Is Global Credit The Missing Asset Class?
The search for income is an ongoing challenge for Australians who want to maintain a comfortable retirement lifestyle.
It's a challenge for advisers too, as they look for ways to help clients maximise income while being mindful of capital protection, longevity risk and the need to manage volatility.
In this context, the conversation that advisers have with clients often ends with weighing up cash/traditional fixed income (i.e. government bonds) versus shares. But this ‘barbell' approach isn't the only solution.
The new environment of record low interest rates globally and locally means that historical returns achieved from cash/fixed income are unlikely to be achieved in the future. Dividends from shares are proving to be no magic bullet either, and come with the increased capital volatility associated with the equity asset class. The recent decision by BHP Billiton to cut its dividend was a wake-up call for equities investors - a reminder that income from shares is discretionary.
In fact, there is a ‘missing' asset class that can fill the gap, between the high volatility/high risk of shares, and the lower risk/lower return of government bonds: this asset class is global credit.
Global credit has been proven historically to deliver good income with an attractive, ‘intermediate' risk profile. It can provide diversification away from the domestic market, more security than equities and the potential for more income than cash/bonds. Chart 1 illustrates where credit sits in the risk spectrum.
While global credit is a core component of many institutional investors' portfolios, it's somewhat surprising that global credit isn't better utilised in income-focused portfolios of individuals and self-managed super funds (SMSFs) in Australia.
In fact, recent Australian Taxation Office (ATO) data shows that SMSFs in Australia have highly concentrated investment portfolios, with approximately 75 per cent allocated to direct Australian equities, cash, and direct Australian property1.
Further education could help individual investors in Australia get a clearer picture of how global credit can contribute to their portfolio, highlighting five key characteristics of the asset class:
1) Income generation
Global credit securities - including corporate bonds, loans and high-yield securities - tend to pay investors regular coupons with a higher yield than cash or traditional fixed interest.
A diversified portfolio of such coupon-paying instruments allows for the smoothing out of all those cashflows, which can be paid out as regular, high-yielding income (i.e., through monthly global credit fund distributions).
Chart 2 shows that while many traditional fixed income asset classes are currently offering yields which fall within or even below the Reserve Bank of Australia's target inflation range (of two to three per cent), the addition of a ‘credit spread' (i.e. the additional compensation paid to credit investors for taking on an issuer's credit risk) allows key global credit sectors to offer yields well in excess of inflation targets.
2) Capital resilience -- seniority and security
While many Australian investors seek to bolster their income with domestic hybrids (preference shares/subordinated notes), senior credit investors (e.g. loan and bond holders) benefit from having priority of payment above hybrid and equity investors.
This is for both payment of coupons and repayment of principal.
A credit investor's ranking in a company's capital structure is a key determinant of their recovery of investment if the company gets into trouble, and their certainty of receiving ongoing distributions.
In addition to seniority, some credit investments also provide investors with the benefit of security over specific assets of the borrower, providing further protection to the investor.
This normally takes the form of a mortgage over property and other realisable assets. These factors mean the capital value of credit investments has been more resilient than equities.
3) A liquid and shock resistant asset class
Global credit is a large and deep market and significantly larger than global share markets. It has many different investor types, including asset managers, banks, insurance companies, pension funds and sovereign wealth funds.
This diversity of investors means credit investments are traded between buyers and sellers even during challenging times.
Global credit also tends to be more resistant to shocks: when credit markets fell in the Global Financial Crisis (GFC), they took just one and a half years to recover, compared to four and a half years for equities.
4) Diversification
Global credit allows Australian investors to diversify away from Australian shares and achieve a broader spread of exposures across issuers and economic/geographic areas.
Industry diversification is particularly important, because corporate failures may occur in clusters - the technology crash in the early 2000s, or financial institutions during the GFC, for example.
Industry diversification is difficult to achieve in the Australian market. Australia is a small economy with a heavy concentration to financials and miners (~60 per cent of ASX 200 market capitalisation is in those two sectors). Far greater diversification is available by investing in global asset classes.
There are many types of credit investments within the global credit asset class, including investment-grade bonds, global syndicated loans, convertible bonds, high-yield bonds, securitised debt, capital securities, and fixed-rate and floating-rate securities. They offer different types of credit risk and return opportunities.
5) Managing credit risk
Like all investments, there are risks to consider. The key one is credit risk, where a company fails to repay coupons or principal in full and on time.
Credit risk can be best managed and mitigated through careful investment analysis and security selection, thorough review of creditor protections in any security (i.e., seniority, security), a focus on rated, liquid investments, and significant diversification.
Accessibility
The credit asset class has traditionally been comprised of largely institutional markets. Even the larger institutional investors, such as Australian industry superannuation funds, typically invest in global credit via managed portfolios provided by specialist asset managers - rather than selecting a small number of individual bonds.
This is because credit investing requires considerably more diversity than equity portfolios. A credit portfolio with 20 to 50 securities is not diversified enough to reap the full benefits of diversification. The diversity required to create a robust credit portfolio is simply not possible to replicate with a small portfolio.
Moreover, credit securities are typically only sold to wholesale investors and/or have large minimum investment sizes (A$500,000 plus). The small number of individual credit securities made available directly to the retail market in Australia are often of "non-institutional quality" - i.e. hybrid securities which are typically subordinated, unrated and have limited market liquidity. Individual investors can, however, access this ‘wholesale' asset class via highly diversified managed funds.
Conclusion
Given today's low government bond yield environment, and volatile equity markets, delivering income for clients will continue to be a challenge for advisers.
However, for those keen to provide clients with more options than the traditional ‘barbell' approach, global credit can be an important part of the portfolio mix.
FOOTNOTE
1) Source: ATO "Self-managed super fund statistical report" -- December 2015.
Richard Quin is the chief executive officer and lead portfolio manager of Bentham Asset Management.
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