Debt markets explained
June 2013
Debt securities and the bond market are sometimes
treated as the ugly duckling of all asset classes.
They are simply not as well understood by investors
as equity markets. In this report we explain the
difference between three classifications often
mentioned by investment managers when they
report back to investors on the performance of their
bond or fixed interest funds.
1. Executive summary
When it comes to debt securities and the bond market there
are three broad terms that are often used by investment
managers. These terms are different ways of classifying debt
securities or bonds and should not be confused as perceived
risk assessment terms.
All debt securities are analysed in terms of the following three
terms:
• Listed or unlisted debt
• Secured or unsecured debt
• Rated or unrated debt
When comparing debt securities on a very high level and in
broad terms listed debt is generally regarded as less risky
than unlisted debt, secured debt is expected to be less risky
than unsecured debt and finally rated debt is presumed to be
less risky than unrated debt.
On closer inspection though there are many intricacies that
need to be kept in mind when analysing debt securities. There
are some listed debt securities that are owned by a small
group of investors and not traded actively on the bond
exchange and are therefore very illiquid. There are many
good credit quality unlisted debt securities.
Secured debt is backed by an asset and could be presumed
to be of better quality due to a better recovery rate on default
than unsecured debt. However, government debt securities
are unsecured debt but are among the highest credit quality
debt securities available.
Securities with higher credit ratings are deemed less risky
than lower rated securities. However, there is a global move
away from only relying on credit rating agencies to assessing
the risks internally. There is no requirement for debt securities
to be rated by independent credit rating agencies before
inclusion in indices or to be listed on the bond market.
There is no blanket answer when assessing the risk of debt
securities and each security should be assessed in detail on
its own.
2. Listed vs Unlisted Debt
2.1. Listed Debt
Listed debt securities are listed on an exchange and can be
bought and sold in the secondary market. These debt
securities are generally more liquid than unlisted debt
securities. However, there are some listed debt securities that
are owned by a small group of investors and not traded
actively on the bond exchange and are therefore very illiquid.
Yield spreads are typically a factor of credit quality and
liquidity but sometimes other factors like market demand can
impact this as well hence the current low spread environment
seen in the current listed credit market.
One benefit of listed debt securities is that pricing is
conducted by an independent entity and all securities are
priced with the same methodology.
2.2. Unlisted Debt
Unlisted debt securities are not traded on an exchange, but
through the Over-The-Counter (OTC) market. Market makers
such as investment banks facilitate the buying and selling of
unlisted debt securities in the OTC market.
In some cases investment managers would originate the debt
themselves such as infrastructure bonds and development
bonds and hold such unlisted debt until maturity. Investors
could think of unlisted debt in the fixed income asset class
similar to what private equity is in the equity asset class.
Unlisted debt securities are not exchange traded and
therefore are perceived to be less liquid than listed debt
securities. This does not however mean that unlisted debt is
of lower credit quality.
A possible drawback of unlisted debt securities is that pricing
may be conducted by the holder of such securities. This
creates a potential conflict of interest and opens it up for
perceived manipulation. It is therefore very important that
investors are fully aware of their investment manager’s
valuation process.
3. Secured vs Unsecured Debt
3.1. Secured Debt
Secured debt is tied to an asset that is considered to be
collateral for the debt. Mortgage and car financing are both
examples of secured debt. Your mortgage loan is secured by
your home. Similarly, your car financing is secured by your
vehicle. If you become delinquent on these loan payments,
the lender can repossess and sell the asset to try to recover
the outstanding debt.
Similarly in the bond market, secured debt is backed by
physical assets that have been securitised such as mortgage
back securities (MBS) and asset backed securities (ABS).
These assets can be repossessed and sold in order to
recover the outstanding debt.
Only a small portion of the listed debt securities (on the bond
exchange) consists of secured debt. Many of the unlisted debt
securities are secured debt and backed by physical assets
such as a solar power plant for example. This is primarily due
to the fact that investment managers have better negotiation
powers in respect of the unlisted market where they are able
to dictate terms to a certain degree whereas the listed market
is pretty much a take it or leave it situation.
3.2. Unsecured Debt
Unsecured debt is not backed by any physical asset or
securitisation vehicle and lenders don't have rights to any
collateral for the debt. This is not to say that unsecured debt is
not backed by a stream of cash flows. For example,
government bonds are unsecured debt securities as it is not
backed by any physical asset that can be repossessed and
sold. However, government bonds are backed by tax
revenues as the government can just raise taxes when it
needs to make debt payments. Tax revenues cannot be
repossessed and sold and therefore does not constitute an
asset that can be used as collateral to secure debt. Other
examples of cash flow streams are toll road revenues and
power plant revenues.
Most of the securities listed on the bond exchange are
unsecured debt. Government debt is among the highest credit
quality securities and therefore being unsecured does not
detract from the quality of the debt security.
4. Rated vs Unrated Debt
Investors have to assess the credit quality of bonds or debt
securities. One approach is by considering the credit ratings
assigned to debt securities by credit rating agencies.
4.1. Rated Debt
Rated debt is debt securities that have been assessed by
credit rating agencies. Securities with higher ratings are
deemed less risky than lower rated securities.
Even so, the Bond Exchange of South Africa (BESA) does not
require debt securities to be rated in order to list on the
exchange. It is completely the preference of the issuer to be
rated or not.
In addition, the Financial Services Board made amendments
in a notice (notice 80 of 2012) to the Collective Investment
Schemes Control Act in which all reference to “credit ratings”
or “rating agencies” were removed.
Regulation 28 and the amended CISCA place the onus on the
investment managers and investors to put internal processes
and ratings in place to assess the risks of debt securities
internally and not only rely on credit rating agencies.
4.2. Unrated Debt
Unrated debt has not been assessed by credit rating
agencies. Issuers of unrated debt securities sometimes have
to offer higher yields than those paid on highly rated debt
securities because there are no quality guarantees. However,
the industry is evolving and as the sophistication of the debt
market improves the yield spreads should narrow and merge.
In the absence of credit ratings, the average investor on the
street cannot differentiate between a low risk bond being
issued by a financially strong institution and a highly
speculative bond. Although credit ratings are not full proof,
unrated bonds are perceived to be more risky but investors
need to take comfort from the expertise of their chosen
investment manager and assess that they have put the proper
steps in place in order to assess the risks at hand.
5. Summary
Debt securities can be classified as listed or unlisted debt,
secured or unsecured debt, and rated or unrated debt.
Most of the bonds listed on the Bond Exchange of South
Africa (BESA) are rated, however this is not a listing
requirement and solely the preference of the issuer. Most of
the bonds on the bond exchange are unsecured debt such as
corporate bonds and government bonds (although
government bonds are implicitly backed by tax revenues).
These terms are different ways of classifying debt securities
and should not be confused as perceived risk assessment
terms. Each debt security should be assessed for risk on a
case by case basis.
For more information please feel free to contact our Research
team on +27 21 852 9092.
Gregoire Theron
Head of Manager Research
Karlien de Bruin
Senior Investment Analyst