Tow­ers Wat­son As­set Man­ager Re­view

The Star Early Edition - - LABOUR FOCUS - Si­mon Howie, port­fo­lio man­ager at IN­VESTEC AS­SET MAN­AGE­MENT Guy Toms, head of in­ter­est bear­ing & strat­egy at PRE­SCIENT IN­VEST­MENT MAN­AGE­MENT An­drew Lap­ping, port­fo­lio man­ager at AL­LAN GRAY Con­rad Wood, head of fixed-in­come strate­gies at MO­MEN­TUM AS­SET MAN

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.

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