By Ian Norden, CEO, Intengo Market
In the financial landscape, the concepts of fair value and mark-to-market often surface, particularly in the evaluation of bonds. While both metrics provide insights into the valuation of financial assets, they serve distinct purposes and are derived through different methodologies. Fair value estimates aim to offer a theoretical assessment of an asset’s worth based on credit risk and other financial factors, often devoid of more immediate market fluctuations. On the other hand, mark-to-market prices reflect the current market conditions, heavily influenced by real-time supply and demand dynamics.
Particularly within the South African fixed income market, the concepts of fair value estimates and mark-to-market prices often diverge significantly. This discrepancy can be attributed to various factors, including market liquidity and the dynamics of supply and demand. This article delves into the reasons behind some of these differences and explores how fair value could be more accurately determined in an illiquid market environment with an adjusted methodology.
Why might this matter?
Institutional investors, such as asset managers and life insurers, who manage pension and retirement fund clients, amongst others, may need to divest from certain bonds or other fixed income assets as clients near retirement. If these bonds are sold below their fair value, the retirement savings of their clients could be diluted at a critical juncture in their savings journey. To mitigate this as far as possible, a liquid bond market plays a crucial within a financial ecosystem. In a liquid and efficient bond market, any divergence between fair value and mark-to-market should be minimal. Unfortunately, this is not the case in the South African corporate bond market, which is why most institutional investors prefer to invest in more liquid fixed income assets like government bonds and bonds issued by banks..
To some extent, this situation can potentially create a negative cycle within the corporate bond market. Investors tend to avoid purchasing corporate bonds due to concerns about future liquidity risk, resulting in these bonds maintaining lower liquidity compared to other bonds, as fewer investors are willing to buy them. One way to help this conundrum from occurring is to provide the market with an independent mechanism for valuing bonds, separate from the liquidity (or lack of liquidity) factors affecting a bond. While this does not guarantee that a bond will trade at its exact fair value, having an independent source to determine the price for both parties in a negotiation can result in trades closer to the appropriate level than might otherwise be achieved.
Fair value explained
Fair value estimates of a bond’s credit spread are intended to represent an objective evaluation of the bond’s worth. This estimation considers the inherent credit risk associated with the bond issuer and other pertinent financial metrics. The goal is to provide an unbiased reflection of the bond’s value, devoid of immediate market sentiment and external pressures.
To achieve this, in our view, fair value estimates should ideally be derived from a uniform group of market participants, such as the credit analysts at institutional investors. By utilising pricing estimates from a broad range of these experienced teams, a model can be developed to construct a credit spread curve that creates a relatively accurate reflection of the aggregate market view. This model can be further refined by grouping issuers into various credit rating buckets and developing curves for each homogenous group..
Mark-to-market pricing
In contrast to fair value estimates, mark-to-market prices are influenced heavily by the real-time dynamics of supply and demand. In South Africa, where bond market liquidity is notably low, this can lead to significant discrepancies between the two valuations. When bonds do trade, the last traded price might not truly reflect the bond’s fair value. Instead, it may be affected by the urgency of sellers to offload their holdings or the scarcity of buyers, resulting in prices that are skewed by immediate market pressures.
For instance, if there is an influx of sellers trying to dispose of a particular bond, the price will likely drop below its fair value to ensure a transaction occurs. This phenomenon is a classic illustration of supply and demand economics, where the equilibrium price is determined by negotiating strength and the current market conditions, and not by an objective assessment of the bond’s worth.
Many will argue that a bond needs to be valued using a likely price that could be achieved if the bond needed to be sold in the market on short notice. Our local market is one where investors typically “buy-to-hold” and some bonds might never change hands in the secondary market whilst others might only trade sporadically. With this nuance in mind, it becomes difficult for a last traded price to reliably predict a future trading price. A fair value estimate, using a different methodology than the bond’s mark-to-market as proxy, is required.
Modelling fair value curves
Building a reliable fair value curve requires aggregating data from various market sources and participants and modelling these inputs to reflect the market’s collective view. In the South African market, as with establishing an accurate mark-to-market, this process is complicated by the limited number of new bond issuances and the resultant scarcity of data. As mentioned earlier, data should be grouped so that some form of reliable modelling can occur at a group level, even if these groups are relatively large (eg all AA, or equivalent risk, corporate issuers in one group).
A corporate issuer’s goal is not to raise new debt from the market at fair value, but rather to raise the right balance of funding for their business needs whilst also minimising borrowing costs. The existence of this second goal suggests that a fair value modelled using bond clearing spreads could differ from a fair value calculated using all available pricing data from all participants in each auction. The way in which the fair value estimate is modelled, and which underlying data contributes to any such model, therefor has a significant impact on any differences observed between the estimated fair value and associated mark-to-market.
In practice, however, a new bond’s issue price (or clearing spread) is the only data point made public after each new bond issuance. Access to bid data is not readily available to all parties and not always shared with the broader public. Intengo Market helps market participants issue and settle new bond issuances. In the process, it is able to confidentially capture and model this data into fair value curves with the goal of improving transparency and price discovery for the fixed income market. Where auctions are not facilitated through the platform’s workflow (yet) bid information is still sourced and incorporated into the models.
Our research shows that corporate fair value curves derived in this manner tend to sit above than those built using only clearing spreads from primary market bond auctions. This adjusted method attempts to account for the influence of the company treasurer’s borrowing needs in the ultimate clearing spread of the bond. It is our view, that this offers a more accurate representation of the bond’s worth than only using the observed primary market clearing spreads. The figure below shows the difference between the fair value curves of the corporate bond market using the two modelling methods set out above. In an economy with a higher growth rate, we would expect corporates to borrow more each time they raise a new bond, and any difference would be smaller (or even flip the other way). The gap, while seemingly small, can have a material impact when we are considering the interest payment across hundreds of billions of debt.
To demonstrate how the demand of the issuer has an impact, the Bank/Financial sector curve, below, paints a very different picture. In this second graph, we can see how the weighted average bid spread sits well below the clearing spread on the short term side of the curve. If clearing spreads are then also used as a proxy for fair value, the issuer’s demand for debt potentially has too much indirect influence over how this spread is determined for it to be an objective measure of fair value.
In conclusion
The disparity between fair value estimates and mark-to-market prices in South Africa’s bond market underscores the importance of understanding the underlying factors driving these valuations. While mark-to-market prices provide a snapshot of current market conditions, fair value estimates offer a more stable and objective measure of a bond’s worth. By accounting for market inefficiencies and applying liquidity premiums, investors can gain a clearer picture of the bond’s true value, aiding in more informed investment decisions and fairer negotiations, benefitting all underlying market participants in the process.
