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).