lengthen the duration of their funding so issuing longerdated bonds makes sense, rather than sticking to shortterm money market funding.
“The growth of the corporate bond market is good as it allows for more choice, both in terms of the type of assets available (floating or fixed rate bonds) and the type of credit risk investors want to take.
“We have fairly big holdings of floating rate credit investments in our portfolios. We like that we can invest in floating rate notes as this allows us to limit our duration risk on these assets.
“The majority of our credit holding is invested in the big banks; we think the risk of a default by the major banks is very low so we are happy to receive the higher yield compared to, for example, a 12-month floating rate money market asset.
“The African Bank failure has increased spreads in the short term and caused a few issuers to postpone their issues,” says Lapping. Adrian van Pallander, fixed income analyst at CORONATION FUND MANAGERS says company fundamentals are, and will continue to be, the starting point for credit.
“As we enter an interest rate hiking cycle with a deteriorating macroeconomic outlook, the impact on company balance sheets is being carefully monitored. Cheap liquidity has created inflated balance sheets and how these asset values unwind is contentious.
“The focus on fundamental credit metrics such as non-performing loans, leverage and interest cover is becoming more acute and pricing is more accurately reflecting default risk on a through-the-cycle basis,” says Van Pallander.
He contends that following the collapse of African Bank, the appetite for credit has waned considerably, given that many funds have started to adopt a more cautious investment ethos.
“Prior to August 2014, credit spreads had tightened considerably given the large investor demand and relatively limited supply in the domestic market. The market is becoming more discerning, and as such, spreads are continuing to widen.
“This higher volatility requires that investors demand a better risk premium. Volatility can, however, create value distortion, and it is in volatile times that discerning investors can find value.
“Credit is still invaluable in generating alpha, given the risk-reward profile. Structural considerations, management and market liquidity are some of the factors which need to be considered and appropriately priced.
“Corporates with solid fundamentals, who have been planning for harsher times, may find their funding lines unfairly penalised, which create an opportune time to buy,” says Van Pallander.
says the non-government bond market has developed significantly as the economy has expanded and the need to borrow has increased for various institutions. This demonstrates developed and mature debt markets locally, something which is fairly rare in the emerging market sphere.
“The expansion has been particularly robust over the last five years, with borrowing institutions keen to capitalise on low interest rates, tight credit spreads and the fact that traditional bank finance has been less readily available or much more expensive. Lending institutions have been attracted to higher yield in a low return world, as well as the additional portfolio diversification available from credit investments.
“In our view, the investment case for credit is very much like any other asset class. There is no doubt that exposure will add to the diversity and return prospects of a portfolio, but an investor needs to assess valuation and what stage of the investment cycle we are currently in.