Adapting to new dynamics in managing credit risk as we move through a recovery
This ranges from the pace at which recovery might be expected to continue, to whether the early signs of recovery we are seeing are sustainable in the long term.
- Investing in credit assets provides an additional source of low-volatility income when both individual credit selection and portfolio construction decisions are effective.
- The credit market reacted immediately to the Covid-19 crisis, with asset quality and demand falling and spreads between corporate and bank instruments widening, due to higher perceived risks for corporate paper.
- Current market dynamics are stabilising against the backdrop of a slow economic recovery.
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
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.
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.
There has been a resurgence in demand for listed credit instruments as bid cover ratios increased. In April 2021, average bid cover ratios1 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.
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.
How do we think about credit in an economic recovery?
Attention has now shifted to economic recovery. Asset class returns from equities and listed property stand to benefit meaningfully from improved prospects for economic recovery, with higher share prices, the resumption of dividends and the ability to realise gains on positions that have recovered from crisis lows.
Credit assets, on the other hand, are primarily exposed to downside risk: namely the risk that borrowers will not repay interest and principal in full and in a timely manner. The relative illiquidity of South African listed credit assets (as opposed to listed equities and listed property) means that the timely realisation or monetization of sizeable gains on credit positions is not always possible.
It is this asymmetric risk profile that underscores the importance of analytically sound and robust credit risk management processes that can take a through-the-cycle view of credit quality in positioning the appropriate long-term response to the economic recovery for client funds.
Individual credit selection remains important when constructing credit portfolios. In the present crisis, changes in creditworthiness differ by sector and subsector to a greater degree than they arguably did in previous recessions, which further underscores the importance of bottom up, fundamental research. However, understanding how these individual credit selection decisions come together in a portfolio context matters just as much as exposures to individual counterparties.
What are we doing in client funds?
The initial credit reaction to the Covid-19 induced economic shock was swift and immediate credit rating and market pricing adjustments to take into account heightened credit and liquidity risk. We believe the credit response to the nascent signs of economic recovery requires a disciplined adherence to our investment philosophy of considered evaluation of through-the-cycle credit quality and selectively raising our exposure to credit assets at the right price.
We are active managers and continue to be selective in adding credit assets to funds managed on behalf of clients. We have heightened our focus on identifying counterparties within sectors that are well-positioned to benefit from the recovery.
Our approach to position sizing and exposure management has been enhanced to consider appropriate medium- to long-term exposure targets for certain sectors. We are actively using tools available to us (concentrated exposure management, maturity management and, to a lesser extent, secondary market trading) to right-size exposures to funds based on our assessment of through-the-cycle credit quality.
Difficult economic cycles call for more, rather than less, diversification. A key focus area for the team is actively expanding our credit coverage universe to ensure that we can identify diverse counterparties that pass our credit quality screening, whether on financial or non-financial (including Environmental, Social and Governance) risks.
Whenever we participate in primary credit auction markets, we bid where we see value, and as a result may not receive our full demand. We are comfortable with this outcome, as it demonstrates consistency with our internal credit process.