More than a retail tale

Preparations for the 2010 Fifa World Cup are in full swing across large cities in the host nation, South Africa. Johannesburg, South Africa's most populous city, is no exception. Besides the modernisation of two major stadiums for use in the competition, the City of Johannesburg - the metropolitan municipality responsible for the provision of a variety of basic services - is working hard to ensure that the infrastructure for which it is responsible, such as sewerage, water, transportation and waste collection, is up to scratch.

To this end, Johannesburg has become the first sub-national municipality to issue retail bonds. "The treasury's goal is to provide funding for the City of Johannesburg's capital expenditure programme," explains William Mathamela, head of treasury for the City of Johannesburg. Capital expenditure for 2007 is expected to be R5 billion.

The R1 billion retail bond programme that the municipality is undertaking to also help diversify its source of funding away from institutional investors and loans from banks commenced in August 2007. Johannesburg had previously issued R3.9 billion of bonds since April 2004. Most of its outstanding debt has been issued in a straightforward bullet format. In terms of funding risk limits, the municipality's internal limit is that debt must not exceed 45% of operating revenue.

Mathamela says he expects retail investors to treat the new retail bonds, known as Jozibonds, as a buy-and-hold investment, and that they will help promote "a culture of saving", as he puts it.

There will, however, be a secondary market too. Johannesburg-based Standard Bank arranged the retail bond deal and is acting as market-maker for the bonds, which were listed on the Johannesburg Securities Exchange in September. The two-, three- and five-year retail bonds pay a quarterly coupon equal to the three-month Johannesburg interbank agreed rate (the South African equivalent of Libor) plus 5 basis points, 25bp and 40bp, respectively.

While the municipality keeps a careful eye on the interest rate risk associated with its current funding activity, Mathamela says it is comfortable with this from an asset/liability management perspective and is not currently hedging.

That is not to say the municipality is anti-hedging - far from it. It uses forward rate agreements to hedge liabilities that are short term - that is, with less than nine months' tenor. The treasury group also uses interest rate swaps for hedging purposes; it does not use them for speculating on the market.

It has R3 billion notional of interest rate swaps outstanding. "We hedged ourselves in 2000 for 10 years for some of the bank loans we had taken when bank lending interest rates were very high," explains Mathamela. Around $1.5 billion of the municipality's loans are structured, granting it the option to extend maturities.

In January 2000, the South African Reserve Bank's repurchase rate stood at 11.75%, and subsequently climbed to 13.75% in September 2002 - a level it maintained until May 2003. In September 2006, the rate stood at 8%, and stood at 10% on October 9, 2007

According to Fitch Ratings, which has rated the municipality, the mark-to-market value on the swaps position amounted to a loss of R6 million at the end of last year. The swaps are currently in-the-money, claims Mathamela, who declines to elaborate. Around three-quarters of the municipality's debt outstanding is on a fixed basis, after swapping.

"We use a (vendor's) treasury system for most of our risk management, including daily mark-to-market valuations of our instruments," says Mathamela. The treasury group meets on a weekly basis to analyse and discuss the risk reports. Candidly, Mathamela says most of the time the treasury employs a "do nothing" strategy, and only enters the market to hedge when deemed absolutely necessary.

In broad terms, the system is largely used just for interest rate risk analysis using standard metrics such as duration, delta (the sensitivity of the price of a derivative to changes in interest rates), profit and loss, and value-at-risk.

"When we issued our first bond in 2004, we were rated BB+ by Fitch," says Mathamela. "Three years later, we are now rated A+. The city has done very well." Considering the municipality's bonds that traded at a 230bp spread to those issued by the South African government in 2004 are now at a premium of around 90bp, it seems the market agrees with the treasurer's assessment.