Investing in the SOE sector: Same, same, no longer different
In SA, the SOE sector is too large to ignore, so what strategies can investors employ to achieve investment success?
The credit strength of state-owned entities (SOEs) is usually heavily reliant on Government for financial support, often in the form of annual subsidies and in the ad hoc provision of liquidity or additional equity to retain the confidence of capital markets. Investors will look to this implied support in their analysis, and credit rating agencies will include any expected support in their formal ratings and reviews.
But what happens to SOEs when the government in question can no longer be relied upon, when its own credit rating is under pressure, and any implied support becomes questioned? When it no longer has the liquidity or capacity to help when required? "What happens" is exactly what has played out before our eyes in South Africa, as Government has been unable to provide timeous support when required. SAA went into business rescue, Denel and other SOEs are teetering on the brink of collapse and Land Bank, the essential development bank that supports our agriculture sector, has defaulted on over R40bn of debt. And so, investors react by withdrawing support for SOEs based on the strength of Government, and any expectation of implied support vanishes, and only explicit, contractual government guarantees are trusted.
The result is a dramatic drop-off in demand for SOE paper, resulting in elevated credit spreads. This widening of credit spreads is in stark contrast to the rest of the market which, as depicted in Figure 1 below, has seen strong demand drive credit spreads back to pre-COVID levels.
The lack of credit support for SOEs is relatively easy to understand from the perspective of a credit investor. SOEs have a unique investment case when their government is strong and has lots of liquidity. But when that's not the case, investors treat SOEs the same as any corporate, and the basic credit fundamentals of the standalone entity must stack up. Same, same; no longer different.
So, what does it mean when investors treat SOEs the same as any corporate? Well, it is certainly not all bad news. Many corporates issue bonds and raise loans from investors. These corporates are not the same, and some are far stronger than others with different credit ratings. But there are some minimum standards; credit investors require some fundamentals before they lend to a corporate (or standalone SOE).
Credit investors care about risk, and before they invest, ask a simple question: "Can this borrower pay the money back?" With no strong parent, they care only about the borrower. If credit investors don't believe the borrower can pay back the money, they will not buy their bonds or advance them loans. It is like a student wanting a loan with no parent guarantee. On the other hand, if investors are comfortable, they will provide borrowers with the capital required to support their operations or grow. And in return, they will be compensated with payments over the life of the investment and, critically, with full repayment at maturity.
So, what fundamentals are required for credit investors to be comfortable that the answer to the question above is, "Yes, in all likelihood this entity can pay us back." In other words, what do SOEs need to get right to attract capital? Both financial and non-financial risks determine the credit profile of an entity. Understanding these risks allows investors to assess the long-term sustainability of an SOE and make investments that deliver attractive risk-adjusted returns.
Ultimately, the investment decision comes down to credit fundamentals – which are no different from the corporate sector. Credit investors are looking for:
1. A resilient business model that can withstand cyclical downturns;
2. Stable cash flow generation and liquidity;
3. A sustainable capital structure; and
4. Experienced management with strong governance oversight.
Avoiding the SOE sector is not sustainable in the long term, not only because of the sector's importance to the local economy but also because the job of a credit investor is to pick investments that can repay the money and build diversified portfolios. Given the SOE sector accounts for approximately 32% of the listed debt capital market (excluding government bonds), it is simply too large to ignore, and it has correlation benefits for investors. It also offers high credit spreads, given the aversion to the sector from most investors.
If we can't ignore the sector, then the question is, what can investors do? In our view, there are two essential strategies that investors should employ in this sector. Firstly, rather than avoid these entities, do the actual work, and find those that stack up from a fundamental perspective. Analysing the SOE sector could also provide the benefit of picking up positive changes early before the market.