The safer bet amongst South African fixed income assets - Angles & Perspectives Q3 2022

The safer bet amongst South African fixed income assets

Despite the market upheaval of the past year, there are still opportunities for fixed income investors. However, investors should be careful when evaluating opportunities in the fixed income market, as focusing on only one consideration, such as volatility, may lead to misleading conclusions.

In his article The new emerging markets?, Head of Research Kevin Cousins outlines how emerging market (EM) assets are under-owned, cheap and well suited to today’s economic fundamentals despite higher historical price volatility. Allocating capital to historically safe, developed market (DM) assets based on backward-looking low price volatility would mean favouring still deeply negative real rates, growing twin (current account and budget) deficits, and inflationary fiscal and monetary stimulus. Meanwhile, EMs like South Africa are becoming relatively less risky. Our central bank is highly experienced in managing the levels of inflation that the developed world must now adapt to, commodity prices have been very supportive of tax revenues and credit metrics, and country-specific bad news seems overpriced. The market has partly recognised this, as observed in the chart below by the country risk premium for EMs, and specifically for South Africa, which has declined over the course of this year.

Valuations matter, even as opportunities abound
We believe that there is still a standout opportunity to own cheap South African assets today. However, that does not mean that all South African assets are cheap. In our view, valuations remain an important consideration, as buying into assets below fair value provides a margin of safety. By contrast, overpaying for assets leaves you especially vulnerable to the vagaries of the market, since everything has to ‘go right’ to continue justifying high valuations.

Unpacking the attraction of corporate bonds
Local fixed income investors have favoured corporate bonds (or ‘credit’) to reduce the month-on-month volatility that investing in very liquid assets like government bonds can bring. Managing volatility to a client’s (or fund’s) requirements is certainly a worthwhile endeavour and can greatly enhance the client experience. However, using low volatility as a leading investment criterion can be quite dangerous and investing in low volatility instruments that are obviously expensive should bring the investment strategy into question.

At the highest end of the risk spectrum within domestic credit, sits a type of bond called ‘Additional Tier 1’ or AT1. To examine both risk and volatility in the context of South African credit, we look at AT1s as a case study.

AT1s are issued by banks in the post-Global Financial Crisis (GFC) era so that bank regulators can ‘bail in’ these bonds and write off the obligation to creditors (the bondholders) in the event that a bank is in distress, instead of using taxpayers’ money to bail the bank out. Before bailing in or writing off these instruments the issuing bank can also take other preventative actions to conserve some of its capital, like skipping coupon payments on these bonds or not buying them back five years after issuance (which is more the norm than not for AT1 instruments). AT1s are, in theory, perpetual instruments and are the one fixed income asset where your income is not necessarily ‘fixed’ (as the coupon payment may be skipped). Due to these features, one can expect AT1 prices to be more reactive to a change in fundamentals and market dynamics than more vanilla senior bonds.

Like all investments, the actual riskiness of AT1s depends on the fundamentals (in this case, of the issuing bank) and on the price. From first issuance in 2016, AT1s have provided local investors with an attractive yield pick-up over more vanilla credit, with issuing bank fundamentals being strong over that period. In fact, the local market seems to believe that our bank fundamentals are so strong that the characteristics of AT1s, which include the potential 100% loss of capital, can be put aside.

South African AT1s exhibit virtually no volatility compared to their developed market counterparts.

Focusing on price movements this year, it is clear that South African AT1 spreads have been virtually static. Not only that, but South African AT1 spreads are lower, and therefore more expensive than US or European equivalents.

We have a very robust and well-run banking sector in South Africa – arguably one of the key investment underpins when investing locally. However, our credit market is suggesting that our banks are of much higher credit quality than global giants such as JP Morgan Chase, BNP Paribas or HSBC.

When assessing the credit quality of banks, investors typically look at three key areas. These are: 1) liquidity, 2) regulatory capital, and 3) credit losses. A bank can fall into distress due to poor performance or management in any of these three areas.

Even throughout the pandemic, the liquidity of our local banks has been strong. But this is equally true for their DM counterparts. Local bank AT1s are therefore not more expensive due to SA banks holding significantly more liquidity than global peers.

Capital ratios below regulatory requirements are a critical risk for AT1 holders, as bank regulators will likely bail in AT1s to strengthen core capital levels if necessary. While our local banks’ capital levels have been robust, so too have DM bank capital levels. The following chart shows that capital ratios cannot be the driver of the price differential between SA and offshore AT1s either.

Credit losses have been much lower in DMs than in SA or other EMs in the past and could trend higher as consumers face higher interest rates than they have been used to over the previous decade. However, for this third element of credit risk assessment, SA banks will (today) score more poorly than the typical DM bank.

The importance of price risk should not be underestimated
Walking through this high-level credit assessment, the conclusion should not be that South African banks are of poor credit quality. To the contrary, they are of the highest quality available within the local credit investment universe. Is South African bank credit cheap though? We don’t believe so. Expensive prices (or low credit spreads) in the SA credit market have, at least in part, been driven by investor demand for assets that have exhibited low volatility in the past.

While fundamental risk in the local AT1 market may not be elevated, we believe that price risk could be. We argue that the lower risk trade is to invest in cheap South African government bonds, which can be more volatile, but where you are being compensated to take on SA’s fundamentals. The case for investing in South African government bonds today is compelling. Investors earn more than 11% by investing in 10-year SA government bonds. Not only is this an attractive investment in absolute terms, but South Africa also stands out on the global stage.

PSG Asset Management.