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Would you buy Eskom’s bonds?

Can you separate the bad story from the investment case?

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.

Read: Eskom can’t pay its debt. Bond investors love it.

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.”

Guarantees

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.”

Indirect exposure

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.”

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Off course I would buy, as Eskom debt is mostly guaranteed by the state (the buck stops with the SA taxpayer). Great returns, without the extreme risk.

One advantage of “prescribed assets” if/when enacted, is a great risk-adjusted fund return.(for now…)

The best investment space to be in, must be as a SA govt bond investor, plus being a tax-resident of another country.

The problem (in the long run) will be the eroding SA taxpayer base (upper & middle class) through steady emigration, and emigration-rate to be made worse by coming NHI. Then a bond default becomes a reality (if China doesn’t step in to assist, or if SA Res Bank/Treasury doesn’t get looted to pay debt)

Kindly let me know how bond-holders in Venezuela debt are doing…..

You say “mostly guaranteed by the state.” Sure, what is the guarantee worth? Not even the banks and lenders trust it any more…

I think it is like a pyramid scheme (it may actually be one by definition) where many investors know it is going to fail but think they will get their money and returns out before it does. Good luck.

I would ask myself if it is the best possible investment I can make with my money.

And the answer is?

No.

The risk is not just SA Inc and ESKOM but the Rand.

The alternative is Eskom goes bankrupt and then the whole party is over.

A South African with most of his assets in ZA should probably not hold Eskom debt. The investor is setting himself up for the classic double whammy. When Eskom defaults then the value of his other ZA assets will also decline.

Extend this thinking to prescribed assets in pension funds.

The underlying issues are one of risk and trust.Is the reward high enough and can you trust the backing entity??

With prescribed assets we are going to be Eskom bond holders whether we like it or not.

ESKOM’s ES33 pays 10.8% (at the present price). The bond is guaranteed by the state. So, what’s not to like?

Great returns until that day arrives when the accumulation pressures can no longer be contained. Thus leading a ditching thereof and a failure to act within a max of the 1st 24hrs after the unraveling has begun of SA and it’s SOE’s…

Deprecation of the rand which is also sensitive to ‘bad’ news. Will similarly erode the final takings. Most of govt bonds are held in local currency and for those buying when the rand is stronger than when they pull out will find that, that return, all tolled is noticeably less than it may have 1st appeared to be.

The lack of transparency and with paralysis firmly set in, the direction SA is headed is unmistakable but where does that journey end? Eskom’s a ticking time bomb and will hit that wall with a bang and instantaneously render those bonds worthless mere moment’s after reaching it’s peak.
Gambling on this mine field requires caution.

“Those who play with matches, will burn their fingers!

SARS won’t grant taxpayers a tax refund without listed and categorized records to serve as proof of there expenses.
But, for those appointed comrade CEO’s such records are to complex to decipher and thus it just gets tallied up with the wasteful expenditure on audits and alike…
Most businesses are stricter over their petty cash than the institutions led by the 7-digit earning, 1-year posted, “lack” of performance bonus receiving ‘tata my chance’ professionals deployed in the public sector.

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