Three lessons from First Strut
The credit quality of South African corporate bonds has over time proven to be of a very high standard. However, the SA market recently experienced its first corporate bond default in the case of the First Tech Group’s R925 million “First Strut” bond. The nature of the default, with widespread fraud being uncovered within the company, means that bond investors are likely to receive minimal recoveries on their investment.
Our credit analysis revealed several red flags with this bond and the Nedgroup Investments Flexible Income Fund had no exposure to it. While the bond’s BBB rating was regarded as “investment grade”, First Tech, the bond issuer, was rated BB- and was therefore a below investment grade “high-yield” issuer. The Flexible Income Fund focuses on maintaining a high level of credit quality and will never take on exposure to below investment grade companies. The First Tech default highlights the importance of comprehensive credit analysis and validates our conservative approach to credit exposures.
Credit is one of the alpha generators in the Flexible Income Fund, and we have used it over a long period of time as a return enhancer. The key to using credit is ensuring that the excess return that one generates is enough to compensate for the level of credit risk being taken on. Managers with the ability to comprehensively analyse credit quality, and maintain conservative credit limits, can enhance the yield of an income fund in a low risk manner. Avoidance of default is key to maximising risk adjusted returns.
The First Tech saga holds three key lessons for investors in corporate bonds who are looking to avoid disaster:
1. Understand the risk
In the case of First Tech, it was impossible to quantify the risk. A staggering fourteen different subsidiaries provided the guarantee for the bonds and nine of these acquisitions were done since 2008. The short track record of the underlying companies, and the fact that it would be virtually impossible for a manager to do a thorough assessment of the fundamentals of all guarantors, made this a highly speculative investment. We believe that if you do not have the information necessary to fully understand and quantify the risk being taken, it is best not to invest.
2. Focus on the fundamentals of the underlying company rather than the official credit rating
The rating agency Global Credit Ratings gave First Tech’s R925 million secured three-year bonds an investment-grade BBB rating, higher than that of the underlying company’s below investment grade level. First Tech was rated BB+, but the First Strut bond was rated BBB (2 notches higher) due to collateral committed to investors.
The financial crisis taught us the limited value of convoluted structured deals, where rating agencies were able to manufacture AAA ratings out of poor quality assets such as sub-prime home loans. Many of these AAA bonds ended up worthless and demonstrated that these structures are unlikely to provide much protection when the underlying assets deteriorate.
In the case of First Tech’s bond, an investment grade bond rating was manufactured from the assets of a lower rated issuer. It is likely that First Tech looked to understand the rating agency’s requirements to rate the bond investment grade, and then contrived a structure to achieve that through fraudulent means. The lesson once again is that the quality of a security is largely dependent on the underlying asset or the issuing company and not the rating the structure receives in isolation.
3. Be conservative, cautious and apply common sense
When pursued aggressively, credit in a portfolio can entail large risk for relatively small yield enhancement. Every counterparty exposure puts capital at risk and for this reason it pays to be conservative. The First Tech issue raised enough red flags to be dismissed as a speculative investment. The company was highly geared, acquisitive and the underlying subsidiaries had relatively short track records. Typical corporate finance principals dictate that a company of this nature should have been funded through equity rather than debt. The auditor of First Tech was Indigo chartered accountants; a firm without a website with a business address located in a residential suburb of Johannesburg. All the analysis done by the banks and credit rating agencies was based on the Audited Financial statements produced by Indigo, but no one questioned their reliability. The company was highly secretive, with “Private and Confidential” plastered across each page of their presentation documents. Cautiousness and common sense made it clear that this was a bond to avoid.
The ultra-low interest rate environment has left investors desperate for yield, which can lead to loosening credit standards in the chase for returns. For the Flexible Income Fund, we adopt a conservative approach and avoid low quality issuers with a significant risk of default. Comprehensive credit analysis will continue to be core to our investment process, enabling us to generate alpha through credit while controlling risk.
Rashaad Tayob is the Investment Manager of the Nedgroup Investments Flexible Income Fund.