- Leigh Cunningham-Scott
- Debt Capital Market Transactor, Rand Merchant Bank
by Leigh Cunningham-Scott and Dave Sinclair, Debt Capital Market Transactors, Rand Merchant Bank
The global macroeconomic backdrop is currently characterised by uncertainty and volatility with limited potential of stabilising in the near term. The key theme that all economists can agree on is that this uncertainty and volatility is here to stay. However, uncertainty creates opportunity, particularly for South African corporates with existing bond structures or those looking to expand offshore.
Financial markets tend to overreact ahead of an event only to revert to normalised levels post the event. Surprises such as Brexit, create market uncertainty and subsequent volatility. While the initial market moves subsequent to Brexit have reverted, overall global growth and deflation fears have increased. Fundamentally this should result in a risk-off scenario where investors move out of emerging markets to invest in safe haven assets. Instead, the anticipated slowdown in developed countries such as the UK has driven renewed interest in emerging markets offering a yield pick-up.
Brexit, in the short term, is unlikely to have further significant effects barring what has already been discounted by the market. Over the longer term, the impact is likely to centre around trade, investment, tourism and aid flows. Domestically, some stabilisation has already been evident with the rand and JSE trading around pre-Brexit levels. Concern is rather focused on long-term financial flows and financial market volatility as investors carefully consider the growth prospects of emerging markets.
The South African economy is particularly vulnerable to capital flows and relies heavily on private-sector capital to finance its large current account deficit. As these flows are historically very volatile, this places the domestic financial markets at a greater risk of volatility relative to other emerging markets. As non-residents can hold up to 35% of government’s rand-denominated debt at any point in time, foreign investor sentiment is extremely important as a substantial outflow would have a significant impact on the underlying yields. The South African economy is already strained with low commodity prices and limited growth prospects, which could result in negative investor sentiment leading to a decoupling from other emerging markets.
Uncertainty surrounding the potential downgrade of the South African sovereign foreign currency credit rating remains. The key metrics that need to be considered in the evaluation of a sovereign downgrade include low growth, high youth unemployment, inflexible labour laws and a level of political resolve. The IMF recently indicated that it anticipates domestic growth at 0.1% for 2016, while the South African Reserve Bank recently indicated that 0% GDP growth is expected for 2016 and 1.1% for 2017. However, S&P indicated that government’s resolve to reduce the fiscal deficit with a target of 3.2% of GDP this year falling to 2.8% in 2017 [1] is considered positive.
A rating downgrade could trigger a short-term forced sell-off as indexed tracker funds are rebalanced to exclude South African foreign currency bonds. The impact of the downgrade will be reflected in a widening of the credit spreads of the Republic of South Africa, South African state-owned enterprises and some corporates, particularly banks. Entities that are closely linked with government will be most impacted as their foreign ratings will be downgraded given the close reliance on the South African government.
Note
1. S&P Global Ratings - South Africa Ratings Affirmed: Outlook Remains Negative on Weak Growth, June 2016
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Movement in credit default swap (CDS) spreads acts as a precursor to anticipated events, generally widening up to 100 bps in the month ahead of a negative event. Following the event, spreads continue to widen marginally and then normalise on certainty, albeit not always to original levels. South African CDS spreads are currently trading in line with other BB+ and BB rated credits suggesting the impact of the downgrade has largely been priced in.
While wider credit spreads, reduced liquidity and lower demand may describe the impact on the international capital markets for South African issuers, domestically the impact is likely to be felt via a weaker exchange rate, rising inflation, market volatility and a continued economic slow-down. Further, given the susceptibility to portfolio and outflows, local yields will also be impacted by potential outflows from the government bonds.
The lack of direction and trending markets make life difficult for corporate treasurers in South Africa. This is particularly true if their company currently has offshore exposure or plans to expand offshore to meet stakeholder return expectations on the back of a benign South African growth outlook. In order to take advantage of opportunities when they arise, a treasurer needs to have flexibility and access to funding at short notice.
Potential funding/ balance sheet management opportunities
South African corporates tapped the offshore debt capital markets during the growth period from 2009 to 2011. The hard currency funding raised in these markets was to be serviced by a combination of hard currency flows from the newly acquired international operations and the residual from South African rand flows. Despite optimistic projections at the time of issuance, growth in the offshore markets has been slower than anticipated and emerging market spreads are now significantly wider than five years ago. These challenges provide treasurers with opportunities to restructure their offshore debt, particularly when the debt is trading at a discount.
Rand Merchant Bank (RMB) has recently had success in providing debt advisory services to South African corporates which have funding positions or operations in the offshore markets. Regardless of whether the corporate wants to restructure existing debt or raise new debt, RMB offers a range of bridge-to-take-out solutions to facilitate the transactions. The critical success factor is that corporate treasurers must have quick access to funding solutions to enable them to opportunistically restructure existing debt or raise additional debt in the volatile and often unpredictable offshore markets. This funding is provided by the extension of a bridge loan that is specifically structured to meet the short-term timing needs of the treasurer and provide flexibility of execution for the anticipated buy-back of existing debt or tapping the markets to raise new long-term capital.
Bond buy-backs and restructuring
The offshore capital market debt raised by South African corporates during the growth period post the financial crisis typically had tenors of five, seven or ten years, meaning that these bonds are rapidly approaching maturity. Corporate treasurers therefore need to decide on the best course of action to refinance or redeem these instruments. The corporate can redeem the debt on the proviso that it has excess cash flow. Given the scarcity of excess cash flow in a period of low growth, the corporate usually needs to refinance the debt.
The existing offshore debt was previously raised in an environment where exchange rates and South African credit spreads were lower. On the assumption that the exchange rate was hedged at the time of issuance, the recent depreciation of the rand from levels of USD1:ZAR8 to current levels of ZAR14.35 to the dollar means that the currency hedges on the full nominal of the debt would be ‘in-the-money’. As a result of the events discussed, South African credit spreads are currently wider than they were at issuance indicating that the bonds are likely to be trading at a discount. The combination of ‘in-the-money’ hedges and discounted bond prices provides an opportunity to monetise the full value in the hedge while repurchasing the bonds below par. The timing of the repurchase is very much dependent on market conditions and should be done opportunistically. This is where the structured bridge loan provides the treasurer with the much need flexibility to time the markets. The bridge loan can be used to finance the full or partial repurchase of the offshore bond prior to its maturity at a discount. The bridge loan is then refinanced with an alternative longer-term funding mechanism, such as bank debt, a syndicated loan, a local bond issuance or an equity raise.
Currently, ZAR funding options are attractive as rand interest rates are expected to move sideways as the South African Reserve Bank tries to balance growth with inflation management. The corporate’s ultimate choice of take-out options is dependent on the corporate’s forward looking strategy and market pricing
Offshore acquisitions
The structured bridge allows corporates to be agile in pursuing and acquiring offshore targets at short notice as the opportunities arise. This is particularly relevant in the context of a fractured UK and European Union post Brexit as foreign entities restructure. The treasurer will have the comfort of having access to funding that can be employed quickly and that is not a drag on the balance sheet, while they look for acquisition opportunities. Once the target is acquired and bedded down, the bridge loan is refinanced into longer-term funding that matches the cash flow of the recently acquired target. Essentially the timing of the acquisition is not dependent on market windows to raise debt and lengthy credit processes of funders. The target is acquired quickly giving the corporate treasurer the advantage of first bidder backed by immediate funding. Thereafter, the bridge is replaced with a long-term funding solution that can be structured to achieve the best result for the acquirer. Take-outs include bank debt, syndicated loans, US private placements, Eurobonds or equity raises which usually take up to three months to arrange.
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Conclusion
Corporate treasurers have the unenviable task of funding the business at the lowest possible cost and not placing unnecessary drag on the balance sheet while the company assesses growth opportunities. Market windows for funding and acquisition opportunities are not often aligned. The challenge is for the treasurer to be agile to secure the best possible result for the business in a volatile and uncertain market environment, with limited growth opportunities domestically. A structured bridge-to-take-out solution provides the corporate with the flexibility and speed to take advantage of market fluctuations to restructure existing debt or acquire targets and determine the appropriate long-term funding structure to match.
Leigh Cunningham-Scott Leigh Cunningham-Scott has over 15 years of investment banking and research experience. She started her career at Standard Bank in the Capital Markets Research team. She joined Absa Capital in 2007 to focus on structuring debt capital markets instruments ranging from securitisations to vanilla corporate bonds. Leigh joined the Debt Capital Markets team of RMB in 2011 and has focused on structuring transactions from financial institutions to gold bonds. Leigh has an M.Comm in Financial Markets. |
Dave Sinclair Dave Sinclair has 13 years of investment banking experience. He began his career at PwC auditing major South African and international banks. In 2003, he joined FirstRand Bank working in various roles within FirstRand Group Treasury and the Global Markets division of RMB. In 2014, he joined the Debt Capital Markets team of RMB and has been involved in a wide range of capital market transactions providing innovative funding solutions to financial institutions and corporates. Dave is a CA(SA) and a CFA charterholder. |
