Delta Cement 12% 2029: Carry Versus Classification
A credit analyst at a Kenyan bank holds KES 100m face of Delta Cement's 12% annual-coupon bond, seven years to maturity, now quoted at 94.50 after a two-notch downgrade to BBB. Treasury marks the yield at about 13.25%. The tranche sits in the held-to-maturity book; a further KES 60m of the same issue sits in the available-for-sale book, marked to market quarterly. A covenant breach at Delta may force the bank to reconsider the classification of both. The internal limit for BBB paper is KES 80m. Secondary liquidity is thin - two dealers, 2.5 points bid-offer. The bank funds at 10.5%. The CFO wants a hold-or-sell recommendation with numbers, not ratings language.
1. Verify the quoted yield, and estimate the price impact of a further 100bp widening.
Read the worked answer
Yield check at 13.25%:
Price = 12 x [1 - 1.1325^-7]/0.1325 + 100/1.1325^7 = 12 x 4.4011 + 100 x 0.4185 (annuity factor 4.4011; discount factor 0.4185) = 52.81 + 41.85 = 94.66, close enough to 94.50 for a quoted round figure. The 13.25% is credible (true YTM is nearer 13.3%).
Duration: discounting each flow at 13.25% gives a price of 94.51 and a Macaulay duration of about 5.05 years; modified duration = 5.05 / 1.1325 = 4.46.
Price impact of +100bp:
Delta P approx -4.46% x 94.51 = -4.21 points, price to about 90.30.
On the KES 100m face holding (market value KES 94.5m) that is a mark-to-market fall of roughly KES 4.2m, before convexity (small, about 0.1-0.2 points of cushion). Key judgement: duration, not credit rating, governs the near-term P&L; the credit view governs the seven-year outcome. A further 100bp on top of a two-notch downgrade is not a tail event.
2. The CFO asks whether selling out of the held-to-maturity book on credit grounds would 'taint' the classification. Advise, and quantify the available-for-sale mark.
Read the worked answer
Classification: the tainting concept exists to stop banks holding at amortised cost while trading opportunistically. Under IFRS 9 the business-model test is not breached by sales made because of a deterioration in credit quality, nor by sales that are insignificant or close to maturity. A sale of this name driven by a documented credit trigger is defensible; routine sale of unimpaired HTM paper to book a gain is not.
Practical point: the bank is not forced to sell the HTM tranche to solve a limit problem - it can sell the AFS tranche first, which has no tainting significance at all.
AFS mark: mid is 94.50. With a 2.5-point bid-offer, the realisable bid is about 93.25. On KES 60m face that is KES 55.95m realisable against amortised cost near par (say 100), i.e. an unrealised loss of roughly KES 4m already sitting in the AFS revaluation reserve and a further ~0.75m of exit cost if sold at bid.
Judgement: classify each tranche by intent and ability, not by which treatment flatters capital this quarter. Document the credit trigger now, in writing, before any sale.
3. Make the hold-or-sell call, addressing the limit, the carry and the expected credit loss.
Read the worked answer
Limit: total exposure is KES 160m against an KES 80m BBB limit. The bank is in breach on the merged view regardless of view; something must be sold. Roughly KES 60m-80m must go.
Carry: yield 13.25% less funding 10.5% = +275bp, about KES 2.75m a year on 100m face.
Expected credit loss: BBB seven-year cumulative default probability is of the order of 5%-6%; with 60% loss given default that is 3.0%-3.6% of face, annualised roughly 0.45%-0.55% (about KES 0.5m a year). Carry comfortably exceeds expected loss - in the base case.
But the covenant breach is information, not noise. If it lifts the annual probability of default to 3%, expected loss becomes 3% x 60% = 1.8% a year, KES 1.8m - still below carry but with a fat left tail: a default forfeits roughly 60 points, KES 60m on the face held.
Recommendation: sell the KES 60m AFS tranche at the bid (cost about KES 0.75m of spread, no tainting risk), retain about KES 80m to sit inside the limit, and hold the HTM tranche only if the covenant breach is waived or cured within the quarter. If it is not, sell down to 80m total using the HTM tranche as the residual. Holding 160m is not an option the analyst is entitled to recommend.