By Michael Kruger, Senior Investment Analyst

Our investment team at Morningstar has written previously about the local fixed income universe and the complexities of navigating the wide (and still growing) range of funds available to investors. Recent news about the potential default of loans provided to a taxi financing business, Bridge Taxi Finance, has again highlighted the care that needs to be taken in making fund selection choices in the South African fixed income universe.

Although it doesn’t appear that these potentially defaulting loans were widely held across local funds, a very well-known fixed income fund, the Mi-Plan IP Enhanced Income Fund, with around R11 billion in assets under management (at the end of January 2024) announced that they had 8.7% of the fund’s assets invested in these floating rate notes¹. Due to the uncertainties surrounding the valuation of these instruments, they have been moved into a “retention fund” which is separate from the “main fund” and will not be accessible by investors for the time being.

Although potential defaults such as these are not uncommon for fixed income funds, the event does raise questions about the pricing of potential credit risk.

Let’s take a closer look at what happened

At the start of the year, two SENS announcements were released regarding the structured products created by Redink Rentals (RF) Limited (“Redink”) and Martius (RF) Limited (“Martius“) in their relevant note programmes. Within these programmes, investors were given exposure to two special purpose vehicles (SPV’s) linked to Bridge Taxi Finance. The SENS announcements issued by the JSE indicated that Bridge Taxi Finance had defaulted on the interest payments on certain instruments and that caution should be exercised when dealing with the above mentioned structured products.

The Martius notes fund the importation, insurance in transit and licensing of new taxis. Redink finances the securitization of debt once the taxis have been sold and leased to owners. Bridge Taxi Finance, established in 2013, provides development credit finance to South African entrepreneurs in the minibus taxi industry, empowering them to provide their clients with safe, secure, and reliable transport. Approximately 70% of all commuter journeys in South Africa are made using taxis.

A difficult economic environment in South Africa

Although the SENS announcements were relatively light on specific details, the default on the interest payments on the notes appears to be caused by economic strain linked to rising interest rates, high inflation, a slowdown in new vehicle sales and elevated petrol prices. All of these factors placed pressure on the ability of Bridge Taxi Finance’s clients to meet their debt obligations. In addition to this, the passing of Martin Bezuidenhout, the CEO of Bridge Taxi Finance, and its operating company, Mokoro, in January 2024, has placed a significant strain on the business.

Significant holders of the defaulting debt

The Mi-Plan IP Enhanced Income Fund, a popular multi-asset income fund, with around R11 billion in assets under management (as at the end of January 2024) was a significant holder of the defaulting Redink and Martius notes. The company (under the direction of the manager of the Mi-Plan fund, Vunani Fund Managers) has announced that following the SENS announcements relating to the default on interest payments, this has created a material uncertainty as to the current valuation of these instruments due to the lack of published information.

As a precautionary measure, interest accruals were suspended on these notes on the 9th of February 2024. To provide time for adequate analysis of the valuation of these instruments, the company announced that they will be moving the impacted assets into a “retention fund”, which is separate from the “main fund”. This effectively leads to the assets being side-pocketed in a separate portfolio from the existing fund.

What does the process of side-pocketing or creating a retention fund entail?

Side-pocketing is the process of separating and transferring an asset out of the main fund and allocating it to a separate newly created retention (side-pocket) fund. This may be a result of the asset being illiquid or its value not being readily, prudently, accurately, or realistically determinable in the prevailing circumstances.

The process of side-pocketing became better known to South African investors due to the default of African Bank Investment Limited (ABIL)’s debt instruments in 2014. These were widely held across the SA fixed income universe and led to many funds side-pocketing the assets in separate portfolios.

The side-pocketed assets in the retention fund are not lost to investors but rather transferred to the newly created fund. It is important to note, however, that while the main fund will continue to operate as normal when it comes to withdrawals and interest accruals, investors will not be able to redeem their units in the newly created retention fund until or unless circumstances change (such as the side-pocketed assets being realized or their valuation confirmed).

Why is the creation of a retention fund or side-pocketing sometimes necessary?

When there is material uncertainty as to the valuation of an asset, it could affect the ability of the fund to sell the asset at a reasonable price to meet investor redemptions. Therefore, the risk exists that prices for subscriptions or redemptions will not be accurately reflected, resulting in concentration or dilutive effects for investors entering or exiting the fund.

Existing investors would be impacted by investors making withdrawals or redemptions and, in those circumstances, would be left with a more significant portion of the affected assets. The main objective of the side pocketing is, therefore, to protect existing and new investors (whether exiting or investing in the main fund).

Impairment of side-pocketed assets

Following extensive engagements with both the issuer (Redink) and the management of the service agent (Mokoro), Vunani Fund Managers (the fund manager of the Mi-Plan fund) announced that they will write down the assets in the retention fund as of the 1st of March 2024.

Despite the SPV’s satisfactory performance, financial distress at the overall sector level has led to subpar collections, which has impacted the valuation of the notes. Unfortunately, legal restrictions prevented the issuer from providing Vunani with the detailed data needed to perform a comprehensive valuation of the notes. Based on the available information, Vunani decided to write down the value of the instruments by between 20% and 40%, depending on the seniority and claims to underlying cashflows within the securitised structures.

In a recent Citywire article², it was noted that BCI’s Saffron BCI Opportunity Income and Saffron BCI Active Bond funds held about 3% and 2% respectively. BCI has written down the value of the instruments to similar levels and also side-pocketed these assets.

Is the pricing of credit risk in the South African context appropriate?

The recent credit event has raised questions about the current pricing of corporate credit in the South African environment. Income funds in South Africa have received significant inflows over the past few years, as riskier assets (such as equities and property) have struggled to deliver significant inflation-beating returns, leading to a decade of disappointment for investors in more aggressive S.A.-focused funds.

We have also seen a significant number of new fund launches over the past 10 years, as fund managers have looked to capitalise on the growth in AUM in the S.A. fixed income ASISA categories.

This has raised questions about the possibility of too much money chasing too few deals, as credit spreads continue to tighten further, despite the deteriorating local economic environment.

Companies continue to face multiple headwinds from high interest rates and inflation, weak economic growth and poor consumer and business confidence. It is, therefore, essential that fund managers are pricing credit risk appropriately in the South African context. This includes sizing positions appropriately and not taking outsized positions to a single counterparty that may materially impact investors in the event of a default. Ultimately, a fund manager’s credit and portfolio construction processes need to properly assess and balance the risk and return equation and determine whether their investors are being suitably compensated for the risk of holding those instruments in their portfolios.

Beauty is in the eye of the fund holder

Given the competition for capital in the S.A. fixed income universe, it has never been more essential for investors to do their homework when allocating capital in what is meant to be the more conservative portion of their portfolios.

Unfortunately, given the large (and growing) number of offerings available in this space, it has become common for certain funds to try and stand out from the crowd by taking on undue illiquidity, interest rate or credit risk. This search for yield and reaching for returns can sometimes result in disappointing outcomes for investors, particularly in the event of a credit event or interest rate movements negatively impacting a significant portion of their portfolios.

Ranking funds according to past absolute or risk-adjusted performance is often not reflective of the level of risk that is being taken in a portfolio context and we would guard against investors making fund choices solely on these metrics.

In conclusion

At Morningstar, our investment team spend the bulk of our time on three main areas - asset allocation, manager selection and portfolio construction. The manager selection component of our work is a vital input to ensure that investors reach their financial goals. We spend a lot of time meeting with and questioning fund managers, to assess whether they can deliver alpha for our clients at an appropriate level of risk. A key component of this analysis is whether managers are appropriately diversified, or whether they are reaching for returns at the expense of sound portfolio construction.

In our view, the fixed income component of a client’s portfolio should provide stability and ballast rather than being the main driver of returns. This includes pricing credit risk appropriately and making sure that investors are not overly exposed to a market outcome impacting them negatively. To quote the wise words of Warren Buffett, “Only when the tide goes out do you discover who's been swimming naked”.