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.