Against the backdrop of the unprecedented global market turmoil experienced over the past few years, technical and practical complications have arisen for market participants across the spectrum of the equity and capital markets. While South Africa was affected less severely by the global financial crisis, the small investor base and limited trading volumes experienced in our developing market meant that investors in markets felt the impact both economically as well as in their financial results.
Falling security prices across the local bourse (the Johannesburg Stock Exchange), coupled with widespread international pessimism, has resulted in the equities market offering less attractive investment opportunities. The capital markets were also negatively impacted by declining trading volumes and liquidity because market participants wanted to decrease their credit exposure on assets held. They attempted to minimise their overall portfolio risk by investing in low risk (high investment grade) assets rather than in corporate bonds traded on the Johannesburg Stock Exchange (JSE).
In particular, this has resulted in limited trading in the South African bond market, especially in corporate bonds listed on the JSE. This decrease in the liquidity of bonds listed on the exchange meant some corporate bonds require reclassification from active to inactive.
The impact of changing the market classification for participants carrying bonds at fair value is on the pricing of the bonds as quoted by the JSE and the resultant impact on the valuation method for determining a fair market value for the bonds traded on the exchange.
Currently most market participants will determine the fair value of their bond positions based on the market price quoted by the JSE. Given an active market and satisfactory liquidity for an individual bond, the price quoted per the exchange can be regarded as an observable and fair market value. However given the liquidity squeeze and the impact on the capital markets discussed above this is not the case when the market for an individual bond listed on the exchange can be classified as inactive.
It is the exchange's policy to only update a bond's price when there has been an executed trade in the bond. In absence of this, the quoted price remains at the previous quoted level until the price can be updated. This policy results in the bond's price neither reflecting current market sentiment nor the change in the risks faced by the bond and underlying issuer (including interest rate and credit risks). In this instance the quoted price will not reflect an observable market fair value.
The price of a bond, specifically a listed corporate bond, is influenced by the supply and demand for that instrument, the market's perception of the issuer's credit risk and the prevailing risk-free rate of return in the market.
If one of these factors has changed since the last trade, it should be reflected in the bond's fair value and updated in the bond's valuation and the investor's annual financial statements.
Market participants holding assets traded on an exchange (especially the capital markets) should consider the pricing rules and policies of the exchange, the limitations thereof and how these limitations affect the fair value of the instrument. Where necessary, appropriate adjustments to the valuation methodologies should be made to address the limitations and bring the quoted market price in line with the fair market price.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.