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Private credit is redefining fixed income

by James Weir | Feb 28, 2024 | Investments, Markets and Economy, Wealth Management

Private credit is redefining fixed income as an asset class, with returns as high as 10 per cent plus attracting an explosion of interest. But all that attention has drawn the usual cowboy operators, so smart investors need to be careful.

What is private credit?

Private credit is investing in loans made by non-bank lenders that can cover a broad range of purposes and borrowers.

Normally a private credit lender raises money from investors and doesn’t use debt, so zero gearing. That makes these companies very different to a normal bank, where the loan book will be dozens of times bigger than the bank’s equity.

Taking out a private credit loan is almost invariably much more expensive than borrowing from a commercial bank, with interest rates currently as high as 12 to 13 per cent. So why are borrowers flocking to private credit lenders?

Why the boom in private credit?

After the GFC, banking regulators around the world forced commercial banks to beef up their balance sheets, requiring them to back their loans with more equity to absorb potential losses, especially loans to sectors that had a history of high default rates, like commercial building and property development. That same regulatory crackdown caught up with the Australian banks in 2016, when their regulator, APRA, declared it wanted them to be the best capitalised banks in the world.

After that, it became far more profitable for Australian banks to lend for residential property, because they didn’t have to set aside as much equity on their balance sheets. Consequently, they all but abandoned some parts of the commercial lending market.

Spotting a huge, and growing, opportunity, private credit groups sprang up to fill the gap. Often staffed by the same experienced credit teams from the big banks who were now twiddling their thumbs, they got backing from investors with the prospect of outsized returns relative to the risk.

The result: EY estimates the Australian private credit market grew from $35 billion in 2016 to $109 billion by the end of 2022, a 21 per cent compounded annual growth rate. The global private credit market was estimated to have grown at 15 per cent per year between 2000 to 2022, reaching more than $1 trillion.

As often happens, Australia is a bit behind the US, where Foresight Analytics estimates non-bank lenders control about 50 per cent of the market for commercial real estate loans, and in Europe it’s about 25 per cent, while in Australia it’s around 10 per cent, but growing strongly.

What’s the attraction for investors?

Fixed income plays two roles in a portfolio: first, to provide some income, and second, to have little, if any, correlation to growth assets like shares, in other words, be a defensive asset.

Income-wise, over 2023 there were a number of private credit funds that returned well above 10 per cent, even as high as 12 per cent. For context, the Australian 10-year bond yield peaked at 4.95 per cent.

In terms of low correlation to shares, the word “private” is the critical part. Unlike corporate or government bonds, private loans are not normally traded on public markets, which makes them far less volatile because there is no day-to-day repricing, the fancy name for which is “mark-to-market risk”. In 2022, when bonds and shares both fell heavily, well-managed private credit funds continued to pay their interest and the unit price never changed.

The other attraction is security. For example, a private credit fund that lends to property developers will take a mortgage over the project, including the land, just the same as when a bank lends to a homeowner. Usually, the lenders require a loan to valuation ratio between 60-65 per cent. That means if the deal goes pear-shaped and the private credit manager repossesses the property, it has a 35-40 per cent buffer before investors lose any money.

In addition, the lender will also normally take a charge over other company assets as well as get a directors’ guarantee, meaning their personal assets are on the line as well. Plus, Australian lending rules are tilted very much in favour of the lender, enabling them to impose onerous covenants on the borrower.

There’s a lot to like about investing in private credit, but its popularity has drawn a lot of new operators, not all of which are experienced in credit analysis and some of which are under pressure to get investors’ money to work so are not as fussy about who they lend to. On top of that, some private credit deals will tie up your capital for up to 18 months, or even “semi-liquid” funds will take 2-3 months to get your money back. It pays to do your homework carefully.

What’s the best way to take advantage of the multi-year selloff in bonds?

by James Weir | Nov 22, 2023 | Investments, Markets and Economy, Wealth Management

It’s never happened before: bonds are about to deliver a third year of negative returns. The BofA Merrill Lynch 10+ Year Treasury Total Return Index in the US was recently more than 40% off its highs – more than double its previous worst drawdown.

It’s left a lot of shell-shocked investors scratching their heads wondering how what’s supposed to be the defensive part of a portfolio could perform so badly, and a whole lot of other investors wondering if there are bargains to be had.

Why were bond returns negative?

The first thing to know about bonds is that inflation is like kryptonite for them. If investors believe inflation is going up, they will demand higher compensation in the form of a higher yield.

The second thing to know is if you hold a government bond to maturity you are assured of getting the principal back, which is always a face value of $100 per bond.

When a plain old government bond is first issued, the interest rate it will pay the holder (which in bond speak is called a ‘coupon’) is fixed and doesn’t change over the life of the bond.

If you bought a newly issued Australian 10-year government bond today you’d receive a yield of about 4.6 per cent per year, and after 10 years you’d get $100 back for each bond. So the annual return is dead easy to calculate: 4.6 per cent.

However, if you wanted to sell that bond and inflation expectations have gone up since it was issued, any potential buyer will insist on a higher yield. Because the coupon is fixed, the only way to compensate the buyer is to reduce the price of the bond. Then, if the buyer hangs on to it until maturity, they’ll get the $100 back but on a lower entry price, thus compensating them.

Since the inflationary outbreak of the late 1970s and early 1980s, inflation has trended downwards over the medium to longer-term, which has been fantastic for bond investors, because the price of those bonds has risen over that medium to longer-term – see chart 1.

Chart showing bond yields trended down, resulting in a 40-year bull market, which went into reverse in mid-2020

However, the inflationary outbreak of the past few years has thrown that into reverse, and as expectations of higher inflation and interest rates has grown, so the price of bonds has fallen.

Is it time to hunt for a bargain?

It’s hardly surprising that any investor accustomed to market cycles would look at an asset that’s dropped 40 per cent and presume there’s a bargain to be had, and there are bond fund managers banging the table insisting now is the time to be buying bonds. But, as with anything in financial markets, unfortunately it’s not that easy.

Government bonds are issued with different lifespans, from 90 days to 30-plus years. The most popular bond yield that gets quoted is the 10-year bond.

The longer-dated the bond, so the more life it has until it matures, the more volatile it will be. The fancy name for that is ‘duration risk’, and it’s something that can be worked out for every bond. Australian 10-year government bonds currently have a duration risk of 8.7, which means if the yield increases by 1 per cent, the price of those bonds will fall by 8.7 per cent, and vice versa.

It’s that duration risk, and the volatility it causes, that’s the trickiest part about investing in bonds, even after they’ve copped a beating.

For a real world example, you can buy an Australian government bond through the ASX. A quick Google of “ASX listed bonds” should take you to the page that lists them. There’s one with the ticker GSBG33, which was originally a 20-year bond issued in 2013, so it has 10 years left until maturity. As you’d expect, its current yield is pretty much bang in line with the quoted 10-year yield, so about 4.5 per cent, and its last traded price was around $100. In other words, what you’d expect from a 10-year bond.

However, in August 2019, that same bond was trading at a price of $147, and at the start of November it was $97, so its price had dropped by 34 per cent – see chart 2. That’s some serious volatility for a supposedly defensive asset; clearly, it’s only defensive if you are certain you’ll hold onto it until maturity, in which case you’ll receive a return of 4.5 per cent, which compares to the September inflation rate of 5.4 per cent.

Chart showing the Australian government bond, GSBG33, has experienced higher
volatility than what many would associate with a defensive investment

For a long-dated bond to provide a better return than 4.5 per cent will require inflation expectations to fall, which is likely to happen if the economy slows down or goes into recession, and importantly, that extra return will effectively come from the price going up, so capital growth.

There are shorter-term bonds, that have lower duration risk and are therefore not as volatile, but the yield is lower. Alternatively, for investors purely interested in locking in a yield, term deposits are now paying as much as 5.25 per cent for 12 months and come with a capital guarantee. The risk you run there is it’s only good for 12 months.

You can also buy bond ETFs, however, they never mature. The ETF will always have some duration risk in it, meaning it will always be potentially volatile.

Another option is to invest through a fixed income fund manager and leave it to their expertise. There are some that specialise only in government bonds and others that operate under a more flexible mandate and can invest in corporate bonds as well. Andrew Papageorgiou, a portfolio manager at Realm Investment House, argues credit spreads on corporate bonds are historically far less volatile than interest rates. Also, good managers can employ fancy strategies to minimise the effect of volatility by using derivatives.

It’s possible those arguing it’s a great time to buy bonds are affected by recency bias: it wasn’t so long ago bond yields were negative, how can they possibly stay above 4.5 per cent? But bond yields don’t necessarily mean revert, the recent downward trend went for 40 years. There are legendary bond commentators, like Jim Grant and Barry Eichengreen, warning of a multi-decade bond bear market.

What’s more, investing in bonds to back a view that yields will decline is effectively targeting a capital return, which rings of a growth investment, whereas bonds are normally part of the defensive fixed income part of a portfolio.

On the bearish side of the fence are the many economists arguing rates will stay “higher for longer”. It really depends on what happens to inflation, and if smart investors have learned nothing else over the past couple of years, it should be that trying to guess where inflation will be years from now is a mug’s game.

If you would like to discuss your investment options, please get in touch.

How to get your head around fixed income

by James Weir | Aug 16, 2022 | Investments, Markets and Economy, Wealth Management

Article featured in the AFR

Fixed income returns over the fiscal 2022 year were the worst on record. When share markets experience returns like that investors have understandably become conditioned to look for bargains, but fixed income markets don’t necessarily work the same way.

Any well diversified portfolio will include defensive holdings designed to reduce its overall volatility and cushion the effects of falling share markets. Fixed income investments normally play that role, and that typically means allocating to government or corporate bonds, which are two very distinct markets, driven by different factors.

Because bonds issued by governments of developed nations are almost certain to be repaid, the price they trade at is not normally influenced so much by their credit rating as the outlook for inflation in their home country. If the market expects inflation to rise, investors will demand a higher yield to compensate, which requires a lower price and vice versa.

By contrast, while inflation also plays a role in pricing of corporate bonds, credit risk is the biggest issue, that is, the risk the company defaults and you don’t get your money back. Consequently, corporate bond prices are more sensitive to the outlook for recession, when company earnings come under increased pressure. The more investors are worried about recession, the higher the premium, or credit spread, to investing in risk-free government bonds they will demand.

Andrew Papageorgiou, managing partner at Realm Investment House, explains, “Just like bargain hunting in the share market, there are short and long-term considerations for fixed income investing. However, unlike the share market, fixed income markets have nuances that are only revealed through information that’s tough for non-professional investors to get their hands on.”

For example, in considering whether it’s a good time to invest in Australian government bonds, it helps to know that, according to the swaps market, inflation is currently forecast to average 2.6 per cent over the next 10 years. If the 10-year bond is yielding 3.15 per cent, that gives you a ‘real’ yield (after inflation) of 0.55 per cent. Is that a fair return? The average real yield over the past 15 years was 0.8 per cent, which makes it look a little low, but the post-GFC average has been 0.13 per cent, which makes it look much better.

In the US the current real yield on 10-year bonds is minus 0.05 per cent, which sounds pretty lousy, but the post-GFC average has been minus 0.17 per cent. Still, with the uncertainty around inflation, a negative real return is tough to swallow. For instance, in June, the real yield was 0.5 per cent, but since then inflation expectations have tumbled.

Meanwhile, credit spreads, or the risk premium, for Australian corporate bonds are as high as they were during the March 2020 COVID crisis. Papageorgiou points out that’s not a good reflection of the current perceived risk of recession, especially compared to the crazy time of early 2020, but is more to do with technical factors. So parts of that market look attractive, particularly compared to the US, where credit spreads are much less generous.

For the longer-term outlook, Damien Hennessy, of Zenith Investment Partners, says the current market signals around whether inflation has peaked, or economies will recess are so mixed that it’s difficult to view fixed income as a set and forget strategy right now. He points out that bond yields in June spiked to levels where he recommended reducing underweight positions but have since fallen again making them less attractive.

For investors who are game to increase their allocation to fixed income, just like with shares, there are passive and active options. Rather than trying to pick individual bonds, which introduces concentration risk, a fund will provide diversification. For passive investors, Vanguard offers both Australian and international government bond ETFs, credit ETFs and blended ETFs.

For investors who prefer to leave the decisions to professional managers, there are many to choose from. A good adviser will be able to help with curated recommendations.

For investors who see fixed income markets as just too uncertain, one option for the defensive portion of a portfolio is cash, which also provides flexibility for picking up bargains. However, with inflation currently many times higher than the bank interest rates on offer, it is guaranteed to lose purchasing power.

Portfolios always benefit from holding defensive assets to protect them against volatility, and over the past 40 years the long-term decline in interest rates has been very kind to smart investors. However, just as with equities, the uncertain outlook for inflation is a game changer.

At Steward Wealth, we went underweight both government and corporate bonds a few years ago and instead invested into ‘private credit’, that is, deals that are not open to the public at large and are usually senior secured mortgages over building and property developments. These loans have the dual benefits of not trading on public markets, so their value doesn’t go up and down like a bond, and they typically pay generous interest of between 5-8 per cent per annum.

Those loans carry their own risks, which have become evident this year with several high profile construction companies going bankrupt. However, we are in regular contact with the lenders and feel comfortable with their assurances that their screening and due diligence processes have become even more stringent. At the same time, the commercial banks have reduced lending to the sector which is throwing up lots of very attractive opportunities at higher rates of return.

Want to discuss your investment strategy with a specialist?

Listed property trusts: primed for a rebound

by James Weir | May 2, 2021 | Financial Planning, Investments, Markets and Economy

Property was possibly the worst affected sector when governments around the world pulled the plug on their economies in 2020. Not only did workers stop going into office buildings and shoppers stopped going to malls, but landlords were forced to shoulder the added burden of rent holidays and eviction moratoriums.

Little wonder real estate indices plunged. Locally the Australian Real Estate Investment Trust (AREIT) index fell 39% between the end of January and March last year, while the global benchmark, the FTSE EPRA Nareit Global index (GREIT), dropped 28% (in USD terms).

However, lingering concerns about both delays in returning to work combined with the effect the new paradigm of working from home will have on valuations for commercial property, as well as the impact of the accelerated migration to online shopping on retail values, have seen real estate indices lagging behind the broader share markets’ recoveries following the COVID crash.

The AREITs index is still 14% below its high of last year, while the ASX200 is only 1% away. Likewise, GREITs have managed to get square with last year’s high, but they’re a long way behind the 19% increase in global shares.

These differences offer smart investors the opportunity to buy what some strategists are describing as the only cheap sector left. Tim Farrelly, a highly regarded asset allocation consultant, recently wrote “Despite pretty severe assumptions on the outlook for rental growth, such as a fall in real office rents of 45% and a fall in real retail rents of 20% over the next decade, the overall impact on 10-year returns is not nearly as catastrophic as might be expected, as markets appear to have priced in these falls and more.”

Indeed, Farrelly’s 10-year return forecast for AREITs is 6.8% per year at current levels, while the forecast for Australian shares is 4.8%. Likewise, Heuristic Investment Systems, another asset allocation consultant, has a 10-year forecast return of 6.25% and an overweight recommendation.

While AREITs do offer compelling long-term value at current levels, our domestic market does suffer some limitations. It is highly concentrated, with the top 10 companies accounting for more than 80% of the ASX 300 AREIT index, and just three sectors, retail, industrial and office, making up more than 60%. The superstar of Australian property trusts, Goodman Group, alone is almost one quarter of the whole index.

By contrast, global REITs not only offer the compelling value, plus, at more than A$2.4 trillion, the total market is more than 19 times bigger than Australia’s. The top 10 companies account for less than 25% of the index and the biggest single company is only 5%.

Most importantly, there is abundant diversification, including to sectors that offer leverage to some of the most important structural themes in global markets. If you want to gain exposure to growing digitisation, 3% of the index is data centres; or e-commerce, 12% is industrial; for demographics, healthcare is 7%, and for urbanisation, 18% is residential.

According to Vanguard, global property was the best returning asset class in the 20 years to 2020, with an annual return of 8.5%. Resolution Capital, an Australian GREIT manager, also points out the asset class enjoyed lower earnings volatility than global equities.

Despite that history of strong returns, 2020 was its worst year since the GFC at -17%. By contrast, however, this time the fall was not because of excessive debt or weak balance sheets, it was a classic exogenous shock. With the progressive relaxation of government restrictions, conditions are in place for a strong rebound.

An added attraction is that historically REITs have been a terrific hedge against inflation, since both rents and property values are typically tied to it. This may sound counterintuitive if you’ve come across the popular misconception that REIT valuations are inversely affected by bond yields, that is, when yields rise, values fall.

Chris Bedingfield, co-portfolio manager of the Quay Global Real Estate Fund, points out that, “Over the long-term, there is actually no correlation at all between REIT valuations and bond yields. However, over the short-term, it seems there are enough investors who believe it that it becomes a self-fulfilling prophecy.” Notably, over the March quarter, GREITs returned more than 7% despite bond yields rising sharply.

To gain exposure to GREITs, you can buy an index fund, such as the VanEck Vectors FTSE International Property ETF (REIT.ASX), or, if you’re wary about the potential for COVID risks, you can choose an actively managed fund from the likes of Quay Global Investors or Resolution Capital.

Why hybrids offer defensive potential but have strings attached

by James Weir | Nov 4, 2020 | Investments, Wealth Management

This article appeared in the Australian Financial Review.

When the best term deposit rate you can get is below 1% from a bank you may never have heard of, the chance to get 4% or better on a hybrid security from one of the big four tends to grab your attention. The problem is, of course, those attractive rates come with all kinds of strings attached.

After emerging 25 years ago as a handy solution for companies to raise money and for share market investors to be able to access higher yielding securities, hybrids have become an entrenched part of the Australian market. However, while they can readily play a role in a smart investor’s well-structured portfolio, they are devilishly complex. There is a variety of structures and features requiring issuing documents that can run into the hundreds of pages, enough to prompt government websites like Moneysmart to describe them as ‘very risky’.

The ‘hybrid’ label is because they blend elements of debt securities and equities, that is, they are part bonds and part shares. Typically they promise to pay a rate of return, which you can think of as an interest rate, for a certain period of time, and at the end of that period, the investor gets the original face value of the security, which is normally $100, in shares.

The interest rate is usually quoted as a margin above the 90-day bank bill rate. Companies with a lower credit rating will have to pay a higher margin, just like a corporate bond. The rate can be fixed at a specific return, or it can ‘float’, meaning if the bank bill rate goes up or down, so too does the interest rate the investor receives. And hybrids commonly incorporate franking credits as part of the yield.

The rate a hybrid pays when it’s issued will normally be set by the issuer’s investment bankers going out to the market and testing investor appetite. Then once the security is trading on the market, the rate an investor receives will depend on the price they pay for the hybrid.

The part that makes hybrids complex and risky is the equity element. No two hybrids are the same, and the obligations of the issuer and the rights of the investor, can vary considerably. Some hybrids allow the issuer to stop paying any interest if it falls into financial difficulties, and some place the investor’s rights to recover their money in the event of the company failing behind all other creditors.

The theoretical price a hybrid security should trade at is determined by the combination of its starting margin over the bank bill rate, its different equity-type features and the length of time before it matures. The longer the time to maturity, the more time there is for something to go wrong and so the higher should be the interest rate.

The upshot of all these features is that hybrids are normally a lot more volatile than pure fixed income investments, but not as volatile as shares. When the ASX 200 fell 37% in February and March this year, the Betashares Active Hybrids ETF (HBRD) dropped by just over 15% and is now getting back to its pre-COVID levels, while the broader share market is still 14% below it.

Andrew Papageorgiou, a portfolio manager at credit investing fund manager Realm Investment House, said, “While hybrid prices do fluctuate, they are underpinned by solid mathematics. Like all securities, from time to time prices can be considerably above or below where we calculate they should be, which creates opportunities.”

This begs the question: if a self-directed investor doesn’t have access to the maths, how do they know when hybrids are cheap or expensive? The various stockbrokers that help sell new issues usually publish research showing the basic valuation measures, such as the current yield, and some of them may offer recommendations.

It’s worth bearing in mind, however, those brokers get paid commission to sell hybrid IPOs (an exception that was carved out from the recent reforms that saw LICs and LITs stop paying commissions), so there is an overarching question of conflicts of interest. There are other websites, such as yieldreport.com.au, that publish tables as well. Papageorgiou says a very rough rule of thumb is that normally bank hybrids, which dominate the Australian market, should generally trade at a margin of about 3.2 to 3.3% over the bank bill rate.

A few years ago Australia’s bank regulator, APRA, introduced clauses into bank hybrids enabling them to stop interest being paid or even to compulsorily convert the hybrids into shares if the bank’s senior equity falls below certain levels. ASIC expressed great concern that investors wouldn’t understand the risks and that hybrids were being marketed as an alternative to term deposits. To be clear, buying a bank hybrid is nothing like placing a term deposit with the same bank. A term deposit is government guaranteed (up to $250,000) and its value doesn’t change on a day to day basis.

However, asset allocation consultant, Tim Farrelly, argues the kind of market events required to trigger the conversion clauses are so extreme, and APRA is sufficiently vigilant, that investors shouldn’t lose sleep buying a bank hybrid provided they are comfortable holding it until maturity. That way they can ignore the market volatility and enjoy the added yield of a defensive, investment grade security. If you don’t think you can stomach the potential for 15% drops in the defensive part of your portfolio, no matter how temporary, then don’t go there.

Want to find out more about your investment options and whether hybrids could work for you? Get in touch today.

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