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A Bond Investor’s Perspective on Regulation 28: Time for a Change

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Regulation 28 of the Pensions Fund Act (Reg28) seeks to set prudent overall risk limits for retirement fund investments. Arguably, it is the most important piece of legislation governing financial investments in South Africa, and it affects every member of any public or private retirement fund.

In the minds of many, Reg28 has become synonymous with safety. However, in the area of debt instruments we find Reg28 is sorely out-of-step with the goal of prudence.

Originally promulgated in 1956, the Pension Funds Act and its Regulation 28 have been amended from time to time, most recently in 2011. Recent amendments did not deal with some fundamental flaws in the area of bond and money-market investments -- and those flaws have worsened in the past few years.

Banks aren’t as safe as you think

Banks do fail:
By our informal count, there have been about 20 bank failures/near-failures in South Africa during the past 25 years. On average, a bank has foundered about every 15 months, and, while the pace of failures has slowed recently, there are still over 20 locally and foreign controlled banks registered in South Africa, and even more foreign bank branch offices. As examples, we can recount the debacle of African Bank’s failure in 2014 and the less noticed curatorship of VBS Mutual Bank on March 12, 2018 (!).

Reg28’s exposure limits to banks are too high:
Despite this chequered history, according to Reg28 a pension fund can have up to 100% of its total assets invested in banks. And, further:

  • For holdings of bank accounts and money market instruments a retirement fund can have up to 25% of its total assets in any one bank without regard to the bank’s size or quality.
  • For longer term instruments a retirement fund can have up to --
    - 25% in a listed bank with a market capitalisation of R20 billion or more;
    - 15% in a listed bank with a market capitalisation of R2 to R20 billion;
    - 10% in a listed bank with a market capitalisation of less than R2 billion; and
    - 5% for any unlisted bank.
    Note: Reg28 cannot be interpreted to use both limits (i.e. 25% for deposits plus, say, 25% for longer-term debt instruments), so the practical limit of aggregate exposure to any one bank is 25%.

Banks work in a highly competitive environment, dealing with volatility in markets, sectors, currencies and the economy, and they do so with geared balance sheets. Banks are not, by any stretch of the imagination, risk-free. And yet the clear implicit message of Reg28 is that banks are low-risk borrowers.

Our view is that, by allowing for potential overexposure to banks, the limits of Reg28 are neither suitable nor prudent.

Reg28 makes no distinction between banks’ senior-debt and subordinated-debt:
Compounding the potential overexposure described above, Reg28 also makes no distinction between banks’ senior-debt and subordinated-debt instruments. Subordinated debt is likely to suffer losses of up to 100% in a bank failure, while senior debt is very unlikely to have such a loss.

Clearly, not all debt instruments are equal. But because Reg28 does not make any distinction, a pension fund could have a very substantial part of its assets exposed to subordinated-debt instruments.

What has changed?
Clearly, the “banks are risk-free” mind-set arises from an era where large banks were too big to fail, and where the South African Reserve Bank was expected to step in to prevent bank failures. However, since the global financial crisis (2008-2009), the world’s bank regulatory framework has materially changed to specifically protect governments from having to bail out banks: The key shift is toward risk-sharing by all of the bank’s financiers – with shareholders’ equity taking the first losses, then preferred shares, then subordinated debt, and finally senior debt suffering capital degradations. Banks were once “too big to fail”, but that era is past.

While some would like to see the failure of African Bank as an outlier, the fact is that it was a reasonable test case for a “new generation” bank failure – with ordinary shareholders, preference shareholders, subordinated debtholders and senior debtholders all bearing a portion of the losses.

Reg28 has always been lax in its exposure limits to banks, and this has been exacerbated by the change in regulations and practices to deal with bank failures.

While no right-thinking investment manager would make full use of the Reg28 limits to banks, a wrong-thinking “financial solutions” salesman or ill-informed trustee might be tempted to make catastrophic decisions based on the current limits to banks in Reg28.*

In sum, we are of the firm view that Reg28 should be revised such that:

  • the overall exposure limits to the banking sector should be reduced;
  • the exposure limit to individual banks should be materially reduced; and
  • there should be a distinction (in exposure limits) between a bank’s senior and subordinated instruments.

For a corporate bond, being “listed” doesn’t add any measurable quality, security, liquidity or price transparency
Over the past few years we have seen a series of corporate failures and debt restructures (e.g. Steinhoff, PPC, Real People, Edcon, FirstStrut, Supergroup) as well as the very visible degradation of South Africa’s State-Owned Enterprises. In all cases, bond holders’ actions have been impaired and their rights unclear. It has become evident that South Africa’s bond market listing standards, reporting standards, legal framework, and debt-placement practices are prejudicial to investors. Bond holders have few protections against corporate degradation, and, when businesses get into trouble, bond holders can be left behind as other creditors take possession of security assets.

Reg28 implies that “listed” instruments are a sort of imprimatur of quality, liquidity and transparency: This is entirely misleading to retirement fund trustees and their consultants. While the listed equity market has well-developed company law and rules of fair play, the listed bond market has precious few investor protections. This has arisen due to the evolution of bond markets since the 1980’s, which was driven by banks – who are, themselves, the biggest borrowers in, and sales-agents of, bonds.

The Reg28 limits for listed debt instruments are up to two times the limits for unlisted debt instruments (e.g. 10% per issuer for listed versus 5% per issuer for unlisted; up to 50% in listed debt instruments versus 25% in unlisted debt instruments). This belies the fact that well-structured unlisted debt often has better conditions, protections, security, reporting and yield.

Further, Reg28 infers that listed bonds have better liquidity and more transparent market valuations: That presumption is deeply flawed, as turnover in the listed (non-government) bond market is scant and price transparency is very weak (and may be easily manipulated).

Because retirement funds take their cue from Reg28, they often mandate their fund managers to buy only listed bonds. In turn, banks, and their collaborator asset managers, then create bespoke listed instruments that have no additional quality, reporting, security or tradability – evidently simply to fit into unwitting clients’ mandate restrictions.

We consider that Reg28’s overall exposure limit of 50% of a fund’s assets to (non-government) bonds is suitable.** Bonds are a natural asset class for retirement funds, and a well-functioning debt-capital market can be an efficient channel to fund productive enterprises. Thus, it is our view that Reg28’s limits to debt instruments are appropriate and should not be reduced. However, it is clear that the legal protections of listed bonds must be improved, and the JSE’s bond listing standards, reporting standards, investor protections and market practices must be materially revised.

The flaws in the listed bond market – exacerbated and promoted by Reg28 – are now visible and ready for a change. The FSB should play its proper regulatory role by ensuring investor protections in the listed bond market are materially improved.

*Sadly, this precise scenario has just occurred: The Bophelo Beneficiary Fund (for mining orphans) -- which falls under Reg28 -- was holding a reported R385 million of deposits in VBS Mutual Bank which was put into curatorship on March 12, 2018. That deposit appears to be more than 50% of the fund’s total assets. This holding exceeds the Reg28 limit (25% to any one bank), but even a 25% exposure to VBS Mutual Bank would have been irresponsible. In any case, this demonstrates the danger of assuming that “banks are safe” or that Trustees can discern quality and suitability.
**Arguably this 50% limit might be set higher since, by definition, debt is less risky than equity which has an overall limit of 75% of a fund’s assets.

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Regulation 28