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The asset class that won’t let you leave

Illiquidity in the corporate bond market.

Many pensioners have no idea how the build-up of illiquidity in the local corporate bond market may affect their retirement savings.

“The Hotel California asset class,” is what Iain Anderson, a fund manager at Sygnia Asset Management, calls the corporate bond market. “You can check out any time you like, but you can never leave. We are frustrated on an almost weekly basis trying to sell these assets.”

Effectively the bond market is frozen because you can buy new corporate bond issues, but cannot sell them. Asset managers disingenuously refer to this as the ‘primary’ and ‘secondary’ markets, with only the ‘secondary’ market being frozen.

Anderson explains that the primary market comprises corporates issuing bonds to funders. While it is freely traded it is essentially a uni-directional market, which means you can buy bonds here but not necessarily sell them.

Market investors have to try to trade in the secondary market, where investors sell to each other, which entails a much larger portion of the market but is not so freely traded.

“Illiquidity in this secondary market especially becomes problematic when everybody tries to leave the room at the same time, but the doors are always way too small. We saw this happening in December last year in the US when the Third Avenue Focused Credit Fund halted investors’ withdrawals,” Anderson says.

A deteriorating environment for high yield bonds made it too difficult for Third Avenue to raise sufficient cash to meet redemption demands from investors. The fund dwindled to $789 million, compared with the over-$3.5 billion assets it once had. Third Avenue had to liquidate its fund and, in order to do so, had to freeze redemptions, causing distress in the market.

“There are concerns that the same thing could happen in South Africa. It is doubtful that funds will be able to meet a sudden escalation of redemptions in times of market pressure.”

According to Anderson another factor at play that makes this component of the market scary, is that the largest holders of these assets are so-called low-risk funds, which by definition have to hold a higher proportion of non-growth assets.

These non-growth assets are typically government bonds and, as the demand and search for higher yields escalate, fund managers are forced to move up the risk curve to the corporate bond market.

It was good for investors while money was pouring in, but the risk profile is changing. When the corporate bond market weakens, investors start to pull money out, looking for higher-returning assets.

Although the bond market experienced high returns, the cycle is turning with the stalling of the recovery in the global economy and a rising interest rates environment. When interest rates rise, bond prices fall, which could inflict a capital loss on investors.

Anderson says the level of illiquidity in the local corporate bond market deteriorated considerably after the African Bank Investments Limited (Abil) debacle in 2014.

“What makes it worse, is that you can’t get out at the price that the bond is reflected in your portfolio. Typically, you have to accept a lower price.

“If portfolios holding these bonds continue to experience inflows from investors there does not appear to be a problem. The moment this changes and investors start to withdraw large amounts from these portfolios or managers try to restructure their portfolios and sell large amounts of their holdings, it can all unravel.

“Investors choose to invest in so-called low-risk funds because they cannot afford to accept high levels of investment risk. But sometimes the risks associated with some types of investments change and some low-risk portfolios become higher risk portfolios. This may be the case with portfolios currently holding large allocations in corporate bonds.”

Anderson says the reality is that a sell-off in South Africa can be triggered by a sovereign credit downgrade, which is definitely one of the risks pencilled in by managers to look out for in 2016.

He believes that mechanisms such as higher transparency, better pricing as well as an enhanced trading process may have a positive effect on the South African bond market.

South Africa doesn’t have central electronic trading for corporate bonds, which are bought and sold over-the-counter. Prices are compiled by the Johannesburg Stock Exchange.

“An illiquid market cuts both ways. If corporate bonds are held to maturity and no defaults occur, the mark-to-market will not affect long-term holders. But, once you have the need to trade the bonds, the seller is forced to take a haircut on the bonds. There is a definite need for reform and process improvement.”

“The bond market is not collapsing, but the illiquidity has become an increasingly risky reality, and is not being recognised or priced correctly,” Anderson says.

This article was sponsored by Sygnia.

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Your article contains a number of inaccuracies. All bonds barring Government issued bonds with outstanding amounts above R10bn and Eskom issued bonds are illiquid. Almost all corporate bonds issued in South Africa are investment grade and they form a very small part of the total market – therefore the credit risk is low, however the liquidity risk is high. Most these bonds mature in three years and have been considered by the market as buy and hold for as long as I can remember. The real problem with tradability comes from South Africa’s concentrated investor base in corporate bonds of approximately 12 asset managers/insurers. Platitudes about ‘reform’, ‘transparency’, ‘better pricing’ and an ‘enhanced trading process’ will do nothing to change the underlying market other than increase the unlisted debt sector which has grown exponentially at the expense of the listed market following ill-conceived regulation (e.g. section 19 of the JSE regs) and onerous continuing obligations which will result in listings on other world exchanges.

End of comments.

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