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Investing Under IFRS 9 Regime: Why Credit Ratings Matter For Asset Managers

Apr 22, 2019   •   by   •   Source: Proshare   •   eye-icon 12428 views

Monday, April 22, 2019  /  05:20PM / By UBA In-House Analyst  / Header Image Credit: Diapason

 

The global financial system will remain vulnerable to human exuberance, a challenge in behavioural finance that seems to be a natural part of investing. It is this phenomenon that underpins many of the regulations and risk management practices in the world of asset management. Interestingly, risk and return are positively correlated, little wonder the appetite for higher yield tends to exacerbate behavioural tendencies in investment decisions, as portfolio managers may stretch the scope of investment policies to attain higher return, even whilst recognizing the increased risk associated with such investment.

 

Thus, regulators in Nigeria, like their peers elsewhere in the world, have strictly codified rules guiding the investment practice of different sub-sectors in the financial system. They range from Nigeria’s Securities and Exchange Commission (SEC), the National Pension Commission (Pencom), the Central Bank of Nigeria (CBN), as well as the Nigerian Insurance Commission (NAICOM), and all have guidelines for investments. These include, but are not limited to a specific definition of qualified investments and asset allocation practices, in addition to permissible performance reporting and disclosure formats.

 

Beyond the investment decision and management practice, performance reporting is increasingly becoming regulated for effective standardization and benchmarking analysis.

It is on this note that Nigerian pension fund managers and traditional asset management firms would have to contend with the emerging challenges of IFRS 9, the proactive accounting standards on measurements and disclosure of Financial Instruments, which replaces IAS 39. The new standard is anchored on an expected loss model, a proactive measure towards early recognition and provisioning for financial instruments, compared to hitherto IAS 39, which is based on an incurred loss model, an after-the-fact approach to risk management.

 

Just like Nigerian banks, pension fund managers have transited from IAS 39 to IFRS 9 as at the effective date of 01 January 2018, thereby reinforcing the need for pension fund managers to re-align investment decisions to these new performance and reporting standards.

 

What Is The Exposure?

With an average of 90% of pension funds invested into fixed income instruments, ranging from money market placements, treasury bills, commercial papers and bonds – sovereign, sub-national and corporates, the key source of credit risk exposure for pension funds is the risk that any of the counterparties or issuers of the financial instruments will default, either in interest payment or principal repayment. Whilst Pencom has proactively mitigated credit risk exposures by limiting investable assets to those with a minimum of “BBB” credit ratings, pension fund managers may need to set internal benchmarks and asset allocations thresholds for investments below “AAA,” which are presumed to be “risk-free,” given the “sanctity” of the issuers of such instruments, designated as “AAA” instruments – mostly sovereign.

 

 

Proshare Nigeria Pvt. Ltd.

 

 

…Are The Mitigants Enough?

Notwithstandingthe proactive guidelines by the Pension Commission, the rationale for fundmanagers to limit exposure to lower-rated bonds and borderline investment gradeassets (“BBB”) is reinforced by the relatively higher impairment charge thatmay be required on such assets with relatively weak credit rating, compared tomore quality assets. Expectedly, all non-sovereign instruments, will beexpected to attract impairment charges, irrespective of performance, even sothe required impairment charge may be immaterial, particularly as there aretheoretically inherent risks and higher “probability of default” forlower-rated corporate bonds in the Nigerian capital market, like anywhere inthe world. Hence, the impairment charge that would be expected on lower ratedbonds would be higher, compared to the higher rated bonds, even when both areestablished to be duly performing.

 

According toDeloitte, as a practical expedient, IFRS 9 allows an entity to assume that thecredit risk on a financial instrument has not increased significantly if it isdetermined to have a ‘low’ credit risk at the reporting date. Interestingly,the International Financial Reporting Standards considers credit risk to be‘low’ if there is a low risk of default and thus suggests that an ‘investmentgrade’ rating might be an indicator for low credit risk.

 

Besides the higherprobability of default on a lower rated instrument and the corresponding higherimpairment charge that may be required on such exposure, the downgrade risk isempirically higher for instruments lower down the rating scale below the “A”rating. This, therefore, suggests a higher probability of a significantincrease in credit risk over the life of the instrument and the potential for areclassification of the assets from “Stage 1” bucket into “Stage 2”,irrespective of the performance of such debt instrument. For instance, ifmacroeconomic volatility or industry-specific challenge leads to the ratingdowngrade of a borderline “BBB” rated instrument, it will become anon-investment grade asset, thus requiring fund managers to divest the asset.Such development may lead to significant price and liquidity risks, as allpension fund managers holding the instrument would seek to exit in compliancewith regulatory guidelines, irrespective of the performance of the asset.

 

An example inIndia is that currently, though corporate bonds rated ‘BBB’ or equivalent areconsidered investment grade, most regulators in India have set a minimum of‘AA’ rating for bonds to be eligible for investment. Therefore, the Indiancorporate bond market is currently skewed towards high-rated debt instruments(AA and AAA).

 

In Nigeria, atotal of N411billion outstanding corporate bonds are listed on the FMDQplatform, out of which N176 billion or 43% are “BBB” rated.

 

Interestingly,N44bn of the corporate bonds are “AAA” rated, ranking pari-pasu with the FGNSecurities, which are backed by the full faith and credit of the FederalGovernment of Nigeria.

 

The “AAA” ratingassigned on the bonds of these corporate bonds: Mixta, NMRC, Viathan, andNorth-South Power, are reflective of the respective guarantee s on the bonds byreputable “AAA” rated institutions. Whilst Mixta and NMRC were backed byGuarantco and the Federal Government of Nigeria respectively; Viathan andNorth-South Power were guaranteed by InfraCredit, a specialized infrastructureguarantee company, backed by the NSIA, Africa Finance Corporation, andGuarantCo.

 

Notably, theGuarantee from these reputable institutions, are pseudo Sovereign creditenhancements and significantly mitigates the credit risk exposures on thebonds, backed by the institutions, which become the ultimate obligor to thebond holders, as the guarantors would fulfill the obligations, in theunexpected incidence of a default from the primary issuer/obligor.

 

In between the“AAA” and “BBB” rated issues are the bonds of highly rated banks like UnitedBank for Africa and Stanbic IBTC as well as non-financial institutions likeLafarge and Dufil Prima, which are assigned credit ratings within the “A” and“AA” categories.

 

Conclusion

Under the IFRS 9dispensation, effective pricing of a Non-Sovereign instrument may become morepertinent than ever, as fund managers seek adequate credit spread to compensatefor inherent differences in credit quality, as may be reflected in the creditrating differentials. Whilst the credit spread has been somewhat standardizedin more developed markets, the Nigerian capital market is still evolving, withno defined pricing mechanism for credit spread.

 

Given therealities of IFRS 9, the perceived pricing inefficiency in the market will begradually corrected, as we expect fund managers, banks, insurance, and otherinvestor categories to increasingly price-in credit risks in new issues in theNigerian capital market. Interestingly, the increasing depth of credit rating inNigeria should support the pricing evolution, as credit ratings are a productof rigorous analysis done by the rating agencies in differentiating obligorsand issues, with the Sovereign serving as the benchmark.

 

For furtherinformation on this article, kindly contact: [email protected]

 

 

Proshare Nigeria Pvt. Ltd.

 

 

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Proshare Nigeria Pvt. Ltd.


Proshare Nigeria Pvt. Ltd.

 

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