The case for credit

Whether it is Curro or Calgro, SAB or BHP, Santam or Sanlam, there currently seems to be a general aversion to investing into credit by retail and institutional clients.

Fund managers often find themselves on the ropes, having to defend the inclusion of specific names in a portfolio, explaining the rationale behind securitisation or project finance and why insurers issue subordinated paper. The underlying reason for all of this seems to be fear. And it is entirely reasonable perhaps given recent market dynamics.

The problem with the fixed income and credit worlds are that there persists a general lack of knowledge and understanding. People are for example very familiar with equities : What they are, how they work and where the risks come from – but unfortunately the same cannot be said of the credit space. Whether it is the sudden default and loss from First Strut, the on-going and unclear process that is the African Bank debacle or the continuing uncertainty around Edcon - the credit world often tends to vagueness.

This is further compounded by the fact that the lack of trading and liquidity in South African credit means that one of the primary purposes of the market - the processing and presentation of information - is usually missing.

Yet taking all of this into account, investing in credit is still an outstanding option in any diversified portfolio. This can easily be seen when looking at the long term default history of credit worldwide* – and there are several studies available to support this. One of the most prominent is a study of Corporate Default and Recovery Rates from 1920 – 2010 by Moody’s. This covers the Great Depression, Great Recession, a World War, the Cold War, 2 Gulf Wars and various other economic and geopolitical events.

The striking thing to emerge from this study is the relatively low level of default of corporates given the prevailing level of fear – for something that seems so relatively rare by historical standards, we certainly seem to harbour a remarkably high level of fear. It seems credit is the “fear of flying” of modern investments.

Below is a table taken from the report:

What is striking is the low levels of loss suffered by investors over that period. Baa** rated corporates for example, suffered average credit losses of 0.57% over 3 years and 1.19% over 5 years – and this is taking all credit into account (numbers are cumulative, not per annum). No credit research, no credit committees, just pure market average.

Investors into credit have seemingly been significantly over-rewarded for the risk they have taken. This phenomenon is so widespread and so well publicised that it has even been given a name – it is called the credit puzzle. Investors into credit have over the last 90 years benefitted disproportionately relative to their risk exposure and no one seems to know why. What is known however this that this incongruity is alive and well – and it is an opportunity that clients can use to their benefit. (In future we will look into some SA specific examples of the credit puzzle.)

*Arguments have been made that the somewhat unique nature of the SA markets make these comparisons unwise, but given an the changes we’ve seen in the recent default history along with the projected changes resulting from the implementation of Basel III, those points seem moot.