Debt Markets Explained
Debt instruments include nominal bonds, index linked bonds (ILBs) and money market instruments. These instruments are grouped under debt as their characteristics are similar to loans where the investor lends money to a company who pays back the “loan” with regular payments.
These instruments can either be listed such as nominal bonds or index linked bonds trading on the bond exchange, or unlisted which is the case for all money market instruments and some nominal bonds or index linked bonds. Being listed makes it easier to transact in those instruments on a regular basis but has little effect on the underlying credit quality of the particular instrument.
Debt instruments are backed by cash flow streams, such as government taxes, income from toll roads or income from generating electricity. The issuers of debt instruments can decide whether they would like to “secure” that cash flow by linking an asset to the debt instrument that can be liquidated in order to repay debt should the cash flow stream not yield enough for the repayment of the debt.
Investors should be cautious to presume secured debt is of better quality to unsecured debt due to a better recovery rate on default though. Government debt instruments are unsecured debt but are among the highest credit quality debt instruments available. In addition, assets used to secure debt instruments could decline in value and not be able to generate enough proceeds to recover outstanding debt such as during the sub-prime crisis in 2008. Investors should make sure they understand the underlying assets used the “secure” debt instruments.
Finally, as illustrated so vividly through the African Bank curatorship, the seniority of debt is very important when the issuer goes into default and even the “low risk” subordinated money market instruments could not escape losses.
What are Debt Instruments?
A company can source capital to finance its operations by making use of debt or equity instruments. Debt includes nominal bonds, index linked bonds (ILBs) and money market instruments. Equity includes preference shares and ordinary shares.
Bonds can be compared to loans which is why bonds are referred to as debt instruments. The investor effectively lends to a company by buying its bonds and in turn the company “repays the loan” by making regular interest payments in the form of coupon payments and by repaying the principal at maturity.
Bonds can be issued for any maturity date from 12 months to as long as 50 years. Debt instruments shorter than 12 months are seen as money market instruments. Although most coupon payments are paid semi-annually, it can be set for any frequency from monthly, quarterly, semi-annually to annually.
Most nominal bonds and ILBs are listed and therefore traded through an exchange. Money market instruments are not listed and therefore are not traded through an exchange.
“Nominal” refers to something that is not directly linked to an underlying index. Nominal bonds are issued with a fixed principal amount and a fixed coupon rate. As an example, a two year bond that is issued with a principal amount of R10 million, a coupon rate of 5% and semi-annual payments meaning that the investor will receive fixed coupon payments of R250 000 every 6 months (R10 million x 5% ÷ 2) for two years, and the principal amount returned at the end of the two year period.
Nominal bonds make up the largest portion of the South African bond market. Nominal bonds range from maturities for more than 12-months and there are nominal bonds with maturities of as long as 30 years.
Index Linked Bonds
Index linked bonds provide investors with a direct hedge against a particular index. Inflation Linked Bonds are a form of an index linked debt instrument and for purposes of illustration have we used debt instruments linked to inflation as an example. The principal amount is adjusted according to changes in the underlying index and in this case the index is headline inflation. Although the coupon rate is fixed, the regular coupon payment will change as it is based on the inflation-adjusted outstanding principal amount. Therefore, if the inflation rate increases, the coupon payment will also increase. Unfortunately the converse is also true that if inflation decreases so will the coupon payment.
Inflation Linked Bonds were first introduced in South Africa in 2000. Government Inflation Linked Bonds have increased from one in 2000 to 9 in 2013 with different maturity dates from 3 to 37 years. Similarly, corporates have followed the trend with increasingly more Inflation Linked Bonds in issue.
Money Market Instruments
Money market instruments are similar to bonds but are short term debt instruments with maturities less than 12 months. These instruments are not traded through an exchange but rather Over-the-Counter (OTC).
The first time that a debt instrument is issued, it is issued and listed in the “primary market”. Debt instruments are issued through a panel of 8 primary dealers in a weekly auction. Only banks are allowed to be part of the primary market. The primary dealers in South Africa are ABSA, Citibank, Deutsche Bank, Investec, JP Morgan Chase, Nedbank, Rand Merchant Bank and Standard Bank. Government bonds dominate primary listings, accounting for more than 60% of all nominal bonds issued.
Subsequent to the debt instruments being issued and listed for the first time in the primary market, they can be bought and sold in the “secondary market”. The Bond Exchange of South Africa (BESA) is a wholly-owned subsidiary of the Johannesburg Stock Exchange (JSE) and is responsible for operating and regulating the secondary market in South Africa. Secondary market investors include banks, pension funds, insurance companies and investment management companies.
South Africa has a highly liquid and sophisticated bond market. The South African bond market was ranked as the fourth largest bond market in the world by the World Federation of Exchanges for the calendar year 2013. The South African bond market turnover in the 2013 calendar year contributed US$2.1 trillion or 9.4% to the total global bond turnover of US$22.4 trillion.
The South African Money Market is an Over-the-Counter (OTC) market which means the buyer and seller is in direct contact and the transaction does not go through an intermediary.
Listed vs Unlisted Debt
Many investors believe that the main indicator of risk in debt instruments is whether a debt instrument is listed or unlisted. This is not necessarily the case. If a debt instrument is held to maturity, you will only need to transact once and do not need the flexibility of a listed or more liquid debt market. Therefore you should be quite indifferent whether it is listed or unlisted.
Listed debt instrument are listed on an exchange and can be bought and sold in the secondary market. These debt instruments are generally more liquid than unlisted debt instruments. However, there are some listed debt instruments that are owned by a small group of investors and not traded actively and are therefore very illiquid.
One benefit of listed debt instruments is that pricing is conducted by an independent entity and all instruments are priced with the same methodology.
Unlisted debt instruments are not traded through an exchange, but through the Over-The-Counter (OTC) market. Market makers such as investment banks facilitate the buying and selling of unlisted debt instruments in the OTC market.
In some cases investment managers would originate the debt themselves such as infrastructure and development bonds and hold such unlisted debt until maturity. Investors could think of unlisted debt in the fixed income asset class similar to what private equity is in the broader equity asset class.
Given that unlisted debt instruments are not exchange traded are they perceived to be less liquid than listed debt instruments. This does not however mean that unlisted debt is of lower credit quality.
A possible drawback of unlisted debt instruments is that pricing may be conducted by the holder of such instruments. This creates a potential conflict of interest and opens it up for perceived manipulation. It is therefore very important that investors are fully aware of their investment manager’s valuation process.
In the event that a company faces a liquidating event or is placed under curatorship such as African Bank, trading in all instruments including debt instruments are usually suspended and all of its debt would become unlisted debt. It does not mean that the instruments cease to exist, but merely that regular trading in such instruments have been halted. Usually the company will still make the coupon payments and debt holders will still receive the value of their investment, however, the curator could decide to halt coupon payments completely as the case with senior unsecured debt issued by African Bank.
Secured vs Unsecured Debt
Whether a debt instrument is secured or unsecured could be an important indicator of risk in debt instruments. This does not protect the investor from the issuer going into default, but protects the underlying cash flow stream used to make coupon payments on the debt instruments.
Secured debt is tied to an asset that is considered to be collateral for the debt. Mortgage and car financing are both examples of secured debt. Your mortgage loan is secured by your home. Similarly, your car financing is secured by your vehicle. If you become delinquent on these loan payments, the lender can repossess and sell the asset to try to recover the outstanding debt.
Similarly in the bond market, secured debt is backed by physical assets that have been securitised such as mortgage back securities (MBS) and asset backed securities (ABS). These assets can be repossessed and sold in order to recover the outstanding debt.
Only a small portion of the listed debt instruments (on the bond exchange) consists of secured debt. Many of the unlisted debt instruments are secured debt and backed by physical assets such as a solar power plant for example. This is primarily due to the fact that investment managers have better negotiation powers in respect of the unlisted market where they are able to dictate terms to a certain degree whereas the listed market is pretty much a take it or leave it situation.
However, in some cases secured debt might give a false sense of security. During the sub-prime crisis in 2008, the underlying mortgages used as security for the mortgage backed securities, declined in value and therefore was not able to generate enough proceeds to recover outstanding debt. Investors should make sure they understand the underlying assets used the “secure” debt instruments.
Unsecured debt is not backed by any physical asset or securitisation vehicle and lenders don’t have rights to any collateral for the debt. This is not to say that unsecured debt is not backed by a stream of cash flows. For example, government bonds are unsecured debt securities as it is not backed by any physical asset that can be repossessed and sold. However, government bonds are backed by tax revenues as the government can just raise taxes when it needs to make debt payments. Tax revenues cannot be repossessed and sold and therefore does not constitute an asset that can be used as collateral to secure debt. Other examples of cash flow streams are toll road revenues and power plant revenues.
Most of the instruments listed on the bond exchange are unsecured debt. Government debt is among the highest credit quality instruments and therefore being unsecured does not detract from the quality of the debt instrument.
Seniority of Debt
The third indicator of risk in debt instruments is the seniority of debt in the capital structure hierarchy. This provides differing levels of protection to the investor should the issuer go into default.
The capital structure that companies use when sourcing capital to fund its operations is broken up into 3 main levels. The top two are debt instruments namely Senior Debt at Level 1 and Subordinate Debt at Level 2, which can be either secured or unsecured. The bottom level is equity namely Preference Shares and Ordinary Shares. An instrument that ranks above another in this table is senior to the other instrument.
Investors holding debt or equity instruments are creditors in the eyes of a company sourcing capital through these instruments. These seniority levels are important in the instance when a company faces bankruptcy or any other liquidation event. Debt holders will always trump equity holders and senior debt holders always trumps subordinated debt holders.
|Level 1a||Senior Debt - Secured|
|Level 1b||Senior Debt - Unsecured|
|Level 2a||Subordinate Debt - Secured|
|Level 2b||Subordinate Debt - Unsecured|
|Level 3a||Equity - Preference Shares|
|Level 3b||Equity - Ordinary Shares|
Whether the debt is secured or unsecured is not as important as its seniority level as senior unsecured debt has priority over subordinated secured debt.
Both nominal bonds and index linked bonds are ranked according to this hierarchy. Generally, the lower a bond ranks on the seniority hierarchy, the higher the risk and thus the higher the expected return from that bond.
Case Study: African Bank
In a recent example with the collapse of African Bank, investors very quickly realised that the most important factor when an issuer goes into default is the seniority of their instrument. Equity holders realised that they are last in line for any repayments and most investors wrote down their African Bank shares to zero value expecting to lose their entire investment. This was expected from previous scenarios where listed companies where delisted from the JSE and the equity holders lost their entire investment. The largest shock was to the debt holders.
Holders of subordinated debt were informed that they stand to lose their entire investment regardless if it was secured or unsecured and holders of senior debt were informed that their investment will lose 10% of its value. The shocking realisation was that many of the money market instruments were subordinated debt and investors in “low risk” money market funds and income funds lost large portions of their savings.
Debt instruments can be classified as listed or unlisted debt, secured or unsecured debt, and senior or subordinated debt.
Whether debt is listed or unlisted assists with the ease of transacting especially regular transacting. To secure debt protects the underlying cash flow stream to a certain extent.
As was highlighted with the African Bank experience, the seniority of debt was the important factor to consider when the issuer went into default. In the end, even money market instruments were not as “low risk” as expected when the seniority of these instruments were ignored.