The CIO of Terebinth Capital, Erik Nel, believes the performance of South African fixed income markets over the past few years may have given investors a false sense of security about corporate credit.
Good yields from floating rate notes in particular have meant that credit fund managers and their clients have enjoyed strong inflation-beating returns. However, Nel believes it would be wrong to expect this to be a persistent feature.
‘For me, credit is cyclical,’ he said. ‘Right now, my view is that you should be overweight government bonds relative to credit, and I had a similar view in 2018.
‘In 2018 I thought you should be positioned at the very front end of the government bond curve and be careful of credit because it was late cycle. Now you should be careful because of how assets are priced.’
Nel, who co-manages the Amplify SCI Strategic Income fund alongside Nomathibana Matshoba, believes the yield on South African government bonds around the middle of the curve makes this a superior opportunity compared with what is priced into credit.
‘You can’t argue that credit is better quality than government bonds, because credit literally prices off government bonds,’ he added. ‘You can have more volatility risk in government bonds, but not more credit risk.’
This, he said, is not always understood, particularly if volatility is used as a primary measure of risk.
‘It never used to be a thing that people reported Sharpe ratios on income funds, and now it is,’ Nel said. ‘But you are really missing the wood for the trees if you are calculating Sharpe ratios on credit. Mark-to-market on credit literally doesn’t change until it trades, so its illiquidity makes it look like you’re getting a great risk-adjusted return. But the risk position might not actually be appropriate.
‘You won’t ever find us saying don’t invest with a credit manager, or pick us over a credit manager, but to compare apples with apples you need a better valuation methodology. You need to understand what’s in the price, where credit spreads are, and then factor for liquidity risk.’
Market risks
It’s also vital to understand how well diversified a credit portfolio is.
‘My lived experience is that bad things happen in the credit market from time to time,’ Nel said. ‘When they do, you get reminded of the old Warren Buffett saying that you only see who’s been swimming without their trunks when the tide goes out.
‘For me a lot of credit can often be like the Hotel California – easy to check in, but not so easy to check out. You need to manage it in such a way that if things do go wrong, you don’t make it the clients’ problem.’
This is particularly relevant in the current environment.
‘As Jibar is stuck to the floor, and the yield curve is so steep, credit managers are being forced to take more and more risk to generate similar returns,’ Nel said. ‘They have to reach further and further.
‘I’ve been in fixed income for 25 years now, and my view is that the quality of credit portfolios at the moment is quite poor. Valuations in the credit market are pretty stretched. Liquidity is poor.’
This will be particularly problematic if the South African economy recovers more strongly than expected.
‘You have two risks with these types of strategies,’ Nel said. ‘If the economy really starts recovering in the coming months and you see a mass exit from the income space into risk assets, the lack of liquidity will result in spreads widening meaningfully, making it very hard to get your expected price in some of those instruments.
‘But it’s not just an asset allocation risk that you face if the economy starts recovering. The other risk is you will get more demand for credit as business confidence picks up. The reason credit is expensive now is that there is a demand-supply mismatch that suppresses yields. If there is a demand to raise credit and corporates compete to issue credit, the spreads will start widening and prices will fall.’
Citywire – Credit can often be like the Hotel California By Patrick Cairns
