Why there’s no place like home for fixed income
With Australia’s superannuation assets currently totalling $2.9 trillion1, super funds have been shifting away from their previous home bias to a higher allocation to global assets.
According to the Association of Superannuation Funds (ASFA)2, over the past 20 years there have been marked movements in super fund allocations away from Australian assets and towards international equities (currently 24%) and international fixed income (9%).
Given the relatively small size of the local equity market, there are sound reasons for this shift. Geographic diversification opens up opportunities to invest in sectors that might be under-represented locally and spreads portfolio risk, reducing volatility and potentially improving returns for investors.
However, there are occasions when a local focus is warranted – particularly when it comes to fixed income, and especially direct private loans.
Growth in the corporate loan market
In recent times, corporate loans have been garnering a great deal of attention in Australia, as a number of large Australian super funds have moved into the market or indicated that they are investigating how to access this asset class.
Banks have been retreating from private debt markets since the global financial crisis forced them to repair their balance sheets and, more recently, Basel III mandated stronger capital adequacy obligations.
As a result, Australia’s non-bank lenders are slowly following the US and UK and taking in a larger slice of the debt market, with many super funds now developing their own direct lending exposures and in-house expertise.
Much of this new lending has focused on global markets – with Australian super funds now funding everything from real estate to infrastructure investments across North America and parts of Europe, with some expanding into emerging market debt.
However, this approach could be exposing members to undue risk, which could be avoided by participating in the Australian domestic corporate loan market. The reason for this is Australia’s strong corporate insolvency laws, which are probably one of the most underappreciated benefits of this type of investment.
Insolvency laws – the Australian advantage
In Australia, legislation governing corporate insolvency is outlined in the Corporations Act 2001. Broadly speaking, creditors are ranked and there are sophisticated and detailed provisions for their treatment.
Where a lender is secured, they rank highest in the pecking order in terms of the capital structure of a company.
If a company’s financial performance was to deteriorate, a lender could ask the borrower to try to raise additional equity and use the proceeds to pay part of the outstanding debt. If the borrower was unable to do so, the lender could then force an asset sales process to recoup funds. If the borrower could not do either of these two things, often a lender might have to take control and exercise the powers available to them under their securities.
Secured creditors in Australia have effective control over companies they lend to, meaning they can take action against the company or property they have security over, and look to either sell assets or restructure the debt, for example by converting it to part debt/ part equity.
According to Minter Ellison Partner Michael Hughes, the Australian system has some distinct advantages over overseas models.
“Australian insolvency laws are very much focused on taking account of and giving priority to the interests of creditors, especially secured lenders, in comparison to the US and UK which are now perceived to be much more focused on the debtor company,” he said.
“For example, we have retained the process of the lender enforcing their security by taking control through the appointment or a receiver and manager, which was abolished by the UK some time ago.
“Australian processes also don’t involve the courts to the same extent as in the US, and we give primacy to the contractual rights conferred on lenders under the indenture [legal contract that reflects a debt obligation].”
Non-banks set to dominate
In addition to favourable legislation on non-performing assets, there is another key reason for wholesale investors to consider the local market – the advantage non-bank lenders have over the big banks.
Bank regulation means if the credit quality of a borrower deteriorates, the banks are required to hold more and more capital against that borrower, recognising the potential risk of loss. In some cases it can become uneconomical for a bank to hold those assets, and rather than restructuring the assets they may be motivated to sell quickly, effectively becoming forced sellers.
In comparison, non-bank lenders can take a longer-term view, seeking to ensure that investor capital is preserved through proactive risk management processes.
As a result of legislative pressures, the major banks have been gradually reducing their exposure to certain sectors. For example, recent analysis by law firm Ashurst shows the big four banks cut their exposure to residential apartment development by more than half in the past three years, from $5.2 billion in 2016 to $2.3 billion this year3.
This increasingly conservative approach has opened up significant opportunities for non-bank lenders locally.
The importance of diversification
While there are compelling reasons for large wholesale investors to consider an allocation to Australian corporate loans, portfolio diversification should be a key consideration.
Corporate loan loss rates in Australia are low, averaging 0.32%4over the past 10 years. However, investing in a diversified portfolio rather than lending directly to a few select corporates, can further limit downside risks by spreading funding across a range of sectors, risk profiles and loan terms.
Direct corporate lending requires experienced management to ensure a sufficient pipeline of high-quality transactions and effective risk mitigation. However we believe that with the right team in place, the corporate loan market will continue to present opportunities for wholesale investors seeking investment opportunities in an increasingly uncertain market.
1. ASFA, as at 30 June 2019
2. ASFA Super Stats, August 2019
3. Ashurst analysis, September 2019
4. ABS, December 2018
Online by Andrew Lockhart
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