Bonds: is the pricing right?

Published Aug 25, 2015

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This article was first published in the second-quarter 2015 edition of Personal Finance magazine.

Bonds – loans raised by governments, parastatals and corporates – are bundled together as a medium-risk, medium-return asset class, ranked between low-risk, low-return cash (bank deposits and money market funds) and high-risk, high-return equities.

There are 1 659 debt instruments listed on the JSE, with an issued value of R2.015 trillion and a market value of R3.825 trillion.

The failure of two major borrowers, African Bank Investments Limited (Abil), which is under curatorship, and First Strut, which is in liquidation, has raised questions about the South African bond market and whether investors are fully aware of the risks of bonds (see “A brief history of First Strut and Abil”, below).

First Strut’s bonds fell from their issued value of R925 million to zero when the company defaulted in July 2013. It is highly unlikely that investors will receive any of their money once the liquidation has been finalised, if reports of massive fraud at First Strut before its collapse are correct.

Trading in Abil’s bonds has been suspended. At the time of writing, in March 2015, Abil’s 25 listed senior bonds (the lenders are first in line to be repaid), with a face value of R40 billion, and junior (subordinated) bonds, with a face value of R4 billion, effectively had three prices:

* A 10-percent reduction in the face value of the R40-billion senior debt following an indication from the South African Reserve Bank (SARB) that bond holders can expect the bonds to be “transferred” from the imploded bank to a “new” bank. This is the price used by collective investment scheme asset managers that hived off the Abil bonds in their portfolios into side-pockets, or retention funds.

The extent of the losses will also be affected by amendments to the Banks Act that are scheduled to be put before Parliament.

Asset managers are concerned that the amendments to the Act may remove rights they held before Abil was placed under curatorship.

Investec Asset Management (IAM) chief investment officer John McNab and IAM economist and strategist Nazmeera Moola say the legislation could negatively affect future bond issues, which, in turn, would have consequences for the economy.

They say the Banks Amendment Bill is retrospective and could nullify lenders’ right to be repaid, not just in the case of Abil, but also in the event of any future failures. This will increase the risk of lending and, therefore, raise the cost of future bond issues.

As a result of the 2008 world economic crisis, the regulator of banks has the right, if an institution is in trouble, to convert subordinated debt issued since 2014 to shares in the issuing institution. This right – which did not apply to the old-style subordinated debt issued by institutions such as Abil – has added about one percentage point to the cost of borrowing, McNab and Moola say.

Until the finalisation of the Banks Amendment Bill, it is not clear what portion of the subordinated debt will be repaid.

* The value of the bonds when their trading on the JSE was suspended.

* The real value of the bonds, which will be known once, or if, the curator of Abil, Tom Winterboer, rehabilitates the microlender and decides what investors will be paid out.

What both Abil and First Strut have in common is that the prices of their bonds did not properly reflect their impending implosions. This raises the question of how bonds are valued on the JSE, as well as whether retail investors and retirement fund members have a right to feel disgruntled about the financial services industry.

The risk to investors is moderated by the fact that most retirement funds and individuals invest in bond portfolios that hold bonds with different degrees of risk. However, the Abil and First Strut meltdowns each knocked as much as two percent off the value of some portfolios.

The South African bond market is dominated by the government, followed by utilities, such as Eskom. Corporate debt, which carries higher risk, is a fledgling sector in this country, but it is expected to grow because of greater reserve requirements placed on banks as a result of the 2008 global economic crisis.

The basic indicator used by portfolio managers to guide retail investors through asset class risk is a very misleading indicator of the risks of bonds. (This indicator is represented graphically – see link at the end of this article.) An example of why this indicator is misleading is that a portfolio comprised of the shares of the top 40 companies listed on the JSE could have a far better risk/return profile than a portfolio that invests in high-yielding, listed corporate debt, particularly if it is debt issued by the likes of Abil and First Strut.

And because of how bonds have been traded, the risk may not be a true reflection of reality, particularly in the case of corporate bonds.

An accurate assessment of the risk of listed bonds is important because of the significant role they play in retirement savings.

The simplistic, asset-graded approach to risk is reflected, to some extent, in the prudential investment requirements that apply to retirement funds – regulation 28 of the Pension Funds Act (see “Prudential investment requirements reduce risk”, below). Regulation 28 applies to both retirement funds and individual fund members and exists to ensure diversification across asset classes, because this is a proven way to reduce risk. In other words, you cannot keep all your eggs in one basket.

The problem with a simplistic approach to risk and returns is exacerbated by the valuation of bonds. If bonds are not priced properly, the risk/return profiles could be misleading.

This mis-pricing was revealed with the implosion of First Strut, considered South Africa’s biggest unlisted corporate at the time of its collapse. The value of its bonds dropped to zero overnight when the company applied for provisional liquidation in July 2013 after chairman Jeff Wiggill was found dead next to his Bentley in Soweto.

Then came Abil in August 2014. The share price had declined steadily, but this was not properly reflected in the price of its bonds on the JSE.

The Financial Services Board (FSB), the JSE, the Association for Savings & Investment SA (Asisa) and the Banking Association of South Africa (Basa) agree that there is a problem with the pricing of bonds, particularly high-yielding bonds.

Graham Smale, the JSE’s director of market development and innovation, says that, unlike equities, which trade on an open market – where institutional and individual buyers and sellers interact

within milliseconds as they make bids or offers for shares – the bond market is more opaque. Buyers and sellers negotiate directly with each other outside the market and then report any transaction to the JSE within 30 minutes of a trade.

Two factors reduce the impact of meltdowns such as Abil on retirement funds:

* Regulation 28 places limits on how much a fund can invest in individual corporate bonds; and

* Most retirement funds have at least 60 percent of their assets in equities, because they have a long-term investment horizon that enables them to smooth out volatility risk while seeking the higher returns provided historically by equities. This potentially reduces a fund’s exposure to bonds and, in particular, higher-risk bonds.

The failures of First Strut and Abil do not affect pensioners with guaranteed annuities issued by life assurance companies, because the life companies take the investment risk.

With investment-linked living annuities, financial services companies apply regulation 28 voluntarily as part of their effort to ensure that pensioners do not run out of money before they die.

But it is a different story for people who invest for an income in non-prudential investment portfolios, such as endowment policies and collective investment schemes.

People who invest in income funds that are not subject to regulation 28 could have quite a high exposure to bonds, particularly if they are high-yield funds. And people who invest in money market funds may not even know that they are exposed to the bond market through instruments called securitisations and conduits, which, in effect, can include long-term debt that is rolled over on a short-term basis.

In conceding there is a problem, Smale warns that, although a securities exchange such as the JSE can assist in providing proper valuations, “the valuation of any asset on an exchange is in no way a reflection of fair value or net asset value, but the last price that a buyer agreed with a seller in the market. This price is also affected by the strategic investment and hedging requirements, market sentiment, global and local macroeconomic conditions, as well as liquidity and the relative urgency to buy or sell at the time.”

The JSE fully appreciates the efficiencies that can be gained from improving the valuation process, Smale says.

Through its Debt Listings Advisory Committee, the JSE is in continual liaison with the Debt Issuers’ Association, Asisa, debt sponsors, such as the banks, and the FSB on how to improve the debt listing requirements.

“The JSE continuously reviews its billing models and trading rules to improve the market,” Smale says. “For example, the JSE is working closely with the asset management community, trading banks and broker members, Asisa and Basa on how bonds can be migrated onto electronic trading. This will assist with transparency and price discovery.

“In respect of valuations, the JSE is working with Asisa and Basa to find ways to get information contributed to the JSE that is not available on the JSE trading systems,” Smale says.

Among other things, the JSE wants investors to be able to see when a valuation was last set; and to be able to source valuations directly from service providers, such as brokers and banks, which are comfortable supplying valuation estimates directly to their clients but are often reluctant to put such values into the public domain or provide them to regulated entities such as exchanges.

Smale says the determination of “value” is inherent in what a professional investor does. Decisions are made to buy and sell assets based on valuation models every day.

“A professional investor is not only allowed (from an accounting perspective), but also has a fiduciary duty, to ensure that all assets under their control are valued ‘correctly’. There are also many firms that provide independent, chargeable valuation services to the market should the use of internal models not be possible,” he says.

The South African market has extracted significant efficiencies through the use of JSE data files in operational processes, and the market has come to trust the valuations disseminated by the JSE, Smale says.

Prudential legislation and investment mandates have been amended to reflect this trust through the status given to listed instruments. The JSE values this trust, “yet we collectively need to recognise that listed instruments sit on a continuum of complexity and liquidity, and that the more complex and less liquid an instrument becomes, the less accurate a valuation is likely to be. The first line of defence by an exchange in addressing this problem is the creation of trading venues where instruments can and do trade.

“We also do not believe that, just because something is illiquid or complex and therefore more difficult to get trading on a venue, such instruments should not be listed.

“The disclosure and continuing obligation standards of the listings requirements have value in their own right, and are in no way undermined by the lack of liquidity and pricing of actual trades from an order book. This is evidenced by the use by issuers of popular listing venues, such as the Irish Stock Exchange or the Luxembourg Exchange, where bonds are listed but rarely, if ever, trade, because the market prefers to trade over the counter,” Smale says.

A BRIEF HISTORY OF FIRST STRUT AND ABIL

The implosion of unlisted company First Strut in 2013 and of African Bank Investments Limited (Abil) in 2014 sent shock waves through the investment community and left investors puzzled by how the risk-assessment skills they assumed asset managers possessed had failed them.

Some members of the severely embarrassed asset management industry ducked for cover, particularly after the collapse of Abil, while others made excuses, most of which were patronising at best and insulting at worst. None apologised to investors and none voluntarily provided details of the losses that their clients could incur.

Investec Asset Management (IAM), which put the savings of investors and retirement funds into both First Strut and Abil, argues that the losses were acceptable given the size and diversification of the portfolios, although the losses came about in quick succession rather than over an extended period, as might have been expected.

John Green, the head of Global Client Group at IAM, argues that Investec has provided its investors with sound returns from bonds, despite First Strut and Abil. For example, he says:

* The Investec Credit Opportunities Fund, which invests in a broad spectrum of credit-related instruments, has provided an annual return of 12.5 percent since 2008, against the 10.3 percent of the All Bond Total Return Index and the seven percent of the Short-term Fixed Interest Index (Stefi). The fund has also out-performed the FTSE/JSE All Share Total Return Index since March 2008, despite a reduction in value of two percentage points as a result of First Strut and Abil.

* The Investec Diversified Income Fund has returned 9.4 percent over the past five years, against the Stefi’s 5.8 percent. (The fund invests in South African bonds, cash, credit and listed property, and in international fixed-income assets.)

* The Investec Credit Opportunity Fund has out-performed the Stefi three-month index and the All Share Total Return Index since March 2008. Both First Strut and Abil resulted in a two-percent reduction in value.

Green says the returns came at comparatively low risk, despite the defaults.

He says that high-yield, higher-risk credit has out-performed all other asset classes over the past 10 years, with an average annual return of 9.57 percent to the end of 2014.

The brief history and current status of the bonds issued by Abil and First Strut are discussed below.

African Bank

The direct and indirect losses to investors in Abil’s bonds could have been much worse if the microlender had not been rescued with a R10-billion package put together by the South African Reserve Bank (SARB) in August 2014.

The rescue package included the SARB taking over R17 billion in non-performing loans made by the microlender, for a price of R7 billion.

Abil imploded because more borrowers than expected failed to meet their repayments and because of problems with furniture retailer Ellerine Holdings, in which Abil held the majority stake.

At stake in the wake of the collapse is about R40 billion in senior bonds, which have a higher level of security in the event of bankruptcy, and about R4 billion in junior, or secondary, debt with little security.

Despite an earlier rescue attempt by a number of bond holders, Abil posted a headline loss of R3.1 billion in the six months to March 2014. The bank claimed that the quality of its loans had improved and it expected a turnaround in the second half of the year. It never delivered. The estimated loss for the full financial year to September 2014 was R6.4 billion.

Gill Marcus, the governor of the SARB at the time, in consultation with the Minister of Finance, decided to intervene. Abil was placed under the curatorship of Tom Winterboer, of accounting company PricewaterhouseCoopers, on August 10, 2014.

The rescue package included an indication that bond holders will have to accept a cut of at least 10 percent in the face value of the senior debt. (The junior debt has been reduced to zero, pending the finalisation of the Banks Amendment Bill.)

The 10-percent haircut, and the potential for further losses, created a problem for the managers of collective investment schemes that had invested in Abil’s bonds: quick-witted investors could sell their holdings, leaving the remaining investors to carry a greater share of the losses.

The solution of the Financial Services Board (FSB) was to allow unit trust funds “to quarantine” in side-pockets, or retention funds, the portion of their funds that was exposed to Abil’s debt. Any interest payments, which were frozen, will accrue in the retention portfolios.

The FSB said that, when the Abil debt matures and is settled by the curator, investors with units in the retention portfolios will have the choice to be paid out their share or to reinvest the money in the original fund.

Leon Campher, the chief executive of the Association for Savings & Investment SA, said the industry supported the move, although it has created problems, such as determining the historical performance of the affected funds, which, among other things, was based on the face value of Abil’s bonds, and any payment of performance fees by investors based on the historical performance, including the incorrect pricing of Abil.

Altogether, 47 unit trust funds have moved R4.63 billion into retention funds. Stanlib has been the biggest contributor to these funds, with 13 funds with an exposure of more than R3 billion after the 10-percent haircut.

In an update issued on March 3, 2015, Winterboer did not provide an indication of when, or if, interest payments to investors will resume, or when the debt will be repaid.

His statement said that “trading in both the debt securities of the bank and the equity securities of Abil will remain suspended. Investors are therefore advised to continue to exercise caution when dealing in the debt securities of the bank and the equity securities of Abil until further detailed announcements are made.”

First Strut

The liquidation of First Strut, trading as First Tech, was the biggest corporate bond default in South African history. The manufacturing, mining and power-generation company was regarded as South Africa’s biggest unlisted company.

First Strut ran up debt of more than R3.5 billion, including bond issues and financing agreements with banks.

Many people, including pension fund members, were blissfully unaware of the risk to which their savings were exposed.

Five major banks and six asset managers lent money to First Strut.

Investec was the most exposed to the default. IAM invested R435 million of its clients’ money, while Investec Bank provided First Strut with a loan of R240 million.

The other asset managers were: Sanlam Capital Markets, with an exposure of R263 million to First Strut's bonds; Fairtree Capital, with R131 million; Prudential Portfolio Managers, with R51 million; Rand Merchant Bank, with R50 million; and Stanlib Asset Management, with R22 million.

First Strut’s founders, Jeff Wiggill and Andris Bertulis, managed to hoodwink a range of investment experts, including banks, asset managers and their consultants, risk consultants, the JSE’s listing requirements committee and even risk-rating company Global Credit Ratings.

It all came crashing down when Wiggill was found shot in the head near Soweto in June 2013 in what some believe was an assisted suicide.

The liquidators still have to decide whether the assets of the company will be sufficient for any repayments to be made, but speculation is that repayments will be minimal, although the bonds were senior, secured bonds.

The asset managers have written down the value of the bonds to zero.

PRUDENTIAL INVESTMENT REQUIREMENTS REDUCE RISK

It is accepted that bonds are a vital component of any retirement savings portfolio, so much so that regulation 28 of the Pension Funds Act insists that bonds are used to reduce investment risk in retirement funds and retirement savings products.

Regulation 28 limits retirement funds to investing up to 75 percent of their assets in equities, whereas they may hold 100 percent in debt instruments, including bonds, if these instruments are issued or guaranteed by the government. For example, a portfolio could invest entirely in debt issued by the government and in government-guaranteed bonds issued by Eskom and the City of Johannesburg.

A retirement fund may invest up to 75 percent of its assets in debt instruments not issued or guaranteed by the government. However, this is not the only investment restriction. For example:

* There is an overall limit of 25 percent on debt issued by a corporate.

* Where the market capitalisation (total value) of a listed bond is R20 billion or more, there is a limit of 25 percent. Where the market capitalisation is between R2 billion and R20 billion, the limit is 15 percent. Where the market capitalisation is less than R2 billion, the limit is 10 percent.

* There is a limit of five percent if the bond is not listed on an exchange.

* Up to 75 percent of a fund’s assets can be invested in debt instruments issued or guaranteed by a South African bank against its balance sheet (in other words, it uses its own assets to back the loan).

* Only 10 percent of a fund’s assets can be invested in a single debt instrument issued or guaranteed by a foreign government.

In the wake of the implosion of African Bank and First Strut, the questions are whether regulation 28 provides investors with sufficient protection, and whether investors in collective investment schemes and members of retirement funds are properly informed of the risk in the underlying portfolios.

A substantial portion of the assets in retirement annuity funds and investment-linked living annuities are invested through collective investment schemes.

Financial Services Board (FSB) chief executive Dube Tshidi says aspects of the bond market have become more complicated and the industry has become more sophisticated, with the result that there should be more disclosure to investors.

The FSB has implemented the Treating Customers Fairly approach to regulation and is busy with the Retail Distribution Review, an investigation into the fees and commissions on financial products.

The FSB has promulgated the “Advertising, marketing and information disclosure requirements for collective investment schemes”, which, he says, “are of a high and modern standard”.

Tshidi says that, where a portfolio’s risk profile is higher than medium risk, he would “certainly expect the collective investment scheme manager to market the portfolio as a higher-risk portfolio”.

The Collective Investment Schemes Control Act requires the disclosure of relevant information, including risk factors, to a potential investor, he says.

“An investor may also not be misled into buying into a portfolio that they did not wish to be invested in. However, it is also important not to presume that all bonds are of a higher-risk nature, and one must consider that the bond markets are also of a cyclical nature, and risk profiles may need to be adjusted accordingly. The risk profile of a fund with a large number of higher-risk bonds would thus need to be considered in the context of the bond cycle against the other financial markets.”

Tshidi says the overall risk profile of a portfolio is largely influenced by the total mix of all the assets in the portfolio and their related risks, not only the interest rate risk or the market risk. So, for example, the quality of a bond issuer is also important.

He says, historically, bonds are considered less risky than shares for a number of reasons, including:

* Bonds bear the promise that the issuer will return the face value of the security to the holder at maturity, whereas shares have no such promise from their issuer.

* Most bonds pay investors a fixed rate of interest, which is backed by a promise from the issuer. Shares sometimes pay dividends, but the issuer is not obliged to pay dividends to shareholders.

* The bond market has generally been less vulnerable to price swings and volatility than the stock market. Historically, the average returns from bonds have been lower, if more stable, than those from shares.

(Note: The multi-asset sector is the most popular unit trust category in South Africa. It is made up of the following sub-categories: flexible, low equity, medium equity, high equity, income and target date. A multi-asset portfolio’s level of risk is based on its exposure to equities, not on the risk of the underlying securities in each of the asset classes in which it invests. Therefore, a low-equity portfolio may, in fact, be riskier than a high-equity portfolio if the low-equity portfolio is loaded with higher-risk corporate bonds.)

A PRIMER ON BONDS

When a government needs money, it can either raise taxes or borrow money. When a utility, such as Eskom, needs money to develop infrastructure, it can increase its tariffs and/or borrow money. When a large company needs money to expand, it can either sell shares on a stock market, making investors part-owners with whom it will share future profits, or it can borrow the money and hope to repay it from future profits.

If any of these three entities requires a substantial amount of money, a single lender, such as a bank, may not have it, or the lender may not be willing to carry the risk on its own, or the interest rate may be too high. The solution is to raise the money by issuing bonds on a public market, where thousands of investors will each lend a portion of the capital required.

Bonds are part of nearly everyone’s long-term savings, whether these are in a collective investment scheme, a life assurance endowment policy or a retirement fund.

According to the Association for Savings & Investment SA, in 2014, R109 billion was invested in collective investment schemes, of which R101 billion was in multi-asset portfolios, which invest in bonds to a lesser or greater degree, depending on how the asset manager wants to manage risk.

Bonds are an interest-earning instrument and can provide a capital gain or loss if traded, because their underlying value can increase or decrease on the secondary market.

Bonds tend to have less risk than equities.

When bonds are issued by borrowers such as the government, parastatals and corporates, investors buy and sell them on the secondary market. Bonds are traded on a secondary market (for example, the JSE) for two main reasons:

* Investors (lenders) may not want to hold the bonds to maturity, because they need the cash or because the risk of default suddenly becomes worse; and

* The interest rates in capital (bond) markets tend to rise and fall, so investors could lend their money for a better return elsewhere.

The most important elements of a bond are:

* The issuer, which is the entity that borrows the money and sets the period for which it wants to borrow the money.

* The principal, which is the amount borrowed from numerous lenders.

* The maturity date, which is the date on which the principal will be repaid to the lenders.

* The coupon, which states what interest rate will be paid and when the interest will be paid. Interest is normally paid every six months.

* The credit-risk rating, which may change. If the credit rating of the borrower declines, demand for the bond in the secondary market will drop, with the result that the bond will sell at a discount, or a loss, to the capital lent (see “Risks that affect the bond market”, below).

* The market price, which is the price at which a bond may be sold. If there is demand for a bond, the price will go up, and the seller will make a capital gain. If the demand drops, the seller will make a capital loss.

The market price will be affected by interest rates. If interest rates are higher than the coupon on the bond, investors will want to sell the bond for a bond with a higher coupon.

* The yield, which is the rate of return on a bond. The yield takes into account the current price of the bond in the secondary market and the interest rate. The greater the perceived risk of a bond, the higher the yield is likely to be.

Very few individuals invest directly in bonds, because significant amounts of money are required – usually multiples of R1 million – and because the bond market is complex.

The best way for individual investors to invest in bonds is to choose a unit trust fund that specialises in bonds and invests in the bonds of different issuers and yields, thereby reducing the risk. High-yielding funds have more risk.

Another way to invest is in RSA Retail Bonds, launched by National Treasury in 2004, which enable you to invest relatively small amounts in bonds issued by the government.

Retail bonds are more akin to bank deposits than actual bonds, because they provide only interest income. They cannot be traded, which means there is little risk of capital loss.

The main features of retail bonds are:

* You can invest between R1 000 and R5 million.

* You must choose an investment period of two, three or five years if you invest in a fixed-rate bond. If you invest in an inflation-linked bond, you must choose a period of three, five or 10 years.

* Interest is paid every six months. The interest rate is set in the month in which you invest and is aligned to the rates in the bond market.

If you think that interest rates will rise soon, you should select a short-term bond. If you believe that rates will drop, you should choose a longer-term bond so that you can lock into the prevailing higher rate.

You can buy RSA Retail Bonds from National Treasury (www.rsaretailbonds.gov.za), the Post Office or a Pick n Pay store.

RISKS THAT AFFECT THE BOND MARKET

A number of different risks affect the bond market. The main risks are:

* Credit/default risk. When you invest in a bond, you are buying debt. If the borrower does not repay the debt, you will lose your money. The reasons that a borrower may default on the repayments include fraud, as happened with First Strut, poor management and excessive borrowing.

Risk-rating companies provide investors with an idea of the risk of a borrower defaulting (see “How bonds are priced”, below). Generally, governments are considered the best borrowers, because, in most cases, they simply tax their citizens in order to repay a loan, but governments have defaulted many times in the past and will do so in the future.

Corporate bonds are more risky, because companies must be profitable to repay a loan.

* Interest rate risk. This is the risk that the interest rates on new bonds will increase, with the result that the bond you hold will pay a lower interest rate than you can earn elsewhere. This is not a problem if you can sell the bond to someone else, but if no one wants the bond, you will have to sell it at a discount (a loss), or you will not find any buyers.

* Inflation risk. When you buy a bond, the borrower commits to paying a specific rate of return (interest) for the duration of the bond, or for as long as you own it. But a few years later, the inflation rate may exceed the interest rate, with the result that your real (after-inflation) return will be negative.

* Liquidity risk. There is almost always a secondary market for government bonds. However, corporate bonds can be difficult to sell.

The lack of investor interest in a bond issue can lead to substantial price volatility and may adversely affect your total return when you sell the bond.

* Volatility risk. This is the propensity of a bond to increase or decrease in value over its duration. One of the main causes of volatility is the interest rate policy of a government.

HOW BONDS ARE PRICED

A bond is effectively priced at two stages: when it is first issued and whenever it is traded in the secondary market, normally on a securities exchange, or on the sidelines of a securities exchange.

Pricing a bond realistically is a problem in the secondary market in particular, mainly because of the lack of trade (illiquidity of the market).

A bond issuer must follow a complex process in setting the “right price” – in other words, the interest it will pay to investors. Lenders want to receive the maximum amount of interest and borrowers want to pay as little as possible.

The factors that determine the cost of lending to large bond issuers are similar to those that affect how much you pay when you want to borrow money. If you have a record of repaying loans on time and can provide security (such as property), you will pay less interest than someone with a poor record and no security.

A variable base rate, called the prime lending rate, determines how much interest you will pay. In South Africa, the prime lending rate is based on the repo rate set by the South African Reserve Bank (SARB). The repo rate is the rate at which the SARB lends money to commercial banks.

The prime rate moves in tandem with the repo rate, which rises and falls because of many factors – in particular, the government’s monetary policy and the demand for money.

The government can use the repo rate, for example, to keep inflation down and protect the value of the rand. In the United States and Europe, governments have used the repo rate to stimulate economic growth by keeping interest rates low, to pull these regions out of the recessions caused by the sub-prime debt disaster in the US in 2008.

Variable base, or benchmark, interest rates also apply when large bond issuers borrow money. When you borrow money, your credit standing determines the rate you pay above or below the prime rate. The higher the perceived risk of a borrower, the more he or she will have to pay above the benchmark.

The judgment call on your creditworthiness is based largely on the records kept by credit bureaus. In the case of countries, parastatals and corporates, lenders rely on credit ratings to decide how much more than the benchmark rate the borrower will pay – in other words, the premium. For example, the premium on the final R925-million First Strut bond issue was a floating-rate note that was 550 basis points above a base rate known as the Johannesburg Interbank Agreed Rate, commonly referred to as the Jibar.

Large issuers that borrow on the bond market will normally negotiate the interest rate with various institutions, called the primary lenders, which on-sell the bonds to investors but underwrite a loan to ensure the required money will be available; or the debt will be auctioned to set the interest rate or the price of the bond.

Risk ratings are provided by credit rating agencies. The main global rating agencies are Moody’s, Standard & Poor’s and Fitch. The biggest player in South Africa is Global Credit Ratings (GCR). Although each agency has its own ratings system, which is not necessarily the same as the system used by another agency, the ratings are similar. Fitch and S&P use AAA to indicate credit of the highest quality, AA for the next best, followed by A, then BBB for good credit. Everything below BBB is considered speculative or worse. A “D” rating indicates that the debtor is in default.

The important thing about credit ratings, particularly when it comes to corporate ratings, is that they are an opinion, not a fact; therefore, rating agencies can provide rate the same bond issuer differently.

Rating agencies can be wrong, as was the case with the toxic sub-prime debt in the US. GCR has been guilty of a few lapses, including awarding First Strut’s bonds an investment-grade rating of BBB+ initially, which was later downgraded to BBB.

Ratings can be changed at any stage as the borrowing and lending environment changes, or as perceptions of the borrower change. For example, the credit rating of South Africa’s sovereign (government) debt has been on a downward slide for a number of years.

Very few corporates receive high credit ratings, because their ability to repay loans depends on future profits; therefore, they have to pay a much higher premium than a government, which can pick the pockets of taxpayers to repay loans. However, governments, too, can default. Russia and Argentina have defaulted in the past, and Greece is technically in default now.

Many corporate bonds receive a rating below investment-grade; these bonds are commonly referred to as junk bonds, meaning the risk of default is high.

Trading in the secondary market may also affect the valuation of bonds, but to a limited extent.

Graham Smale, the JSE’s director of market development and innovation, says it is when bonds are traded in the secondary market that securities exchanges assist in establishing prices, by providing a market for willing buyers and sellers.

He says the functions of an exchange include:

* Acting as a conduit for bond issuers and investors.

* Setting the disclosure and continuing-obligation standards for an instrument to be listed. The JSE has a set of rules, the Debt Listings Requirements, that govern the listing of all interest-rate instruments on the exchange. The JSE’s listing requirements are guided by global regulatory standards. The JSE tries to balance the increasing demands from investors for more disclosure with the increasing burden of these costs on issuers.

“The core ethos is to try to put investors in the best position to be able to make an accurate assessment of the risks associated with an investment, through disclosure standards prior to issuance and continuing disclosure obligations during the life of a listing,” Smale says.

* Creating a venue for trading the assets it agrees to list, which allows a willing buyer to find a willing seller in a safe, trusted and transparent environment. But Smale concedes this “is an idealised statement, and each market and product has microstructure characteristics that are unique to that market and product”.

There is no central electronic order book for the South African bond market, as there is for equities. This means that parties negotiate and settle trades bilaterally.

Smale says that, in most bond markets, trades are negotiated off-exchange. However, all bond trades facilitated by members of the JSE must be reported within 30 minutes of execution. “This allows for significantly better surveillance and reporting of activities in the South African bond market than is currently possible virtually anywhere else in the world.”

Smale says that, with any instrument, the starting point for a valuation by the JSE is either the result of trades executed across the JSE’s systems, or firm bids and offers posted on its systems.

Investec Asset Management interest income specialists John McNab and Nazmeera Moola say that the acceptance by the JSE of firm offers to buy or sell bonds, rather than trades alone, has helped to improve pricing.

They say that, when a firm bid is made, it is now obligatory for all portfolio managers to reflect that price in valuing their portfolios.

However, the valuation of bonds is bedevilled by their infrequent trade.

To improve the situation, where no traded prices or bids and offers are observable, the JSE applies an industry-agreed valuation model that accounts for two key variables:

* The broad level of interest rates that affects all instruments influenced by interest rates, such as the yields on South African government bonds or the pricing of swaps and forward rate agreements in the interbank market; and

* The specific additional interest rate associated with the issuer and the instrument both at the date of issue and every time the bond trades in the market. The additional interest rate is associated with the probability of the issuer not repaying.

The JSE valuation model adjusts to the daily moves in the broad parameters but is less frequently based on when a bond trades.

A lack of liquidity has its own “price”, which is built into the valuation of an asset. “For a bond, this will generally translate into an additional interest cost over and above that interest cost that represents the probability of default,” Smale says.

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