Prior to 2008 there was very little innovation. However, this year saw the introduction of products like Absa Capital's enhanced return credit-linked notes, inflation credit-linked notes and a few other variations to the traditional credit-linked notes.
The South African credit derivatives market has remained relatively immature as a result of:
- a lack of any liquid interdealer credit default swap (CDS) market;
- virtually no secondary corporate bond trading;
- exchange controls; and
- a limited corporate bond supply.
The lack of liquidity restricts the range of local structured credit, or correlation products on offer, since dealers are unable to delta hedge with any level of certainty. Despite current market challenges and conditions, there is still significant scope to develop the local structured credit product market according to Absa Capital.
The local investor base has and will continue to play a vital role in developing the structured credit market further. The product expansion - limited as it may be - witnessed in 2008, was made possible by the local investor base, which has become more comfortable with the products and the associated documentation. Specifically, the recent establishment and continued success of credit-specific funds and hedge funds will be key to the further development of the market.
These are certainly interesting times for credit and structured credit, both locally and abroad. There is also little doubt that the markets will remain challenging for some time to come. Over a year into the global credit crisis, many believe that we may not be out of the woods just yet, despite credit markets having stabilised.
Total write-downs to date are estimated to be in the region of US$500 billion. As asset quality continues to deteriorate we might expect to see further write-downs and losses for financial institutions. Proactive intervention by central bankers has certainly helped liquidity, but the question remains: how many more Bear Sterns scenarios can central banks afford to bail out? After allowing Lehman Brothers to go to the wall, it became clear that current market sentiment is not strong enough or stable enough to suffer a default of that magnitude, the largest Chapter 11 bankruptcy in US history. It is hard to even fathom what might have happened if AIG, Merrill Lynch, Morgan Stanley or even Goldman Sachs had been gone down. Clearly, the proposed $700 billion US Treasury rescue package indicates that the systemic risk and cost associated with large financial institutions failing is larger than the cost of bailing them out. Thus supporting the 'too big to go down' theory.
While the US has underperformed Europe through the majority of the crisis, there are indications that the European economic situation is starting to deteriorate fast - especially since the eurozone has less policy flexibility.
Inflationary pressure continues to hurt the global market as food price inflation marches ahead relentlessly and the oil price looks set to remain elevated on the back of supply and demand pressures. While global economic growth thus far has been surprisingly resilient, consumers remain under the cosh. Ultimately, we would expect this to hamper growth and corporate earnings. We might well only be at the beginning of the ratings migration and default cycle, particularly with regard to the high yield sectors.
Internationally, unprecedented volatility in credit markets has been observed. The iTraxx five-year Main (the most liquid 125 European investment-grade CDS names) reached wides of 159 basis points in March and 140bp in September 2008 from around 20bp in June 2007. The iTraxx five-year Xover (the most liquid 50 European sub-investment-grade CDS names) similarly went to 636bp in March and 646bp in September 2008 from around 241bp in June 2007. Since then iTraxx Main has been back to the 60bp range and Xover to 376bp with the markets currently sitting at 110bp and 575bp, respectively.
Absa Capital has seen that international credit, to a large degree, has been correlated with the equity markets. As sentiment has improved equity markets have rallied, with credit spreads tightening, while credit spreads have widened in sympathy with weakening equity markets.
Although the fundamental and macroeconomic picture has declined, the unwinding of structured credit products has created far more pronounced credit volatility than existed in previous bear markets. These products have included constant proportion debt obligations (CPDOs), constant proportion portfolio insurance (CPPI) structures, synthetic and cash collateralised debt obligations (CDOs). Market value structures with cash-out or margining triggers have been the biggest culprits. It was these same technical factors - the issuance of synthetic credit products - that drove the five-year iTraxx Main to tighten to 20bp in June 2007.
Despite the fact that most of the technical factors have played out, the potential revision of rating agency methodology around structured credit products could still have some impact. Assets might be money good and mark-to-market bad, but downgrades by the rating agencies and further deterioration in asset quality may force certain investors to liquidate their position. Secondary bond liquidity remains weak and bank funding levels have been climbing. Many international banks have been able to raise 'remedy' capital with relative ease, but this might not be the case if the credit crisis continues.
Significantly, while the credit crisis was gathering momentum abroad, the initial effect on the local market was quite benign. Asset-backed security (ABS) transactions were still being placed right up to the end of 2007 - long after the international ABS market was effectively shut.
It was also only late in the first quarter of 2008 that local investors really started to push back on issuers demanding far higher spreads to take up the assets, resulting in a number of ABS and other issues being pulled. The local ABS issuance window opened again briefly in August 2008 before the most recent financial crisis once again forced issuers to pull deals.
Part of the reason for this lag is that there is very little liquidity in the local market and, unless assets trade on the Bond Exchange of South Africa, they are not marked-to-market to reflect current market conditions.
The regulatory environment that South African investors operate in also creates artificial supply and demand pressures. These have tended to keep local credit spreads far tighter than the equivalent risk in the offshore markets. The credit derivative markets on the whole reacts a lot faster to market news but, in the absence of any liquidity, this is not as noticeable in the local market.
Secondary bond liquidity is now similar in international and local markets, where South Africa never really had any liquidity. Local bank funding spreads have also continued to rise.
The local credit markets have been coming under renewed pressure, with banks and parastatals likely to dominate issuance in 2008. Local banks, like their international counterparts, have continued to raise capital with relative ease. This has been driven by strong organic growth of bank assets and the associated capital requirements. Unsurprisingly, with South Africa's infrastructure development in full swing, parastatals have and will continue to tap the local capital markets for their considerable funding requirements for some time to come.
Moody's recent downgrade of Eskom gives a clear indication that the costs of infrastructure finance may be significantly more than expected if the government does not provide adequate support to maintain credit ratings. If the local market is unable to absorb the parastatal funding requirements, it could be very expensive for them to raise capital in the international markets (under current market conditions).
After many years of tight credit spreads there is at last some real value in both the local and in the international credit markets. The current market conditions offer significant opportunities for the savvy investors. Volatility is likely to remain high with increasing default and rating migration rates.
The lack of liquidity in the local credit derivatives markets limits the range of products and potential opportunities but does seem to have resulted in less volatility. We believe that, in these challenging market conditions, Absa Capital is best placed to provide investors with both local and international structured credit product solutions. Andrew Selby, Head of Sales T. +27 11 895 6000