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Dalriada Trustees Presentation

Speech by Charlotte Gerken

PPF Strategic Plan: an observation for private market investment managers

The PPF released it's 3-year strategic plan today.

The statement that caught my eye was

"In the future we expect there to be fewer claims from schemes on the PPF than today, and therefore the levy we need to collect will be small in comparison to our own assets and liabilities. Our current projection is that this point will be be reached in 2030."

Might the timeframe for a decline in total risk-based levies paid to the PPF tell us something about the pace at which the c. £1.5trn corporate DB pension fund industry will pivot away from equity and towards mezzanine and senior debt?


1. The PPF think that DB pension funds reach a tipping point in 2030 where the PPF will not be collecting nearly the same amount of levies as it does today.

2. The majority of levies collected is from schemes with a buy-out deficit. Fully-funded schemes pay a trivial amount in levies.

• Schemes in deficit on a buy-out basis pay a levy of approximately 10 basis points of that buy-out deficit.
• Schemes that are fully funded on a buy-out basis pay a levy of approximately 1/10 of one basis point of their total buy-out liabilities.

3. The PPF's suggestion of a tipping point in 2030 therefore seems to suggest that they are planning for a world where a significant number of schemes are fully funded on a buy-out basis by 2030.

• Of course a best-case scenario for financial soundness of DB pension funds corresponds to a worst-case scenario for future levy income for the PPF and so perhaps the PPF is being overly cautious in its planning.

4. If, however, this scenario were to come to pass, it may have implications for asset managers and the types of products that they will need to develop, as well as for the sources of capital available to fund unlisted investments such as infrastructure.

• For example, much is made of the institutional investor trend toward private market assets. Under the sort of scenario outlined by the PPF, DB pension funds invested in private markets are increasingly likely, over time, to switch their private market exposure away from equity and towards mezzanine and senior debt.

• In the run-up to achieving fully-funded status, equity and mezzanine debt (with its higher returns) could feature more heavily as funds seek to close funding gaps. As fully funded status is reached, senior, secured debt with lower, but more stable returns, may well dominate.

• Now you could say we have always know this but the scenario outlined by the PPF may allow us to place a timeline on this. 

• Private market equity (infra, real estate and corporate) will continue to be gradually squeezed out of DB fund allocations over the next 11 years (2019-2030) as funding levels improve and reduce the need for growth assets.

• In the 1st half of the next decade (2020-205), pension funds may close their funding deficits by continuing to allocate to private market equity.

• Gradually, as funding levels improve, mezzanine and junior tranches may see higher demand and benefit from early flows away from equity. This may happen if mezz debt is  perceived to offer favourable returns to allow (smaller) funding gaps to be closed but at lower volatility compared to investments in equity.   

• As funding levels improve further still, senior debt may gain favour 

• The pace at which this all happens will clearly depend on how well funded pension funds actually become over the next decade. 

• One could say that private market equity may well become a  a victim of its own success by allowing better funded pension plans to more quickly reverse out of equity and into mezzanine and senior debt. 

5. For asset managers raising private market funds in the next few years, equity funds will remain attractive but increasingly these managers may wish to consider diversifying their product mix to offer capabilities and funds that invest in other parts of the capital structure, including mezzanine and senior debt.

6. Private market investment managers with strong credentials in equity investment should be ideally placed to understand the risks of investing in mezzanine debt and hold a competitive edge over those asset managers with more experience in managing debt. That competitive advantage may erode with time. 

   

The Impact of Physical Climate Risk on CDI and Secured Income strategies

So called Secured Income Funds may invest in Commercial Mortgage Backed Securities.  Whilst not a significant holding, it is nevertheless an asset class used by many managers of Secured Income strategies and one worth understanding a bit better. Holdings in CMBS by Secured Income Funds vary but may be between 5-15%.

So, what are the implications for risk-adjusted returns on CMBS that arise from the recent study by BlackRock and Rhodium, into climate-related risks?

The BlackRock study focuses on the US CMBS market but the key observation may well translate into other markets and so investors would do well to engage their asset managers on the issues raised.

Turning to the key points from this latest research:

1. Hurricanes give rise to flood and wind risk.

2. Commercial mortgages within CMBS pools are required to have insurance against wind risk.

3. However, flood risk for CMBS mortgages is, typically, only insured in FEMA-designated areas (again a specific feature of the US CMBS market and not applicable to European or UK CMBS).

4. Hurricane risks are increasing and expected to increase further

• BlackRock highlight past and expected future changes in hurricane risk for US properties underpinning commercial mortgages in the CMBS market as follows:

           - a 137% increase since 1980 and
           - a 275% expected increase by 2050 assuming "no climate action" is taken.

5. If the losses arising from flood risk (and other climate-related changes) are not properly allowed for then valuations in the CMBS market may be underestimating the true physical risk to the underlying collateral pool from changes to our climate. This may mean that risk-adjusted returns are overstated.

[SB observation: this risk also applies to insured flood risks. For insured risks, risk-adjusted returns should allow for higher premiums in the event that insurance rates tighten. This may be especially true if insurers are underpricing the true risk from climate change.]

So what could UK pension funds who implement CDI, through Secured Income strategies, do?

• The key point is that when allowing for expected returns (net of expected losses) from a Secured Income strategy, it will become increasingly important to build in some prudence for higher expected losses to the underlying collateral pool that may arise from climate-related risks. 

• Taken on its own, a CDI strategy that has less than 5% of total fund assets invested in CMBS may not be sufficiently adversely impacted by a small deterioration in expected losses. [E.g. in one modelled scenario, BlackRock estimate a 60bps increase in expected losses for US CMBS.]

• However, adding in Residential MBS and other loans (private infrastructure debt and private real estate debt) that underpin Secured Income strategies, may well increase the overall impact on expected losses due to climate risk.

• UK pension funds appear to be paying more attention to potential investments in junior infrastructure debt and mezzanine real estate debt at the expense of senior debt. This appears to be linked to a "crowding-out effect" -senior, investment-grade debt is being bid-up by UK annuity books who view this part of the debt market as offering attractive returns after allowing for the favourable capital treatment that Solvency 2 regulations afford to senior, secured, investment-grade debt. Unexpected losses, from unforeseen climate risks, are more likely to be absorbed by junior and mezzanine tranches, which rank lower in the capital structure than senior debt holders. So, to the extent that UK pension funds are considering debt investments lower down in the capital structure, then climate-related risks may be more likely to "bite" and it becomes more pressing to allow for this risk.

• Given the recent focus by government on the action being taken by the UK's largest pension funds in addressing the impact of climate-related risks, perhaps this study from BlackRock, together with the observation of how Secured Income strategies are impacted, may provide a catalyst to revisit expected loss assumptions and ensure that self-sufficiency discount rates are set having considered, in more detail, the climate-related risks in the underlying loan collateral pool?

A word (or three) of caution. Clearly when the largest asset manager in the world raises an issue, it will garner attention but it would be incorrect to assume that other key participants in this market have been oblivious to the risk being highlighted.

In fact, a recent article from Bloomberg highlights that these risks are, not only, well-known by market participants but many market participants including banks, rating agencies and asset managers have applied themselves to quantifying these risks.

A gratuitous plug for my own employer, DWS and their recent report on climate risk which was equally comprehensive and insightful.

Four Twenty Seven is another organisation at the forefront of quantifying climate-related risks in the Real Estate world as evidenced by this recent report into the impact on the REITs market.

• Could Jeff Bezos' Amazon solve the pensions conundrum?

Jeff Bezos has plenty of reasons to smile. Amazon, the company he started in 1994, today, has a market capitalisation of $559bn. If Amazon was a country it would be 23rd largest country in the world ranking just below Switzerland.

Not that it is even a glint in the corner of his eye but Jeff's retirement plan couldn't be in better shape; Jeff's 16% shareholding in Amazon Inc is valued at $91bn. And if Mr Bezos was his own sovereign nation, he would rank as the 66th largest country - somewhere between the Ukraine and the Slovak Republic and larger than Sri Lanka.

But could Mr Bezos, having secured his own retirement, help secure the retirement of millions of his users. And even if his cause was less noble, could Amazon catapult its market capitalisation to the next level by bringing about an ‘Uber’ style revolution in the world of pensions.

How could this happen?

In today’s saving environment, retirees now find that their retirement income levels depend mostly on their own discipline to save during their working lives.

Millions of today's savers are face an uncertain financial future in retirement due to a once-in-a-generation shift in investment risk from companies to employees. The closure of defined benefit pension funds and the transition to defined contribution (DC) arrangements means that, in the future, retirees from a DC arrangement can no longer rely on access to a retirement income that bears a high degree of resemblance to their working income just prior to retiring or to an income that is inflation-protected. Rather, the shift to DC means that the adage ‘what you put in is what you get out’ has never been more apt when it comes to pensions.

But, as the pictures show, too many people are simply not saving enough.

We may choose to blame a change in the values of millennials versus baby-boomers or a cultural acceptance of instant gratification. Either way, too many people are simply not saving enough to ensure a comfortable retirement.

And, to compound matters, saving for retirement, when it does happen, tends to start later in life.

Most of us only sober up to the need for a retirement plan when we start a family or hit mid-life. The power of compound interest, whilst still effective at this later age, would have been even more effective if our saving habit kicked in a bit earlier. To make matters worse, marriages are occurring much later (if at all) and children, often a catalyst for future planning, are being had later in life.

In summary, how do we get the world saving more, and from an earlier age, to provide for their retirement?The answer may lie in a simple, yet powerful observation, that saving and spending are two sides of the same coin.

Human nature would appear to pre-dispose us to spending on items that meet our immediate needs, often at the expense of saving for a longer-term goal. What if we could tap into this natural propensity to spend and turn it into a savings plan; a savings plan on auto-pilot.

What if, for each pound spent, a little bit of that pound could be automatically squirreled away?

So how could one of the most recognisable sales platforms, Amazon, be turned into the world’s most powerful savings platform?

In two simple steps.

1.   By allowing users to establish an Amazon profile that automatically, at checkout, added, say, 10% to cost of the basket.

 2.   By automatically directing that ‘10%’ into a retirement savings account, either a default account administered by Amazon or a plan chosen by the user, for example, an existing 401(k) plan in the US or self-invested personal pension in the UK.

Simple, yet effective.

Of course, we could continue to develop on this theme and rethink the savings ecosystem around this simple, yet basic concept.

Other possibilities include:

1. At the customer’s election, Amazon could link up with the local tax collecting authority (e.g. the IRS or HMRC) so that, at the time of tax filing, the tax credit emanating from this pension contribution was identified and paid directly back into the “Amazon” retirement savings account rather than being refunded into a bank account.
2. In the event that other retailers offered their customers the same option to set up their online buying profiles in a similar way then, Amazon, having built the plumbing to facilitate and track savings, could allow other online retailers access to the default Amazon savings platform.

Back to Amazon and Mr Bezos. Revenue at Amazon last year was approximately $135bn, of which $90bn was attributable to retail sales. With a 20% take-up rate of this ‘auto-pilot’ retirement savings option, and a 10% 'contribution rate', Amazon could be helping their customers squirrel away $1.8bn every year. This amount could be multiples higher than this, in the event that customers began to view Amazon as their primary retirement savings vehicle. It isn’t hard to imagine Amazon building a retirement savings business, that in a short span of time, accumulated assets under management well in excess of $100bn. It would also make Amazon a Top 200 asset management firm, ranked by assets under management. Something that Amazon’s shareholders may well come to appreciate. 

For those of you thinking that this doesn't sound core to Amazon’s business of being an online retailer, it may be worthwhile pointing out that Amazon’s core profit making business is not its online retail business. Whilst the majority of Amazon’s revenuecomes from online sales, the online retail sales business is not the major driver of profits. Amazon’s profits come from a more obscure part of its business, its Amazon Web Services (AWS) – a part of the business that provides outsourced cloud computing services. For example, Netflix uses AWS for almost all its backend infrastructure, storing and streaming of its web series.

So, should Amazon wish to add a further revenue stream through providing financial services, and more importantly financial security, it could do worse than consider exploring the world of pension saving.

In summary, whilst this blog considers a specific example of how Amazon could enable their customers to save more for retirement, the more general point is to question our current paradigm of separating spending and saving ecosystems. The exception may be 'rewards' programmes (e.g. earning air miles for spending) but one could argue that even this does not go nearly far enough towards integrating the two ecosystems.

More specifically, by looking into innovative ways in which we can redesign how we link our savings ecosystem more directly with our spending ecosystem, we may stand a better of chance of introducing a disciplined and consistent approach to saving for retirement. One that begins with the very first pay cheque.

Assessing the liquidity risk premium in government-guaranteed bonds

There are two main risks when investing  in government-guaranteed, inflation-linked, Eskom bonds. 1.  Credit risk The government guarantee on these bonds means that these bonds are free from Eskom credit risk. In our view the guarantee wording is suitably robust. That said, we would observe that, in the event of a sovereign stress event that requires some form of waterfall or priority to be set for meeting sovereign obligations, then it would not be unreasonable for the sovereign to primarily focus on firstly meeting the sovereign obligations before turning to the government-guaranteed obligations. This means that, in our view, there should be some compensation for this risk, even if it is small. 2.  Liquidity risk Eskom is the only State-Owned Enterprise (SOE) that makes a market in its own bonds. This, together with the fact that Eskom has the largest SOE bond issuance programme, makes Eskom bonds the most liquid of all the SOE-issued bonds available to a South African investor. That said, this liquidity is bifurcated with the nominal bonds generally being more liquid than inflation-linked bonds. In our opinion, this lack of liquidity, relative to an equivalent sovereign bond, should also be compensated for. The purpose of this post is to consider the suitability of Eskom’s government-guaranteed, inflation-linked bonds for purposes of improving the yield on an LDI portfolio. In particular, which of the following two alternatives should be preferred:                                                                                                                           1) Buying the physical Eskom bond and earning liquidity and credit risk premia                                                                                                                        or                                                                                                                   2) Buying an inflation-linked government bond and then repoing this bond out  to raise cash to be invested      in credit assets.                                                                                                                                                            In order to answer this question we adopt the following approach. We acknowledge that this other approaches are possible:                                                                                                          We compare the yield on an Eskom government-guaranteed, inflation-linked bond to that available on a sovereign-issued bond with a similar modified duration* in order to calculate the additional yield earned over sovereign bonds. This provides us with an estimate of the liquidity risk premium that Eskom bonds offer, assuming of course that the guarantee is robust and that, for this reason, investors do not demand any additional premium for credit risk over the sovereign. We can aim to quantify the credit risk premium in Eskom bonds by looking at the difference in yield between government-guaranteed Eskom bonds and the non-government guaranteed bonds issued by Eskom We then aim to quantify the market’s implied pricing of the lower liquidity in Eskom government guarantee bonds using the repo market, which is only one measure of liquidity risk. If we can demonstrate that the (repo?) market’s implied pricing is greater than the additional spread being earned on Eskom bonds over sovereign bonds then we may be able to conclude that perhaps the additional yield on Eskom bonds is not sufficiently compensated for the risk.                                                                                                                                                                                                                                                       Step 1: Identify a market that can be used to estimate the liquidity risk premium on Eskom government-guaranteed bonds To do this we want to consider market observable data in order to arrive at the market’s implied price for the lower liquidity of Eskom government-guaranteed bonds.                                                                                                                         One way of quantifying this is to look at the repo market. The repo market allows us to create liquidity on an Eskom bond by repoing out the bond in exchange for cash. The table below shows recent repo pricing received from one of the Big 4 SA banks. Govt Guaranteed Bonds HC @ 5% Bid  (Bps) Offer (Bps) 1 month (1m JIBAR +) 85 10 3 month (3m JIBAR +) 90 15  This table (see ‘bid’ column)  shows that the cost of a 3-month repo on Eskom government-guaranteed bonds is 3-month JIBAR plus 90bps.                    -  We note that this pricing applies to nominal, government-guaranteed bonds and not to inflation-linked bonds                    -   Pricing on inflation-linked bonds would be different – either the spread would be higher (ie higher than 90bps) or the haircut would be higher.                    -   For now, we ignore this complication which would only serve to further increase the market implied price for the liquidity premium that should                        be earned on an Eskom bond.We note that this pricing applies to nominal, government-guaranteed bonds and not to inflation-linked bond Based on our trading experience, the cost of a 3-month repo on inflation-linked government bonds has been approx. 3-month JIBAR plus 50bps. 3-month JIBAR is currently 7.36%. This means a 3-month repo on                                                                                                                              -   an Eskom government guaranteed bond would cost 7.36%+0.9% = 8.26% to fund R95 of such                         a bond.                     -   a government bond would cost 7.36% plus 0.5% = 7.86% to fund R100.                                                                                                                                                                                                  At first glance this may suggest a liquidity premium of 40bps. However, this estimate ignores the haircut on the Eskom bond.                                                                                                                         Step 2: Adjust the ‘raw’ market price for the impact of the haircut                                                                                                                           We now adjust the effective financing rate on the Eskom repo to allow for the fact that only R95 of the bond is funded compared to R100 of funding released from the repo of a government bond.                                                                                                                           To release R100 of cash on the Eskom bond would require us to repo R100/0.95 = R105.26 of Eskom bonds              Financing this R105.26 of Eskom bonds would cost 8.26% of R105.26 = R8.69.                                               Therefore the equivalent cost of raising R100 cash from an Eskom bond is R8.69 vs R7.86 for a government bond. The repo costs of each can now be compared, on a like-for-like basis, as follows                                                                                                       Government bond = 7.86% = 3-month JIBAR plus 50bps.                            Eskom bond = 8.69% = 3-month JIBAR plus 133bps                                                                                                                            When viewed in this way then the liquidity risk premium on Eskom bonds should be at least 83bps to compensate us for the higher cost of funding cash using an Eskom government-guaranteed bond vs a government bond. We note that this 83bps is likely to underestimate the market’s true cost because the repo market pricing used here applies to the more liquid, fixed-rate, government-guaranteed Eskom bonds. Pricing on the less liquid, inflation-linked equivalent is likely to be higher and this would then imply an even higher liquidity premium. Step 3: Identify the additional yield that is available on Eskom government-guaranteed bonds over government bonds Eskom-issued, government guaranteed, inflation-linked bonds have traded (over long periods of time) at a spread (above matched-maturity government bonds) that is not too far off 60bps.                                                                                                                           We compare this 60bps to the 83bps implied by the repo market and conclude that based on this measure, Eskom bonds do not offer nearly enough compensation for the additional cost of using them to fund a cash investment in credit. Put differently, assuming that Eskom government-guaranteed bonds have no credit risk and only liquidity risk, then, based on pricing derived from the repo market, these bonds should offer us at least 83bps of liquidity premium.                                                                                            For this reason we would generally have a stronger preference to buy government bonds and use them to fund a position in credit using the repo markets. That said, Eskom inflation-linked bonds offer a valuable source of inflation-linked duration in a market where this is in short supply. For those investors with large hedging programmes, it could be argued that investing in Eskom inflation linked bonds still makes sense because the tight spread to the sovereign is a direct reflection of the scarcity premium attached to quasi-government inflation-linked assets.

Monitoring credit risk in South African fixed income portfolios

                                                                                                                 

By Shalin Bhagwan and Jana Kershaw

Who should read this?

• Investors in fixed income assets, including, but not limited to, those invested in:
• Bond funds such as those benchmarked to the ALBI, CILI.
• Cash funds such as those benchmarked to STeFI.
• Balanced funds with allocations to bond and/or cash funds.
• Credit funds aiming to outperform cash returns by investing in corporate bonds or similar instruments.

What is the key client takeaway?

·         Fixed income fund managers typically target excess returns above their benchmarks and many will do so by taking credit risk i.e. lending investors’ money to borrowers who pay a premium to compensate the lender for the risk of non-payment.

·         Measuring credit risk is a complex task and credit rating agencies are professional firms that measure credit risk associated with individual borrowers.

·         A fourth credit rating firm, GCR, has now been recognised by the SARB. Over time we would expect GCR to increase their market share (more local debt issues rated by GCR) and this will place greater onus on fixed income managers to ensure they are consistently interpreting credit ratings from different providers.

·         Investors should take care to ensure that reporting on credit rating exposures correctly classifies securities to avoid a portfolio being classified as being of a higher credit quality based on credit ratings alone without any adjustment for different rating methodologies used by different rating agencies.

·         The benefit to investors would be to ensure that the amount of risk being taken in their fixed income portfolios is consistent with their risk appetite.

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Credit ratings are an important tool used by fixed income managers and their investors to control overall risk at portfolio level. Whilst a credit rating cannot mitigate or improve the risk of any individual debt security, when these ratings are used to set upper limits on the amount of an investor’s portfolio that can be exposed to securities with a certain rating, then this can help set the expected maximum loss from taking credit risk. In addition, investors can also dictate the amount of risk they are willing to take by setting limits, for example, with regard to the minimum credit rating of companies whose bonds they invest in. For example, “investment grade” bonds are bonds that are issued by companies considered to be of the highest credit quality and will have credit ratings that are above a universally accepted threshold. By stating that they only wish to invest in investment grade bonds, investors and their fund managers place an upper bound on their credit risk tolerance.

The South African Reserve Bank’s (SARB) approval last week of Global Credit Ratings (Pty) Ltd (“GCR”) as an External Credit Assessment Institution is positive news.  Previously only the large 3 global agencies (S&P, Moody’s and Fitch often collectively referred to as the “Big 3”) were approved by the SARB.

The endorsement by the SARB may well provide additional comfort to bond investors who may have previously been reluctant to rely exclusively on a GCR rating.

This development may therefore mean that fixed income portfolio managers could (if they have not already done so) consider widening the universe of companies they can invest in, if current internal and/or client-driven restrictions meant that only a credit rating from the Big 3 would have sufficed. The SARB approval may well provide the required comfort to lift any implicit restrictions on the use of GCR.

1.       Credit ratings as a risk measure* remain valid but different vendor methodologies means that these differences have to be understood to ensure consistency…..

While most agencies would implement some form of ratings uplift for secured instruments, the differences in methodologies relating to upward notching of ratings to reflect security** may produce varying results. While the GCR secured-bond methodology allows for rating uplift based on the impact that the security has on overall recovery prospects, other agencies’ notching may be dependent on both the recovery prospects as well as the starting point of the rating (higher-rated entities get less benefit for security than lower-rated entities). Fixed income teams and credit analysts who have intimate knowledge of the differences in ratings agencies’ methodologies will be better placed to navigate these differences and, specifically in the case of split ratings (where the same entity is rated differently by multiple rating agencies), will be better placed to consolidate different ratings into a single comparable rating.  [For those interested in reading more about the limitations of credit ratings we would refer to our previous article on this topic which can be found by clicking on this link: http://ldihedge.blogspot.com/2014/08/guns-dont-kill-people-people-kill.html

*Credit quality is assessed through two measures; a probability of default (“PD”) and loss given default (“LGD”). The product of these gives the “Expected Loss”. For example, a bond may have a PD of 1% and a LGD of 50%. This means that the expected loss assuming a R100 investment in that bond would be 50c (R100 x 0.01 x 0.5).  

** Typically “security” arises when a borrower provides a lender with a priority claim on clearly earmarked assets (tangible and/or non-tangible) in the event that the borrower runs into difficulties in meeting its obligations to the lender. The provision of security by the borrower may or may not be a pre-requisite for the lender.

2.       …and having recognised these differences, then reporting systems may need to be adapted, perhaps manually, to ensure that the correct reporting reaches clients.

This will not be new information for fixed income managers and it is likely that such adjustments will be made even though these adjustments will most likely have to be done manually. It is important for the asset manager to make sure that such adjustments are correctly captured by reporting systems that may well be designed to produce automated information based on unadjusted credit ratings.

[In this note we do not aim to cover, the potentially thorny question of, how these adjustments will be made and whether a subjective judgement may lead to inconsistencies across one or more asset managers].

Client and consultants should ensure that reporting is accurately captured for the purposes of monitoring their managers as well as controlling for credit risk at aggregate fund level.

3.       In some cases, definitions in fixed income mandates may need to be updated / clarified to ensure that the portfolio manager has the scope to make use of a GCR rating

Some large pension fund investors have awarded stand-alone, segregated credit mandates and for these investors it may well be important to revisit the wording in their mandates around the use of credit rating agencies.

-          Where the wording is broad enough to automatically allow the use of GCR as a rating agency (some clients have restricted the use of ratings to those provided by the “Big 3”) then investors will wish to ensure that any standardisation that may be necessary is carried out for reporting purposes.

-          Where the wording is not sufficiently broad so as to allow the use of GCR then consideration should be given to broadening the wording of the mandate to allow the use of GCR. However, in this case, we would highlight one further challenge that arises where GCR is included in a manager’s universe of rating providers for the first time: if a mandate’s requirement does not prescribe the choice of credit rating (for example, by prescribing the use of the lowest rating across providers) then if GCR’s ratings are, on average, higher than those of the Big 3, then taking the highest rating across all four rating providers could optically improve the perceived credit worthiness of the portfolio.

4.       GCR ratings may take on greater prominence in South Africa given that they tend to be cheaper to obtain

Finally, there are good reasons, mostly relating to the cost of obtaining a credit rating, as to why GCR ratings may be preferred, especially by debt issuers and fund managers seeking a rating on previously unrated debt.  Given that GCR is locally based, their costs tend to be mainly Rand-denominated and so their pricing tariff for carrying out rating assessments reflects this. The Big 3 agencies tend to have (US) dollar-denominated costs and this drives up their cost for awarding a rating. In this case, it will become increasingly important to understand the subtle differences between each agencies ratings methodology and the impact on the credit rating that is awarded.

Other reasons why GCR may take on greater prominence include:

-          The ease of access to a locally based credit rating team

-          It may be argued that a locally based team may be better placed to understand the idiosyncrasies of the South African debt landscape (however we accept that there are equally valid counter arguments).

The bluffers guide to covered bonds

Bluffers guide to Covered bonds

Next week the World Bank is in South Africa to discuss covered bonds with the local association of investment managers. For Uber taxi-drivers lucky enough to ferry our hard-currency, well-heeled visitors from abroad, here’s the bluffer’s guide to covered bonds. You may find it useful in striking up a conversation and earning that sought after five-star rating for your driving experience.  

The South African banking regulator’s position on covered bonds	On May 23rd 2011 the South African Reserve Bank’s (SARB) Office of the Registrar of Banks issued a guidance note banning South African banks and branches of foreign banks from issuing covered bonds or from engaging in any structured transaction that was the economic equivalent of a covered bond.   As covered bond ranks senior to uninsured depositors as well as to senior, unsecured creditors, the Bank Supervision Department (BSD) of the SARB was concerned with protecting depositors.   As South Africa does not have any scheme protecting depositors, the implications of covered bonds on the local depositor base would be different to that in, say, the UK where depositors are protected for the first £85,000 of deposits held with a single authorised bank.
The South African banking sector	Ring-fencing retail from investment banking is not on the cards and so protecting depositors will need to take another form, as in the rest of Europe, UK and the US.   According to the SARB, the four largest South African banks (often called “the Big 4”) are Domestically Systemically Important Banks (D-SIB) and the SARB is applying many G-SIB proposals to these Big Four banks. In fact the TLAC (Total Loss Absorbing Capacity) requirement to be applied to these D-SIBs has been finalised but remains confidential. South African banks   -          Are dependent on wholesale, short-term funding -          Tap into a retail deposit base that is small since most retail savings is channelled into pension, insurance and money market funds -          Tap into a larger corporate deposit base but corporate deposits are typically “haircutted” relative to retail deposits and are therefore not as favourably treated for purposes of meeting the LCR and NSFR requirements -          Have limited access to long-term funding in capital markets   SA banks have -          an LCR shortfall of c. R140bn (SARB; Guidance Note 6; 2013). The LCR of five of six South African banks tested by the IMF is below 100% but as the IMF noted, the SARB introduced a CLF (committed liquidity facility) which allowed all banks to meet the LCR. -          An NSFR of below 100% with the exception of one bank   Barclays estimates that the five largest South African banks may need to issue approximately R402bn of listed debt vs their current outstanding debt of R207bn or a total listed bank debt of R280bn.   The cost of raising this debt is likely to be penal, especially if only existing instruments are used. Covered bonds may be one way of softening the blow on the local banks however, given South Africa’s lack of a scheme protecting depositors, covered bonds could subordinate the very people that the new banking regulations are seeking to protect.   On the other hand, complying with the LCR and NSFR regulations is going to have an adverse impact on the profitability of local banks. No doubt the brunt of this pain this will ultimately be felt  on an already stretched South African consumer, many with high debt burdens.   It is therefore in the country’s interests to find a solution to this problem.
What are covered bonds?	They are senior, bullet instruments of an issuer (typically a bank) where the bond holder has recourse both to the issuer as well as an underlying collateral pool.   The bullet payment can be “hard” i.e. no possibility of extension risk or is can be “soft” with the some option for the issuer to extend the repayment date by a period, typically no more than 12 months.   Bonds can either be fixed rate or floating but the majority of issuance globally to date has been fixed rate. Hard bullets tend to dominate over soft bullets with mortgages being the overwhelmingly dominant type of collateral.
What collateral is typical?	Typically collateral types will be defined by legislation. In the UK, for example, where legislation was, for a long time, lacking then collateral types would have been defined in transaction documents   Typical collateral types -          Mortgages (residential and commercial) -          Public sector exposures -          Shipping, SME and aircraft exposures   Mortgages account for c. 80% of collateral across global covered bond market and public sector exposures c. 18%.
What risk is there to a covered bondholder?	The bondholder is exposed to the risk of the issuer (the bank) defaulting. In the event that the bank defaults, the bondholder will have recourse to ring-fenced collateral pool, the nature of which has been pre-agreed with the bank. On bank default the credit risk changes from being bank credit risk to credit risk exposure to the underlying collateral pool.   Should the collateral pool be insufficient to meet the claims of covered bondholders, then the outstanding amount becomes a claim against the issuer (the bank) and ranks pari passu with other senior, unsecured bondholders.
Why covered bonds differ from Residential Mortgage Backed Securities?	RMBS are characterised by -          A pass-through structure vs a bullet under a covered bonds -          Recourse to the collateral pool only vs covered bonds having recourse to both the issuer and the collateral pool -          Credit enhancement in the form of subordination vs covered bonds where the enhancement is typically only through over-collateralisation
What are the structural forms of covered bonds?	There are three structural forms – the first two are typically called “legislative” models and the third a “structured” model. This terminology arises because some countries did not have covered bond legislation in place and so sought to make use of existing securitisation legislation and methods to create the economic equivalent of covered bonds. Many of these countries have since created the appropriate legislation blurring the lines between “legislative” and “structured” markets.   1.       On-balance sheet Covered bond is issued from the balance sheet of an originating bank with the collateral pool remaining with the originator but ring-fenced in case of insolvency.   2.       Specialist Bank Principle The bank that wishes to access covered bond financing establishes a wholly-owned subsidiary to which it transfers the collateral pool. The subsidiary issues the covered bond which is backed by the transferred collateral pool.     3.       Structured/guarantor model Covered bonds are issued by the bank as unsecured obligations. Money raised by issuing the bonds is then lent to a limited liability SPV which then acquires the collateral pool using the loan proceeds. The SPV then guarantees the unsecured bonds and will use the collateral to pay bondholders in the event of the issuer’s insolvency.
Where might covered bonds feature in SA fixed income mandates?	Covered bonds rank right at the top of an issuing bank’s capital structure – above uninsured depositors (in the case of SA, that is all depositors!) and senior, unsecured bondholders.   In a South African context, given the D-SIB recognition by the SARB, then the credit risk related to covered bonds (should they come into existence) issued by the Big 4 banks may lie just below that of the debt of State Owned Companies   A ranking of credit risk in the SA market may look (from highest to lowest) as follows   -          South African government bonds -          Government guaranteed bonds issued by State-owned Companies -          Non-government guaranteed senior debt issued by State Owned Companies -          Covered bonds issued by Big 4 SA banks -          Senior, unsecured Big 4 bank debt -          Other bank debt/ Corporate debt / Old-style bank sub-debt / new style bank sub-debt   It is therefore very likely that fixed income managers are likely to view covered bonds somewhere between non-government guaranteed bonds issued by State Owned Companies and senior, unsecured Big 4 bank debt when looking for yield enhancement in fixed income mandates managed against both market and liability benchmarks.   Assuming that SA Big 4 banks do ultimately issue covered bonds, then depending on the level of spreads on offer, the potential danger for SOC issuers is that covered bonds may be seen to offer a more attractive risk-adjusted return that their non-government guaranteed debt especially given the D-SIB status of the Big 4 SA banks.   Certainly, in the early stages of any such market developing the natural process of price-discovery in the early days may create opportunities for those investors whose mandates are flexible enough to allow their fund managers room to invest in covered bonds.
Key market statistics globally	1.       Largest covered bond market is Germany followed by Denmark, Spain, France and Sweden. 2.       2/3rds of covered bonds are denominated in Euros. 3.       Bank in Spain and Denmark are the largest issuers of mortgage-backed covered bonds. 4.       German banks are the largest issuers of public-sector backed covered bonds.