For many South Africans, the decision as to whether anyone should invest in the bonds of local state-owned enterprises (SOEs) is an easy one. Eskom’s problems are constantly in the news, Denel and Transnet have been involved in massive corruption, and Sanral has made a mess of e-tolls. Why would anyone want exposure to these entities?
The simple answer is that investors are being handsomely compensated for taking the risk of lending money to these SOEs. For the first half of 2019, select Eskom bonds delivered some of the best performance available from any utility in the world. Its 2028 dollar securities gave investors a 22.8% return in under six months.
This illustrates how difficult it can be to separate a good story from a good investment. On the surface, there is almost nothing positive one can say about the current state of Eskom. Yet, one can still have a bullish view on its bonds.
This is a question of perspective.
What’s the reality?
“Let’s face it, bad news sells,” says Gareth Bern, the head of fixed income at Prudential Investment Managers. “We have a deluge of bad news coming at us, so that all of us have a more negative view of the world than it is in reality.”
The level of corruption in South Africa is one example of this. There is no question that corruption escalated under the Zuma administration, and much of it targeted SOEs. However, South Africa is neither unique nor exceptional when it comes to facing this scourge.
According to Transparency International’s Corruption Perceptions Index, South Africa ranks 73rd out of 180 countries analysed – in other words it is less corrupt than the median country.
Source: Transparency International, 2018 (click to enlarge)
“We are faced daily with revelations from the various commissions and newspaper articles, so you would have thought we were world leaders in corruption,” says Bern. “But we don’t really stand out. That’s not to say we should feel happy with the corruption we see, but its useful to put things into perspective.”
Investors also need perspective when it comes to understanding how much risk they are really taking when buying SOE bonds. Just over half of all SOE debt is explicitly government guaranteed. This includes most of Eskom’s debt, and almost all of Sanral’s.
Source: JSE and Standard Bank (click to enlarge)
“One can’t just look at these entities on a standalone basis without taking into account the support from government,” Bern argues.
“When these entities get into trouble, they are supported by guarantees or equity injections. So your risk is equalised by the state.”
Effectively, that means that buying the bond of an SOE backed by an explicit government guarantee is no more risky than buying a government bond. Yet the yields being offered are often higher.
“You are being paid more because there is a liquidity premium,” Bern explains. “It’s more difficult to trade some of these bonds. So some of this is not just credit compensation, but compensation for a lack of liquidity.”
Investors should also consider that there are many ways in which they may be indirectly exposed to SOE debt, even if they try to avoid it directly.
“You often hear comments that SOEs are a total disaster and I don’t want anything to do with them,” says Bern. “But if you buy government bonds you are exposed to SOEs. The government is the shareholder in these entities and it has guaranteed almost R500 billion worth of debt. If you are buying government bonds you are exposed to SOEs.”
Similarly, if you are invested in either the equity or bonds of banks, you are also taking exposure to SOEs. Local banks lend significant amounts of money to state-owned companies, and they therefore carry that risk.
Buying a bond index tracker will also expose you to SOE debt. Around 7% of the FTSE/JSE All Bond Index is SOE debt.
Investors who have benefited from investing in the renewable energy programme in South Africa have also taken indirect exposure to SOEs.
“Renewable energy projects have been a very successful venture in the local economy, but those projects rely on tariffs to be paid,” Bern explains. “Who pays those tariffs? Eskom.
“No one wants to take a risk on Eskom, so all the investors in this project rely on the guarantee provided by government,” he adds. “To my mind that’s no different to buying an explicitly guaranteed Eskom bond. If you invest in a renewable energy project, you are sitting in exactly the same position as you would be as a buyer of Eskom debt.”
None of this diminishes the problems that these entities are facing or the need for urgent reforms. Sometimes, however, the most uncomfortable investments can be the most rewarding.
“Are SOEs a state of emergency or an alpha opportunity?” Bern asks. “I think the answer is both.”