Is there a case to be made for corporate credit?

At Ashburton Investments we believe that investing in corporate debt is a good strategy to optimise returns, particularly during challenging global market conditions. Including listed corporate bonds and unlisted private loans in investment portfolios, traditionally run with cash, bonds and equities, can create a more balanced approach and help to mitigate risk.

With equity valuations looking slightly stretched and demanding relative to historical norms, Ashburton Investments is forecasting equity returns for the next 12 months to be in the high single digits with some risk existing around this forecast. If we look at corporate credit, an investor can achieve similar returns but with more certainty.

The South African corporate bond market comprises approximately 46 entities that have issued approximately R100 billion in collective bonds and more than 400 borrowers that have a combined R650 billion in unlisted loans. 

Returns on investment grade credit or listed bonds issued by financially sound companies are likely to be in the range of JIBAR plus 180 to 200 basis points, which translates into a current yield of just over 9% at todays’ prevailing interest rates. We see that as a very safe asset class and suitable for pension funds in their low risk portfolios as well as other investors with a low tolerance for risk.

Similarly, returns on sub-investment grade credit or debt issued by leveraged companies are expected to outpace those of equities. Here, an investor has the ability to earn slightly higher yields [compared with those of investment grade credit] where returns of JIBAR plus 350 to 400 basis points or 11% to 11.5% are achievable. We see that as a good enhancement for growth assets currently sitting in portfolios with more aggressive return targets, especially from a diversification perspective, as these returns can be earned without taking equity beta risk in the market. 

However, investing in corporate debt does come with drawbacks. With credit being an asymmetric asset class, investor returns are capped on the upside at the yield on the bond or loan that you purchase while theoretically your downside is a full loss of capital. If the company defaults and lenders are unable to secure any recovery on their loan in terms of the liquidation or business rescue process, one does have the potential to lose your full capital but that is an unlikely scenario.

A number of protection mechanisms built in to corporate credit do give investors or lenders a level of surety. Covenants in banks loans act as early warning systems and give lenders a chance to engage and interact with companies in pursuit of an amicable outcome before the company reaches high levels if distress.     

While covenants aren’t as common in the listed market, early redemption provisions can also be another example of a safety mechanism. As an example, when ratings agency Standard & Poor’s downgraded PPC’s national scale credit rating from zaA to zaBB in May this year, an early redemption clause, at the option of bond holders, on PPC bonds was trigged. PPC did make a proposal to extend the bond redemption period but that was rejected by bond holders. Ultimately, bond holders were repaid in full on 1 July. So, because of that deterioration in the credit quality bond holders were actually repaid and in fact got their money back early. Conversely, the shares in PPC declined 25% between the downgrade and date on which bond holders were paid.

Another drawback to investing in corporate credit is that the market for listed and unlisted credit is largely illiquid which makes entry and exit of corporate credit instruments challenging. Thus, investors should have a longer term investment horizon before committing to the asset class.

While the prospect of a credit ratings downgrade may have an effect on costs for South African borrowers in the international market, the impact on rand investors in corporate credit is unlikely to be material. Given the poor market conditions around the time of the previous rating announcement, the prospect of a sovereign credit-rating downgrade seemed to have been fully priced in. Since then, conditions have improved considerably, largely as a result of the global backdrop, leaving some room for a market sell-off. Our base case remains for a rating downgrade this year by at least one rating agency. Should this happen, the reaction is largely going to depend on the global risk environment. Given current market conditions, the reaction would likely be muted but should there be a risk-off environment at the time of downgrade, with investors worrying about the global macroeconomic situation, then we could see a an exaggerated move following a downgrade action. 

Investors interested in accessing the corporate debt market should ensure that their portfolios are diversified, a thorough due diligence on potential investment options is conducted by themselves or their investment manager and that they have the platforms in place to deal with companies should they become distressed. This will ensure stable returns through the cycle and a continuing source of alpha for those invested.