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
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
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.
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