The collapse of First Strut, the country’s largest unlisted company, in a sea of fraud, leaving billions of rands in debt owing to, among others, retirement funds, is having an impact on local financial markets and investment product providers.
The two immediate effects are:
* Asset managers and banks, particularly those that have been caught up in the failure of First Strut, are having to reassess and, where necessary, overhaul their processes for assessing risk; and
* Higher-risk borrowers, particularly corporate borrowers on the bond markets, will have to pay higher interest rates that are more commensurate with the risk taken by investors. This will be a double whammy for borrowers, already facing higher borrowing costs as the United States, among other countries, plan to slow its central bank’s printing presses, which have been pouring out billions of dollars to stimulate the economy (known as quantitative easing).
Charles de Kock, a senior fund manager at Coronation Fund Managers, says the threat by the US to slow its monetary stimulus sparked the withdrawal of foreign investors from South Africa this year, which is reflected in the 20-percent drop in the value of the rand against the US dollar. (Monetary stimulus in developed countries drove down interest rates, making the higher interest rates on offer in developing countries, such as South Africa, attractive to investors.) The withdrawal of foreign investors means there is less money available for borrowing in South Africa, and this will push up interest rates.
Months before it collapsed, First Strut sold to asset managers what proved to be very fragile debt. Some asset managers took the bait and invested, but others performed checks that set off alarm bells, and they backed away.
The losses for individual investors – mainly members of retirement funds – as a result of the collapse of First Strut (which traded as First Tech Group) could total more than R800 million.
First Strut borrowed R925 million on the corporate bond market, most of which will not be recovered. The bonds now have a zero value.
Asset management companies that invest in corporate bonds say that the banks, which are owed billions of rands by First Strut, have first claim on any assets.
The asset managers that are known to be exposed to the failed corporate bonds are Investec Asset Management (IAM), Sanlam, Prudential, Stanlib and Fairtree.
The biggest loser is IAM, with R435 million of First Strut debt in the seven funds that make up its Credit Opportunities Strategy Portfolio, which is used mainly for retirement fund investments.
One of the funds is jointly managed by financial services company Riscura, which advises retirement funds on investments, and which had invested retirement fund members’ money in the failed bonds through the portfolio.
Riscura also advises two major retirement funds, the Telkom Retirement Fund and the Sentinel Mining Industry Retirement Fund.
Riscura, through Riscura Analytics, also provides risk assessment to financial institutions, mainly those that manage retirement funds to which Riscura acts as an asset management consultant.
However, Riscura failed to pick up the potential failure of First Strut or even the improbable property valuations in the Rockland “barren sand dune saga” last year. Both the Telkom and the Sentinel funds invested in the Rockland Targeted Development Investment Fund, which was placed under provisional curatorship last year.
One of the asset managers that did say no to the First Strut corporate bonds was Coronation Fund Managers. This is despite the fact that Coronation manages unit trust products, such as the Balanced Defensive Fund and the Capital Plus Fund, that seek out high-yielding bonds, such as those issued by First Strut, to provide investors with superior performance.
At a series of report-backs to financial advisers on its performance, Coronation portfolio manager Henk Groenewald, said that Coronation has no exposure to First Strut, because the company had done its research properly.
“Credit risk is something which we watch carefully. We do not want to lose capital for investors.”
In response to questions from Personal Finance, Luke Henkeman, Coronation credit analyst, said the First Strut bond issue “did not pass our initial screening process” for the following reasons:
* Coronation prefers to lend to listed, rather than unlisted, companies, because the former tend to have better access to the equity markets in tough times, which provides a better safety underpin for bondholders.
* Therefore, where Coronation does lend to unlisted companies, the risk-adjusted return requirement is higher. In addition, Coronation prefers that the company owns very strong franchises in its areas of business activity. This was not the case with First Strut, which was a collection of many small businesses in multiple areas of activity.
* First Strut already had reasonably high levels of debt before the corporate bond issue. This, in Coronation’s view, increased the risk of lending to the company.
Henkeman concedes that the best-designed risk-assessment processes and due diligence exercises will not always prevent losses where fraud is taking place. All market participants have to rely on the audited numbers presented by the bond-issuers.
Groenewald told the financial advisers that income assets, such as corporate bonds, will always play an important role in Coronation’s portfolios such as the Balanced Defensive Fund and the Capital Plus Fund in an attempt to provide superior returns consistently.
Coronation’s portfolios “look very different to a conventional bond portfolio, as we are continually searching for new ways to minimise risk and increase returns”, he says.
In particular, account has to be taken of the need to out-perform inflation, with the result that portfolios have to incorporate higher-yielding corporate bonds, because lower-risk government bonds provide lower yields, Groenewald says.
Henkeman says the search for higher yields was made more difficult, because, globally, interest rates have been kept artificially low since the financial crisis in 2008.
He says that, because of the demand for safer bond investments, an environment was created that led to a significant compression in credit spreads (differences in interest rates between higher-risk bonds and lower-risk bonds). This narrowing of credit spreads was supported by a reasonably benign environment, with very few negative credit “events” in South Africa and no high-profile disasters until the First Strut default, Henkeman says.
“Conditions in both the general interest rate markets (as a result of anticipation that quantitative easing will end) and the corporate bond market have now changed, which is likely to lead to wider spreads for the foreseeable future,” he says.
But, Henkeman says, the collapse of First Strut has sparked “a return of rationality to the market, as professional investors re-price the additional reward required for taking the additional risk”.