Corporate bond market compromised by inaccurate valuations
Against the backdrop of the subprime crisis, problems with structured credit and fears of a recession in the US, it is hardly surprising that global credit markets are in turmoil. While some may have believed the domestic credit market to be somewhat sheltered from international woes, the truth is that our market has not been spared. In fact, it faces a host of other challenges, argues Investec Asset Management’s credit team.
“With investors putting a premium on cash holdings, liquidity is scarce and cash is not being put to work to buy new bond issues,” says Simon Howie, credit portfolio manager at Investec Asset Management.
The state of the domestic market is well illustrated by the recent issue of the Development Bank of Southern Africa (DBSA). “New corporate bond issues are proving difficult. In the case of the DBSA issue only R1 billion of the planned R2 billion was issued at a credit spread of 0.90%, double the spread of its existing bonds in issue.”
The real concern, however, he says, is that valuations are not reflecting the state of the market. As a result trading is hampered and investors are reluctant to increase their holdings of corporate bonds.
“Despite new bond issue spreads being at new highs the bulk of our listed market is still being valued at 2007 levels. It is only when investors want to liquidate their credit holdings that they realise that the value at which they hold the bonds does not reflect the true value, as the market is reliant on actual trades for changes in credit spreads. Valuations therefore simply reflect the last trade, which in some instances is many months ago. This situation is further exacerbated by the current illiquid state of our market, and with so little trade happening, bonds are just not being repriced,” Howie explained.
According to Marshall Brown, credit portfolio manager at Investec Asset Management, the Bond Exchange has attempted to address this problem. “A valuation committee was formed and a draft paper released, but unfortunately very little progress has been made a year down the line. While there are some investors and banks pushing hard for reform, there is clearly resistance in the market,” he says.
“Yes, repricing will affect performance, particularly those funds that are overweight corporate bonds. And yes, repricing existing bonds may put even more pressure on the pricing of new bonds, but inaccurate valuations simply distort performance and the actual value of funds,” he added.
Brown believes the reason for the little progress on valuations may be that an equitable solution is not that easy. “The panel proposed by the Bond Exchange may be the best interim solution, but for the market to develop we need to create more liquidity in the secondary market.”
Currently, most corporate bond issues are viewed as buy and hold and there is very little secondary market support from issuers and banks. “Internationally, valuations are based on broker’s quotes; the actual level at which bonds can be sold. As a result, valuations respond immediately to market changes. For this to happen in our market issuers need to support market making and banks need to be more active in trading corporate bonds,” Brown says.
He believes investors have an important role to play in encouraging issuers and banks in this respect.
According to Howie the problem with valuations is not restricted to the listed bond market. “Unlisted instruments in fixed income portfolios can also distort performance and valuations when they are not valued accurately.” The solution here, he believes, lies in accurate disclosure and third party verification of valuations.
“The importance of accurate valuations cannot be understated. Issuers need an accurate indication of their cost of funding, which impacts on the value of their liabilities. And investors need accurate valuations to fairly reflect the value of portfolios,” Brown said.
Not resolving the valuation problem will negatively impact on the development of the corporate bond market, they concluded.
