The South African credit market is a growing and vibrant part of the resource allocation process within asset management as well as private and governmental funding.
More and more entities are looking for funding which requires a level of expertise on the part of the funder to assess the potential risks and returns of the loan they are about to make.
Further if you are trading credit, you need to make sure it is priced correctly and that the probability of default is low enough to match your risk profile. Have you ever wondered exactly what a credit analyst does all day and why it’s important? Candice Paine speaks to Wafeeqah Mallick, credit analyst at Futuregrowth Asset Management.
This special podcast is brought to you by Futuregrowth Asset Management and today, I’m talking to Wafeeqah Mallick, Credit Analyst with Futuregrowth. She’s going to be telling us all about credit markets. Wafeeqah, what is credit as an asset class, just to kick off with?
If you look a company’s balance sheet, you’ll see that assets are funded either from equity, which is shareholders’ ownership in the company or by debt.
If a company wants to raise funding to grow the business, either they would go to the shareholders to ask for money, or they’ll come to banks or institutional investors and ask to borrow money. That’s where we fit in. We lend money to good entities whom we think have a good credit quality.
How do you determine that? How do you determine whether they’re worth lending to or not?
We have to perform our due diligence on the companies. There are credit rating agencies that provide credit ratings for debt, so it would be Triple-A to Double-A and all of that links to the probability of default but that’s really, just an input. We do our own due diligence.
When we look at the analysis, we look at the fundamentals of the company. What does the company do? How do they make their money? How do they spend it? Who is management? Is management credible?
What are the risks that they face? In what industries do they operate? How do they mitigate those risks? All of that really, just feeds into whether it’s a sustainable company and do we like management.
Wafeeqah, what is the difference between equity and credit?
With equity investors, they’re there for upside risk. The share price can really shoot up and shoot the lights out, and then you get capital appreciation and dividends whereas with credit, we’re here to protect downside. With equity, the dividends are really discretionary to management.
Yes, directors give a sort of indication on what dividends they’d like to pay, but in the end, it’s discretionary. If the business isn’t doing well, they don’t have to pay the dividend whereas with debt, they have to pay the interest and that’s where we look at the gearing metrics and how much debt they have on their books.
Are the able to service their debt? If not, it will be an event of default and that might cause a restructuring process. It’s definitely rather downside risk because we don’t see any upside. We want to make sure that the fundamentals are absolutely strong, so they will be able to service the debt for the term horizon we’re looking at.
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What would be the biggest red flag to you when looking at a company?
As I mentioned, there’s the gearing metrics. If they’re overly geared, where the company really looks to use funding/external borrowing to fund their business and the owners of the business do not have enough skin in the game…that would be the equity side of the debt equity ratio as a gearing metric because we want to see management in there.
We want to see that they want to grow the business and do the best for the business. Of course, there are other fundamental ratios around the [inaudible 03:15] ratio. Governance is key thing, which we look at, specifically at Futuregrowth where we focus on the economic, social, and governance ESG factors.
We want to see that the Board of Directors are suitably qualified, that they have integrity, that they run the Board with good corporate governance, and that the auditors are on board so that we don’t have shoddy auditors who might not do proper work. As a result, when we look at the financials, we know that the auditors can assess that they have enough financial control.
Okay. It’s quite an onerous process that you take on – to come up with a credit rating to ultimately, include this credit in one of your funds so a Credit Analyst is not only about quantitative analysis. There’s a lot of qualitative and experience. In your opinion, what makes a good Credit Analyst?
As you mentioned, the fundamentals are very important. You need to have a thorough understanding of how accounting works because no matter what happens in the business and no matter what the economic outlook is, all of that filters through in the numbers.
If you are able to unpack those numbers, decipher any trends, and have a forward-looking view; that’s fundamental. In addition, many soft skills are involved in credit analysis. You’re dealing with management. You have to deal with management and different types of personalities and you’re dealing with different individuals as well.
We’re dealing with investment bankers, brokers, and lawyers when we draft our legal stuff, so it’s a very diverse nature. You’re not just sitting there behind your computer, crunching numbers.
It’s a lot of interaction with the market and understanding what the market dynamics are and how we price these instruments. You have to be able to incorporate all of that into your analysis and come up with the final rating and the final price.
It’s a lot of cognitive processing from different paradigms, to come up with one answer.
Yes. Definitely.
In the context of Retirement Funds, they are able to invest in credit and obviously, there’s a fiduciary duty around portfolio managers to deliver what retirees need. How is credit included in retirement funds in the South African context?
Yes. There’s Regulation 28 of the Pension Funds Act and that outlines the percentages that need to be invested in credit. The reason behind that is that credit is seen as a relatively riskless asset, although we think that there is risk in credit as we’ve seen in the African Bank saga and First Strut.
There’s definitely risk to credit but relative to equities, it’s considered lower risk and with lower risk, there’s lower returns.
While you might get a lower return on the credit assets (because with Pension Funds, you need to pay out that money when individuals retire, etcetera) there need to be enough assets in a relatively safe environment because these instruments mature at a certain age.
You will therefore, get your money back, barring any event of default whereas with equities, the market can be very volatile and by the time the pensioner needs to withdraw his funds, the market might have crashed and there might not be anything left.
With debt, it’s relatively more stable. Within the fixed income space, there’s a spectrum of risk so we start with Vanilla Bonds (Government Bonds), which are considered risk-free.
Then you move to Listed Credit, which is listed entities issuing credit. Your unlisted credit, which is more unknown names where you can structure your deals according to a bilateral negotiation and you can get all the way down to your Distressed Debt, where some companies would buy failing companies’ debt for maybe ten cents in the Rand with hope of receiving 20 cents in the Rand.
As you move down that risk spectrum, the return you get would also increase because of the risk reward/trade-off that you get. At Futuregrowth, we don’t necessarily do the Distressed Debt scenario but we can offer our clients exposure to different levels of risk and typically, we measure that by the credit quality.
For instance, Triple-A, Triple-B, or Single B and we can definitely tailor-make our funds or segregate the funds according to our clients’ risk appetite. That would then determine required return.
Read also: How SA can avoid another notch slide to a “Junk” credit rating
Okay, but let’s just touch on that. You made quite a profound statement when you said that credit is not risk-less, which may be new to many people listening to this podcast. Why is credit analysis so important? I’m sure it has to do with this inherent risk that is in credit.
Perhaps I can take you through what we call the waterfall effect. If a company were to default and there’s only X amount of money left in the business, that would have to be restructured and distributed. If you follow the waterfall effect, usually the staff and the tax man is paid first, and then the creditors and whatever’s left (the residual) goes to the equity holders.
Within that debt space, there’s a couple of tranches. You get the senior debt, subordinated debt, junior debt, and mezzanine debt, etcetera.
We fit on the scale when the waterfall will determine how much risk there is. If you’re in subordinated debt…although its debt, the risk is closely linked to equities. You need to understand exactly where you fall in the waterfall and how much cushion there is.
You have to look at whether there are enough assets in the balance sheet… If there is a case of default, will we be repaid? That falls into our recovery assumptions in our credit analysis and that then feeds into the pricing.
Wafeeqah, the first port of call for Credit Analysts is to determine what the probability of default is and then, if the company were to default, what amount you would get out as the investor. Is that correct?
Yes. That is the recovery that we look at. I keep referring to accounting because I am an accountant but if you look at the balance sheet, it’s made up of different types of assets. Some of the assets might not be tangible.
For example, ‘goodwill’ on the balance sheet… If the company fails, goodwill means nothing so we look at tangible assets. What is left of the inventory now? If we were to get the inventory, would we be able to sell it at 100 percent of what’s sitting on the balance sheets? We apply certain haircuts.
We look at cash. Cash can disappear in a second. When we look at all of that, we come up with a recovery rate that we expect; that if this company were to default, we’d only get 40% for example, which is 40 cents on the Rand. We plug that into our models and we’re able to get a price from that.
From a Futuregrowth perspective, you are working in a very competitive space, especially because the margin between returns from credit is very small. What do you think (in your view) is the edge that Futuregrowth would have over any other Credit Analysts out there?
At Futuregrowth, we have a big investment team. We have the Fixed Interest team that looks at the interest rate cycles and makes calls on the interest rate and inflation. Then we have the Credit team and that’s split up between listed and unlisted.
I’m specifically on the listed space where we look at all the listed bonds. We can, equally, buy and sell shares or buy and sell listed bonds. Then we have the unlisted side that deals with (not necessarily a small account as it can still be a very big), well-known corporate companies on a bilateral agreement. We are able to draft our legal agreements to ensure that we have enough protections in place.
We have an Agricultural Fund. There’s so much happening within this business. Although it’s debt predominantly, there are so many facets to it and we have a big team that looks at specific areas.
In addition, it allows fluidity. Futuregrowth really fosters fluidity within the team so although I’m a Listed Credit Analyst, I’m involved with unlisted deals, and sometimes some equity valuations if we have equity in a business.
Futuregrowth really strives to produce Investment Analysts as opposed to purely, Listed Credit Analysts or Unlisted Credit Analysts.
Okay, so it sounds as though the flexibility and scale of the team at Futuregrowth allows you to take advantage of opportunities as they come along.
Definitely.
I’ve been speaking to Wafeeqah Mallick, Credit Analyst at Futuregrowth Asset Management. Thanks for your time.
Thank you, Candice.
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