Corporate credit
Companies typically finance themselves via debt or equity. Servicing the interest on debt and debt capital repayment is done out of the company’s cash flows before equity is entitled to receive anything. Equity holders have a right to the uncapped residual cash flows a company generates, but only after the fixed commitments to its debtholders are met. Therefore, investors that provide companies with capital, face very different risk and return profiles in buying debt or equity securities, with equity returns potentially varying widely and credit returns being very certain and predictable unless there is a default.

Credit risk assessment
Debt securities expose investors to the risk of their fixed repayment commitments not being paid by the issuing company, ie default risk (credit risk). In default situations, investors may wait for an extended period before they receive a partial payout from the company, or they may lose everything. The higher the default risk, the higher the extra return compensation (risk premium) that will be sought by investors to attract them to supply this debt capital.

Corporate bonds typically pay a regular interest consideration and pay back the principal debt at bond maturity. When valuing a bond, it is critical to consider the borrower’s risk profile, which relates to the uncertainty surrounding the borrower’s potential ability to meet the obligatory payments. Very importantly, listed credit generally is not backed by specific collateral security and investors must be keenly aware of the seniority of the specific credit in the company’s debt structure.

Credit risk is estimated through in-depth analysis of a company’s financial statements, its industry and competitive position along with the consequent assessment of its ability to pay off debt through different future economic and business conditions. Key fundamental considerations include: the potential variability and future growth of a company’s operating cash flows and the strength of its current balance sheet.

Companies with very predictable operating cash flows, growing cash flows and strong balance sheets present lower risks of default and will generally be able to raise debt at lower credit spreads (above risk free rates).

In contrast, company characteristics that would lead to higher credit spreads include:

• variable revenue lines (eg for price taker companies or those with cyclical demand drivers) – especially where cost bases are largely fixed;
• revenue prospects that are stagnant or in decline;
• cost bases that may vary independently of company actions (eg those with commodity inputs);
• weak industry competitive positions; and
• high starting debt balances.

The local listed credit market
There are 42 non-bank corporate bond issuers in the South African listed credit market, comprising real estate investment trusts, industrial companies and insurers, with a total listed credit market value of approximately R170 billion. This is small in the context of the total listed debt market in South Africa.

The size of the listed bank credit market is approximately R459 billion and makes up 47% of the listed credit market. Government’s local issued debt, including fixed coupon bonds, inflation-linked bonds and the recently issued floating rate note is approximately R3.3 trillion. South Africa’s unlisted credit market is relatively small compared to the market value of the listed market. The below chart (left) shows that non-government debt, including bank credit, makes up less than 25% of the South African debt market.

In a corporate credit market this small (relative to the overall savings industry), increased demand can materially affect security prices (ie push credit spreads lower). Over the past five years, primary issue demand has been substantially higher than company issue targets, as indicated in the right chart below. This higher demand has led to higher clearing bond prices and lower credit risk premiums at issue and thereafter in the secondary market.

Other credit market dynamics
Given the scarcity of listed credit instruments relative to the demand for them in South Africa, most listed credit investors buy credit instruments at issue and then hold them to maturity. This results in a lack of visibility on true current credit spread market pricing (as there are often long periods when there are no trades in an instrument) and restricts credit investor buying opportunities to the infrequent primary auctions.

The largest source of credit to South African corporates is provided by banks, who generally provide secured credit or revolving credit facilities (akin to a company overdraft). The appetite from the banks for providing this credit will impact the degree to which corporates will tap the listed debt market for credit. Bank corporate lending growth has been very low over the past few years. This is due to low business confidence given the weak South African economy, which has depressed corporate demand for credit.

Banks are also active investors in both the primary and secondary credit markets using bond instruments as an additional destination for their lending activity.

Credit pricing trends
The chart below indicates how (post-2019) a specific measure of default risk has risen in line with the weak economy, but how credit spreads have continued to decline, other than a pandemic-interrupted bump up. This is counter intuitive and, in our opinion, reflects a low corporate appetite for credit and the high demand for these instruments from institutional investors. Specifically, income fund unit trusts have grown markedly as a category in recent years and primarily invest in these instruments.

Prudence is needed
In South Africa, given that current credit spreads generally are inadequate for the risks taken on, our clients have a low exposure to corporate credit.