We have seen globally that the gradual lifting of COVID-19-related restrictions is shifting the focus to economic recovery in all its forms. This ranges from the pace at which recovery might be expected to continue, to whether the early signs of recovery we saw before the announcement of Level 4 lockdown restrictions in SA are sustainable in the long term.
As active fixed income managers, we are watching the changing dynamics in the listed credit market and evolving our risk management and portfolio construction processes to optimise return outcomes for our clients as a result of the COVID-19-induced economic shock.
The role of credit in a fixed income portfolio
It is important to remember why we invest in credit assets. Investors in these assets are effectively providing a company with a loan to grow the business in return for regular interest payments and the ultimate repayment of this loan. An investment in credit assets provides an additional source of low-volatility income compared with investments in listed equity or listed property. Companies can defer or materially reduce dividends to shareholders during periods of market stress, but the interest paid to debt holders on credit assets is a contractual commitment.
However, the volatility of income and returns generated by credit assets is only low if:
Effective credit selection has appropriately mitigated (as oppose to eliminated) the risk of corporates defaulting on interest and capital payments; and
Portfolios are constructed in such a way that the diversity of credit issuers and instruments serves to reduce the volatility of returns, even if defaults were to occur.
Investing in credit assets provides investors with an opportunity to support corporate growth. Although there are still risks, investors’ legal claim to interest and principal due on credit instruments ranks higher than the claims of equity investors. While upside gains may be limited compared with equity, there is a level of downside risk protection.
Current dynamics in listed credit markets
Market cycles vary and it is important to consider the current dynamics and what may lead to long-term fundamental shifts, rather than short-term reactions to market news. The current dynamics of the listed credit market can be explained by four elements:
the quality of instruments in the market (the credit risk)
the supply of instruments to the markets
the demand from local and international investors for credit instruments
valuations.
Quality
The chart below shows a number of downgrades / upgrades for official S&P Global Ratings in South Africa. Of 20 South African issuers, 15 were downgraded by at least by one notch in Q2 2020, which changed the average global scale ratings from BB to BB-. The chart also illustrates that, so far in 2021, credit quality can be best characterised as stabilising rather than improving.
Chart 1: The evolution of S&P global ratings in SA
Source: S&P Global Market Intelligence
Supply
The net monthly outstanding issuance shows how much listed debt issued by banks, corporates and SOEs is outstanding. It takes into account new debt issuances as well as debt that has been repaid. The graph below shows that the net monthly outstanding issuance across all sectors is still lower than in comparative periods, but the rate of decline is slowing down.
Total issuance volumes are not yet growing in positive terms – it is merely that the rate of deceleration is slowing down. This further exacerbates demand and supply imbalances and may partly explain why bid cover ratios (an indicator of demand for instruments up for sale at auctions) have been increasing so significantly.
Chart 2: Net monthly outstanding issuance (supply) per sector
Source: Standard Bank Research, JSE, data as at 30 April 2021
Demand
There has been a resurgence in demand for listed credit instruments as bid cover ratios increased. In April 2021, average bid cover ratios [1] were higher than in the previous four years. This means that the extent to which demand for listed credit outstrips the available supply at auctions is at its highest since 2017. On average, auctions were between 2.5 and three times oversubscribed compared with 2018, 2019 and 2020, when bid coverage ratios were between two and 2.5 times, on average.
Chart 3: Primary market auctions: monthly volumes issued vs bids
Valuation
The graph below shows one view of spread dynamics in the listed credit market by comparing the spread on corporate debt with the spread on bank debt. We clearly see how credit spread widening in 2020, following the COVID-19-induced economic shock, has been replaced by a relatively sustained trend of corporate spread narrowing, although at a slower pace in 2021 than at the end of 2020.
Within corporates, a distinct differential in spread trajectory and pace is emerging for higher-quality corporates. SOE spreads remain elevated and refinance risks continue in this sector, as many SOEs need to restructure their balance sheets to sustain their businesses.
Chart 4: Comparing corporate spreads (Floating Rate Notes) with bank debt spreads (NCDs)
ENDS
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[1] A measure of demand for listed credit relative to available supply of credit at listed credit auctions
