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Trying to break the vicious circle

20 Nov 2006

The South African corporate bond market has a problem: investors are loath to become too exposed to the same group of issuers, but low demand deters potential borrowers. However, offshore investors are coming to the rescue

To say South African companies have an equity culture is not a cliché so much as an understatement. At the end of 2005 bonds listed on the Bond Exchange of South Africa had a total nominal value of R637bn ($87.15bn) and a market capitalisation of R756bn — 21% of the market capitalisation of the equity market. Stripping out government bonds, which accounted for two-thirds of total issuance, securitisation (7%) and commercial paper (4%), leaves corporate bond issuance totalling R140bn ($19.14bn) at the end of last year.

More than half of that paper was issued by financial institutions, mostly the big banks. Banks have long been the top bond issuers after the South African government, primarily of tier two, and also tier three, capital.

What is left is the non-financial corporate debt market, with outstanding issuance of R104.9bn ($14.38) at the end of October. This can be further broken down into two types of issuers: private sector companies, and the state-supported parastatal companies such as transport provider Transnet and electricity utility Eskom. These parastatals were the first to tap the bond market, Transnet leading the way in the 1980s, and are still the biggest issuers in the non-financial corporate bond market.

Private sector issuers — why so few?

There are few regular private sector issuers. Daimler Chrysler South Africa returned to the market at the end of May with a R2bn issue of five year bonds, taking the company's total bond issuance up to R6bn. Other repeat issuers in the last year include Imperial Group (the country's largest private sector transport company, a subsidiary of Imperial Holdings which also owns Imperial Bank), which last came to the market in December 2005, and Infrastructure Finance Corporation (INCA).

Easily the biggest recent issuer is telecoms service provider Mobile Telephone Networks (MTN), which in July issued R6.3bn of medium term notes. This constituted R5bn of four year paper with a fixed coupon of 10.01% and R1.3bn with an eight year maturity and a 10.19% coupon.

Bankers have some hope for more issuance from the telecoms sector. Vodafone dipped its toe in the capital markets with a syndicated loan in September, while domestic rival telco Vodacom has yet to access the capital markets. But new issuers are not queueing up at the moment.

Why is there such little corporate issuance? The overall picture is that few large South African companies have the need, or perhaps the inclination, for long term borrowing.

"In the recent corporate environment there has not been the need for debt financing," says Tertius Smith, senior director at Fitch Ratings Southern Africa in Johannesburg. "Companies have been focusing more on rebuilding their balance sheets, and we have seen a period of restructuring of the old conglomerates — by definition a non-expansionary strategy."

And there are few potential prospects for large scale expansion in the corporate sector to tempt companies out of that conservatism.

"Growth opportunities are limited," says Gill Raine, responsible for debt capital markets distribution at Rand Merchant Bank in Johannesburg. "We have a relatively mature corporate sector inside South Africa with little pressure for consolidation. And we have a landlocked economy, with few opportunities for companies to expand in the region. Nor are we seeing much in terms of capital expenditure from the companies, outside of the property sector."

Then there is the cultural factor of South African business. "The whole concept of efficient use of capital is very new," says one banker. "We still have a lingering lazy balance sheet syndrome, where companies are scared of taking on debt."

High yield issuers go offshore

With a small number of investment grade corporate issuers, everyone agrees what is needed is a push down into lower rated issuance. Currently there are no companies in the bond market with ratings below national scale triple-B, and only two below single-A — transport company Super Group rated A-zaf by Fitch (zaf — the national scale of ratings for South Africa), and Harmony Gold Mining Company at BBBzaf.

In fact the main story in the bond market of late has been a run of offshore issues from lower grade companies. It began with mobile phone operator Cell C (rated B2 by Moody's at the time, since downgraded to B3), which in April 2005 issued senior secured debt of Eu400m and $270m in senior subordinated paper. Food producer Foodcorp, also rated B2, brought a Eu175m secured bond in June 2005. In January 2006, The New Reclamation Group which recycles secondary metals and is rated Ba3, issued a $253m secured bond, and B2 rated Savcio, which provides maintenance and repair services for rotating electrical equipment and transformers, issued $125m a month later. Both Foodcorp and Cell C returned to the international capital markets with further issues in June and July this year.

"What's happening now is that the lower rated issuers are going offshore," says one banker. "Which, when you think about it, is crazy — do we really believe that overseas markets can analyse and take a local high yield credit before local markets?"

Most commentators think that the explanation lies on the demand side. South African investors are unwilling, or perhaps unable, to buy high yield credits.

Some investors are const d by regulation. Both the Pension Fund Act and the Long-Term Insurance Act set limits on the proportion of private sector bonds that funds they may hold in those sectors (2.5% for pension funds). With such tight restrictions, pension funds and long term insurers may decide to place their private sector bond holdings in the safest companies.

For unit trusts, the Collective Investment Scheme Act places a specific limit on sub-investment grade credits of 10%. As Marilize Petzer, the Bond Exchange of South Africa's general manager of market development, wrote in a November 2005 commentary for the Exchange, "such a restrictive prescription automatically eliminates potential corporates with credit ratings of BBB or lower from greatly participating in the debt market, even though their business model may be based on sound financial principles."

With such an act in place, it would be easy for a broad range of investors to adopt the CIS Act rather than develop an independent mandate to embrace debt from more low grade companies.

"It is speculated that many asset managers and clients have adopted the limits prescribed in terms of the CIS Act into their mandates instead of investigating and researching their own mandates, thereby increasing the number of investors indirectly falling within the ambit of the legislation," says Petzer.

Bankers agree that the restrictive mandates imposed by fund trustees, often with stronger terms than legislation requires, present a serious obstacle to the further development of the bond market. Compounding this is the problem of concentration risk.

"Even if mandates do permit them to invest," says one banker, "asset managers will often say that they are worried about concentration risk because there aren't enough of these credits for them to form a portfolio. So issuers will go instead to the offshore markets where they can find hedge funds and other diversified funds who have high yield portfolios and can take the bonds."

Bankers suggest that they are working on various solutions to this 'Catch 22' problem. For example, one banker suggests that a CDO structured fund effectively offering investors a ready-made portfolio might tempt them into the market.

Reynold Leegerstee, general manager at Moody's Investor Services in Johannesburg, hopes it may just be that there is a spillover effect from the current international issuance back into the domestic market.

"South African investors will be taking note of what happens with these issues," he says, "and as these bonds build up a data trail, that may encourage investors here to look at lower rated opportunities. Of course, in many cases that would require opening up investment mandates for lower rated paper. But increased demand for higher yielding assets, combined with track record and increased disclosure, can help to further develop the domestic high yield market."

Funding for infrastructure

In the state-supported sector, a big boost to the bond market could come from the government's infrastructure programme.

Despite its spending plans, however, the government's aim is to reduce still further its own debt. The inference is that much of the responsibility for delivering and funding infrastructure development is likely to be passed to local authorities and the parastatal entities.

Transnet, the parastatal company that runs much of South Africa's transport infrastructure, has declared a R64.5bn capital spending programme over the next three years. Most of this will be paid for from transport revenues, as well as a programme of disposals of non-core assets, but R23bn will be raised as debt. Electricity utility Eskom is also expected to commit to a large spending programme.

The parastatals are not saying anything yet about their choice of funding sources, but they are familiar with the bond markets. Eskom started the corporate bond market with its first issues in the 1980s, which it used to fund the construction of a series of power stations. The company has been in the markets this year — in March it sold into both the domestic and offshore markets with a R2.5bn year bond and a seven year offshore placement worth Eu500m. Fixed line telephone monopoly Telkom last issued in April 2005, but has outstanding debt of R6.7bn.

"Altogether we could see a parastatal infrastructure programme of around R200bn," says Riaan Kemp, head of debt capital markets at Absa bank in Johannesburg, "which is about half the current level of total government debt. To fund a programme that size will mean a range of sources including domestic bond issues, but also international private placements and syndications."

South Africa is hosting the next Fifa World Cup in 2010 so there is a pressing incentive to bring the country's infrastructure up to date. Local authorities will play a big role in the drive to modernise the country's utilities and transport networks, and there is a push from government for municipalities to become more financially independent. The National Treasury's Local Government Budgets and Expenditure Review 2001-02 to 2007-08, published on October 17, states: "If municipalities are to reinforce their developmental role, the proportion of their capital budgets funded from their own revenue sources needs to increase in the period ahead."

The transition to the capital markets, however, may not be an easy one. "Like other public authorities, the municipalities have traditionally funded through bank borrowing rather than the capital markets," says Kristin Lindow, senior credit officer at Moody's in New York, "and it will mean a real change for them to have to go out and get ratings, particularly as some municipalities have had problems with revenue collection in the past."

But there are signs that this is a change the government wants to drive forward. At a press briefing on the local government review, TV Pillay, the national treasury's chief director of local government, pointed to the success of recently oversubscribed Johannesburg municipal bond issues as an example for other local authorities to follow. Johannesburg is the first municipality to make public use of the bond market, most recently with a R1.2bn bond in June. Other municipalities have made private placements. Proposals for a new municipal disclosure code could also represent a sign that the cities are being led towards the capital markets.

20 Nov 2006