Banking on a squeeze
The South African credit market has evolved significantly over the last decade. In nominal terms, approximately R1.15 trillion in corporate-issued paper is currently outstanding, with a heavy skew toward financial institutions and banks. Recent years have seen strong inflows into income funds, while corporate issuance has remained lacklustre, resulting in a persistent demand-supply imbalance and sustained spread compression. Issuers have prioritised strengthening their balance sheets and have limited new issuance (fund raising via debt) due to subdued local growth prospects and macro-economic headwinds.
Peril or parity?
One market segment currently catching a lot of flak is South African banks’ Additional Tier 1 (AT1) instruments, which like senior unsecured debt, have compressed to their narrowest levels since issuance began. Compared to South African Government Bonds (SAGBs), the spread differential has narrowed, raising concerns among some investors that the compensation for holding AT1s may no longer justify the risk – especially versus the “risk-free rate” or versus offshore equivalents.
But is this a fair comparison?
The asset swap (ASW) market suggests that SAGBs have not been risk-free since the days of “Nenegate” (December 2015). There has been growing divergence between SAGB yields and equivalent interest rate swaps as highlighted in chart 2. This difference or spread – interpreted as the compensation for credit risk (credit risk premium) – challenges the traditional definition of risk-free. As South Africa’s fiscal outlook continues to deteriorate, the ASW spread continues to widen.
When evaluating potential returns on SAGBs, it is important to understand that investors are not only being rewarded for taking on interest rate risk and/or volatility. In my view this difference constitutes an overlapping risk with bank and corporate exposure as a sovereign default or restructuring would ripple across the broader credit market. Some investors may however see this as an additive risk. Either way, it complicates the picture when comparing the risk and rewards of investing in AT1s versus government bonds.
When benchmarked against developed market AT1 spreads, South African AT1s appear marginally expensive, at best. However, any direct comparison must adjust for the cross-currency basis, which narrows the differential between local and offshore yields.
This is important because the valuation for regulatory capital instruments, like AT1s, must account not only for credit and liquidity risks but also for currency and structural considerations, particularly as South Africa prepares to introduce a new class of loss-absorbing instruments.
A diminishing opportunity set
AT1 instruments represent a good example of a different type of debt becoming available to fixed income managers in recent years and requiring managers to evaluate the risk and reward of including these instruments into a diversified portfolio. The evolution of the fixed income market has not reached the finish line. South Africa’s capital markets continue to mature amidst further regulatory developments. 2026 will mark another milestone with the introduction of FLAC (First Loss After Capital) instruments. These are designed to strengthen the loss-absorbing and recapitalisation capacity of the banking system, enabling an orderly resolution that minimises financial stability risks, ensures continuity of critical functions, and reduces reliance on public funds. While the implementation has been delayed to 2026, the implications are already material. The requirement will likely reshape the investable universe for local fixed income managers, forcing a reassessment of strategy and risk.
At present, investment managers could broadly fall into two camps: those who seek safety (hide from risk) and those who are returns-focused. But avoiding risk will become increasingly difficult. According to the SARB’s July 2024 Statement of Impact, to meet new base minimum FLAC requirement (bMFR) issuance targets, the 6 systemically important As shown in chart 4, South African banks will need to raise R268bn of FLAC instruments over a 6-year phase-in period, with the first requirement being 60% at year 3. This figure is based on the SARB’s reference calculations and will scale with banking sector growth during implementation.
Unsurprisingly, many banks have already signalled that maturing senior debt will be replaced by FLAC instruments.
The minimum FLAC requirement (MFR) includes an idiosyncratic component specific to each bank, in addition to the bMFR. Its inclusion could result in a total requirement of R360bn.
The maturity profile of existing senior debt paper over the coming years alone does not meet the requirements, resulting in a potential shortfall through the replacement of senior unsecured debt. The proportion of loss-absorbing instruments in South Africa’s credit market (excluding government debt) could rise from 10% loss-absorbing instruments today to about 30%-40%.
Ready or not? Here it comes.
The South African corporate credit market is on the cusp of fundamental change. Whether we are ready or not. As FLAC instruments become a larger share of the outstanding issuance, market participants will need to adapt their strategies, moving away from traditional comfort of senior debt and toward a more nuanced understanding of credit risk.
The shift will reward investors with the analytical capabilities to understand risks in capital structures and identify value in loss-absorbing layers. Those who prefer to invest in “senior-only” may find themselves increasingly constrained.
There remains an outside possibility that government-issued floating rate notes could partially fill the gap left by reduced senior bank issuance. However, this outcome is not guaranteed and would depend on fiscal policy decisions and market appetite for sovereign exposure.
The introduction of FLAC instruments represents more than a regulatory adjustment – it is a fundamental reconfiguration of South Africa’s credit landscape. As the market shifts towards a higher proportion of loss-absorbing debt, investors will need to evolve.