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Fixed income returns – the increasing importance of credit structures

Andrew Lockhart
— 1 minute read

Heavily indebted governments, an increasingly indebted corporate sector, rising unemployment and growth in the number of corporate balance sheets needing repair make for complex credit markets.

Andrew Lockhart

In the current market conditions, many fixed-income investments are no longer offering the safe haven and downside protection they once did. Bonds no longer rise as equities fall, making “balanced portfolios” a lot less stable in times of turmoil.

Investors, of all sorts, need to revisit and better understand the wide range of credit structures and the role they can, and sometimes can’t, play in portfolios today.

To further complicate the decision-making process, today there are far more investment options available compared to a decade ago.  

This can make it harder for investors, such as self-managed super funds (SMSFs), retirees and near retirees to understand and assess what defensive assets they should be considering.

Corporate loans

One such fixed-income investment is Australian corporate credit. These are loans to Australian corporates and have been a mainstay of the big banks for decades. 

Today investors large and small can invest in the corporate loan sector, as a result of increasing competition in the market. Retail investors can now invest in a diversified portfolio of corporate loans – the same corporates that equity investors can invest in.  

Corporate loans can offer a sound alternative to cash because of the defensive nature of the investments. In terms of their classification, corporate loans are considered a subset of fixed income because of their potential to generate regular, predictable yields. 

They are lower down the risk spectrum than growth assets such as equities because they come with a range of embedded protections, are generally secured by the borrower’s assets and lenders are paid before equity holders in the event of business insolvency.

These loans, unlike equities, are often secured with covenants and controls such as restrictions on leverage or distributions to mitigate the risk of loss. This means that corporate loan portfolio investors effectively own the assets of those corporates and if they default, lenders can take control of those assets.

Non-bank lenders provide support for borrowers

It is not just governments and the big banks that provide fixed income instruments such as government bonds, singular corporate bonds, term deposits, hybrids and more.

Non-bank lenders also offer credit structures and have raised a substantial pool of capital in recent years. Metrics alone has raised in excess of $5 billion.

While non-bank lending in Australia had developed to the point where it is competing with the bank sector, it is also complementing it, with non-banks investing alongside the major banks for the same loans. 

During this stressful time for businesses and corporate borrowers, non-bank lenders can therefore deliver crucial sources of liquidity and support borrowers in these difficult times. 

Credit spreads – where to from here? A credit crunch?

While some commentators talk about an impending credit crunch offshore and a substantial rise in corporate defaults, apart from the collapse of Virgin this is not currently the case here in Australia.

Within Metrics portfolios, for example, we stringently assess borrowers for credit quality before lending to them and we currently have no borrowers in default or arrears.

We are committed to working in the best interests of borrowers and investors to protect and manage the capital value of all our funds.

The importance of cash flow

As investor concerns mount about the effects of the COVID-19 on markets and their investments, fixed income investors – just like equity investors – need to recognise the importance of assessing and analysing cash flow of corporates.

At times like this, cash flow is the key measure to assess as it enables corporates to service any debt, to pay wages and continue to operate.

Cash flow is what will enable organisations to survive and ultimately grow once markets recover – and even acquire competitors where appropriate.

Andrew Lockhart is managing partner at Metrics Credit Partners

 

Fixed income returns – the increasing importance of credit structures
Andrew Lockhart
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