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By Shalin Bhagwan – Head: Institutional Solutions and Jana Kershaw – Credit Fund Manager and Analyst at Ashburton Investments
Ashburton Investments considers the inclusion of bank-issued inflation-linked paper instead of government-issued linkers (inflation-linked bonds) when constructing Liability Driven Investment (LDI) portfolios.
Since the issue of the first inflation-linked South African government bond in March 2000, the universe of inflation-linked bonds available in South Africa has long since expanded beyond just government bonds. As at the end of May 2014, there were 9 issues of government inflation-linked bonds listed on the Johannesburg Stock Exchange (JSE) with a market value of R369.3bn. This compares to 10 non-government issuers (excluding special purpose vehicles and notes) of listed inflation-linked bonds with an outstanding market value of R72.1bn across 38 issues. Within the non-government issuers of inflation-linked bonds, the local banks are the largest issuers. Their total issuance of R38.3bn across 65 issues amounts to 53% of non-government issuance and exceeds that of even the State Owned Companies (SOCs). By comparison, the SOCs have issued inflation-linked bonds with a market value of R33.4bn across 9 issues.
Some LDI portfolio managers have been buying bank-issued inflation-linked bonds and in this context it is important for clients to be aware that their de-risking portfolios contain credit risk. Taking credit risk in the LDI portfolio is not without international precedent but clients and advisers should asses the credit skill, experience and business model of the LDI manager before allowing the manager flexibility to include credit in the LDI portfolio.
1. An inflation-linked bond (or linker) is said to be an accreting asset.
1. An inflation-linked bond (or linker) is said to be an accreting asset.
What this means is that both the coupons and the final redemption payment increase in line with the reference inflation rate over time. This differs from a fixed interest bond.
By way of example consider two bonds:
Bond 1
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7-year fixed bond maturing 31.12.2020, issued at par (R100) with a fixed coupon of 9% p.a.
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Bond 2
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7-year inflation-linked bond maturing 31.12.2020, issued at par with a real coupon of 5.75% p.a.
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Assume that inflation runs at 6% p.a. over the period to maturity of these bonds. Expected cashflows on these bonds are illustrated in the chart below.
Source: Ashburton Investments
2. So, inflation-linked bondholders expect their invested capital to be returned later than if they had invested in a comparable fixed-rate bond.
Bond issuers understand the accreting nature of an inflation-linked asset and that this feature means that bondholders effectively lend the bond issuer money for longer (as shown by our chart above). In the case of utilities or infrastructure providers, such as Eskom and SANRAL, issuing inflation-linked bonds to fund their borrowing requirements makes sense since their revenues are in part linked to inflation. There is good grounding in corporate finance theory to suggest that businesses with inflation-linked revenues can actually reduce the volatility of their net profits by having some of their borrowings as inflation-linked rather than fixed rate debt.
The fundamental case for banks issuing inflation-linked debt is less clear although banks are probably best placed to understand the risks and rewards of doing so. With sophisticated treasury teams, banks are able to hedge any risks posed to them from the issuance of such debt whilst ensuring that the favourable economics on offer, such as being able to capture greater borrowing for longer, is retained.
It is perhaps not surprising then that, outside of the government, banks are one of the largest issuers of inflation-linked bonds in South Africa. The chart shows the total size of all non-government issuers inflation-linked bond programmes across all maturities and issues. Apart from Eskom, SANRAL and the Trans Caledon Tunnel Authority (TCTA) the other main issuers of inflation-linked bonds are the banks. The aggregate issuance by the banks is greater than the aggregate issuance of Eskom, SANRAL and the TCTA.
Source: JSE
Given the premium placed on inflation-linked assets by local LDI investors and their simultaneous need for acceptable returns for their members, issuing inflation-linked bonds for credit risky borrowers can be a ‘win-win’ for both the issuer and the buyer. The credit-risky borrower is forced to issue the linker at a higher real yield than would be implied by a comparable government inflation-linked bond. The additional yield is compensation for the additional credit risk that the investor is taking but helps investors meet their return objectives in the current low-yield environment.
That said, we would argue that, fundamental to the ‘win-win’ premise is a thorough understanding of the risks involved which, due to the longer payback period, is even greater than may be immediately obvious.
3. For the most part South African LDI mandates own government and explicitly government-guaranteed inflation-linked bonds
Historically, the main non-government issuers of inflation-linked paper have been Eskom, SANRAL and TCTA. These are all explicitly guaranteed by the government of South Africa. For example, the SANRAL and Eskom guarantees are basically the same where the government becomes responsible for payment in the event that SANRAL or Eskom cannot repay the debt. Government has 20 and 5 business days to pay in the case of SANRAL and Eskom. Each bondholder can enforce their rights separately against the government. The TCTA guarantee calls for immediate payment if they fail to meet their obligations.
4. Bank issued inflation-linked bonds present a very different credit risk profile to their government and government-guaranteed counterparts and should be evaluated differently before inclusion in an LDI portfolio.
Clearly a thorough credit analysis must be carried out prior to investing in bank-issued inflation-linked bonds. More than that, the long-term nature of the funding being provided by the debt holder should be understood and properly compensated for.
This is critical in an LDI portfolio which is designed to be a hedging portfolio. A hedging portfolio should be designed to mitigate risk. This should extend to mitigating risk in stressed market conditions.
A further risk is liquidity risk. Since bank issued bonds tend to be of a smaller size, trading in the secondary market is much more limited and bid-offer spreads (the costs of buying and selling) are higher than government and government-guaranteed inflation-linked bonds.
As an example, the second chart above illustrates the difference one could expect in liquidity by considering the size of the various (non-government) issuers total inflation-linked bond programmes across all maturities and issues. In general, all else being equal, the larger the amount of stock in issue, the more liquid the bond. Other features do, however also impact liquidity.
The total size of bank issues (per issuer) range between 27% - 46% of the total issue size of government-guaranteed Eskom bonds. This feature combined with the government guarantee on Eskom bonds makes the latter far more liquid than the bank bonds.
5. LDI portfolios which include inflation-linked bonds issued by banks (and other credit-risky borrowers) should ensure that they have evaluated the risks of doing so.
The risks of holding a bank bond include both credit and liquidity risk as explained above. . Moody’s, in a report on the South African banking system, released in May 2014, noted that the outlook for the local banking sector remains negative – mainly the result of subdued economic growth, which will continue to exert pressure on asset quality. We have also seen recent negative rating action on some South African banks, and rating outlooks, in most cases, remain negative. In our view, this places any decision to hold non-government guaranteed bonds in the LDI portfolio firmly in the spotlight.
To demonstrate that these issues are not purely theoretical, the cashflow analysis we have shown above is broadly based on an actual bank issued inflation-linked bond maturing in 2020 and that also carries a coupon of 5.75%.
Holders of South African banks’ inflation-linked bonds, especially where held as part of a de-risking or LDI programmes, should ensure that their managers have the skill and credit analysis experience necessary in order to evaluate the risk-reward trade-off from holding these bonds.
6. Is a pension fund’s investment decision to increase their strategic exposure to inflation-linked bonds consistent with buying short-dated credit risky bonds?
Increasing the pension fund’s exposure to inflation-linked assets may be considered to be important for strategic reasons. In that context, buyers of credit-risky bank bonds should also consider the additional inflation-linked exposure being gained from buying the credit-risky inflation-linked bond. For bonds maturing in the next 3-7 years the additional duration provided is likely to be very small.
Returning to our example of the South African bank’s bond maturing in 2020, holders of this bond are only adding approximately 5 years of (modified) duration to the LDI portfolio. This should be compared to a modified duration of approximately 5 times as much (25 years) on the longest dated inflation-linked bond in the South African market.
Of course, the counterargument may be that the scheme requires some of these shorter dated bonds for cashflow reasons. We would argue that even then, consideration should be given to the likelihood that the bond repayments do not materialise as expected in which case the pension fund could be a forced seller of other assets at an inopportune time.
All these considerations (and others) should be taken into account when assessing the additional yield being earned on the credit-risky bond. For example, the 2020 bank issued inflation-linked bond in our example offered a real yield of 5.89% at the end of May, well in excess of real yields available on bonds from other banks. Comparable inflation-linked bonds from other banks were, at the time, trading at a real yield that was closer to 2%. Comparable government inflation-linked, by comparison were offering real yields closer to 1%p.a. Clearly, the additional yield offered by bank bonds relative to government bonds appears attractive but is it sufficient? Furthermore, within bank bonds further analysis, grounded in sound credit due-diligence, is necessary in evaluating the relative value of inflation-linked bonds across the different bank issuers.
7. The investment decision to increase the pension fund’s strategic exposure to inflation-linked bonds, could, in our view, be separated from the decision to take credit risk….
If the pension fund wished to buy a short-dated inflation-linked bond to pay cashflows, for example, it may consider buying the government inflation-linked bond maturing in 2017 but which (at the end of May) offered a real yield of only 0.9% p.a. For funds that are comfortable awarding their LDI manager a degree of flexibility then the LDI manager could access a wider toolkit to enhance the yield on the purchase of this bond.
This wider toolkit may include the use of credit-risky bonds and would allow the manager flexibility to synthetically create the exposure to the inflation-linked bond and use the cash to invest in a credit-risky bond which then need not be inflation-linked.
8. ...and credit risk, in turn, should be further decomposed to ensure a proper diversification of idiosyncratic credit risk as well as some consideration of the asymmetric nature of credit risk.
When investing in credit one of the commonly held tenets is to diversify idiosyncratic risk by ensuring exposure to a wide spectrum of issuers. By synthetically creating the inflation-linked bond exposure, the manager is free to diversify the credit-risky bond portfolio across different issuers (irrespective of whether the bond itself was inflation-linked) and in so doing avoid concentration risk to a single issuer.
The caveat here is that the South African listed corporate bond market is concentrated and so the benefits of this diversification are limited. As an example, there are only 52 different companies with listed bonds. Even if we extend our definition of credit, beyond listed bonds, to include loans to companies that have been syndicated by the banks making those loans, our estimate is that the average South African investor is only able to access no more than 100 different South African companies. This is in stark contrast to the world’s most liquid corporate bond market, the USA, which has more than 600 different issuers.
With the nascent state of our corporate bond markets, achieving further diversification requires investors to consider the unlisted debt space as an avenue for obtaining credit risk exposure to a wider spectrum of South African companies. The unlisted market could, in our view, assist South African investors in their diversification efforts by offering access to, at least, a further 400 different companies.
The second commonly held tenet is that any consideration of credit risk should include a proper evaluation of the asymmetrical risk-return profile of corporate bonds. By ‘asymmetric’ we mean that, unlike equities, corporate bonds have limited upside and unlimited downside. ‘Limited upside’ means that the maximum annual return is known at the outset and is defined by the gross redemption yield on the bond. This is in contrast to equities where the potential for capital gain is, in theory, unlimited. But both corporate bonds and equities have ‘unlimited downside’. That is, as with an equity investment, investors in corporate bonds can lose their entire investment.
To properly account for the asymmetric nature of their investment in credit, investors should expect their manager to also consider the risks associated with default and the subsequent likelihood of recovering if not all, then at least some, of their initial investment. This then leads to the concept of secured credit vs. unsecured credit.
Listed corporate bonds are generally unsecured in nature. Diversifying into unlisted credit can allow investors to access secured credit assets which, in turn, can offer investors greater protection should the credit worthiness of the borrower deteriorate.
9. It is a fallacy to believe that because an LDI portfolio’s holding in a credit-risky bank issue is only a small part of the overall LDI portfolio, that diversification of idiosyncratic credit risk has taken place.
A bond-only LDI portfolio may be stocked with government and government-guaranteed bonds. Adding a relatively small holding in a single name bank bond such as our example above may be considered prudent since the holding is small relative to the total LDI portfolio. Is this really the case?
In our view, a more appropriate way of evaluating the holding would be as set out below:
- For the pension fund to consider what total exposure it would like to credit as an asset class (through a risk budgeting and strategic asset allocation exercise which could attempt to allow for differences in the risk-return profile of different credit instruments e.g. listed vs unlisted; secured vs unsecured).
- To then control for idiosyncratic risk by setting appropriate parameters such as issuer, issue and sector concentration limits.
- Not to follow such an approach raises the risk that the pension fund's portfolio could be overexposed to a specific issuer or sector at portfolio level. This could arise since the fund’s other asset managers (i.e. those not managing the LDI portfolio) could also be exposed to the same credit-risky issuer through their portfolios which hold their equity or indeed their bonds.
Key investor takeaway
When drafting the investment guidelines for an LDI mandate, clients should set explicit parameters around the types of inflation-linked bonds that the manager is permitted to include. For managers with appropriately skilled credit teams, allowing the manager to buy credit-risky inflation linked bonds could enhance the yield on the LDI portfolio. However, even then clear limits should be agreed with the LDI manager and those limits should be set based on the pension fund’s risk budget. Limits could include:
- The percentage of the LDI portfolio that could be invested in credit–risky bonds.
- Single issue limits.
- Single issuer/obligor limits.
- The exclusion of certain issuers.
Shalin Bhagwan, Head of Solutions
Shalin is a qualified actuary and responsible for Liability Driven Investment (LDI) and other risk management solutions for institutional clients including pension fund and insurers. He was previously Head of UK LDI for AXA Investment Managers. Prior to AXA, Shalin spent 5 years as Head of Structuring in the LDI team at Legal & General Investment Management, where he helped build both the UK and US LDI businesses, working out of London and Chicago. Shalin has previously worked as a pensions and investment consultant for Mercer and Aon Hewitt in London. Prior to leaving South Africa in 2003, Shalin was part of the Executive Committee in Sanlam’s pensions business.
Jana Kershaw, Credit Fund Manager and Analyst
Jana has over 10 years of experience in credit, including six years at RMB as a sell-side credit research analyst specialising in listed and unlisted debt issuers in South Africa. Prior to that, she spent four years at the Old Mutual Investment Group and Old Mutual Specialised Finance focusing on structured and high-yield debt. Jana was ranked number one credit analyst in South Africa by the Financial Mail for three consecutive years. RMB’s team, Jana Kershaw and Elena Ilkova were also ranked number one credit analyst team in the Financial Mail/JSE Spire Awards in 2012.
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