Banks can absorb bad debts: Spectrum AM

Banks can absorb bad debts: Spectrum AM

Australia's credit cycle may be about to take a “turn for the worse”, with defaults steadily increasing from record lows – but corporate issuers are well-placed to absorb any losses, says Spectrum Asset Management.

In a note to investors titled Rising defaults  should bond investors worry?, Spectrum Asset Management principal Damien Wood said corporate bond investors should “pause and put things in perspective”.

Bad debts are “currently near zero percentages in Australia”, with the major Australian banks reporting domestic bad loans at around 0.5 per cent of all loans – with losses “at just a fraction of this amount”, Mr Wood said.

Bank shares were heavily sold off last week amid news that ANZ had provisioned an extra $100 million for expected bad and doubtful debts.

“Default rates in Australia are very low for both corporates and individuals. A quarter of a century without a recession and a significant decline in interest rates over the same period make for favourable conditions to repay debt,” Mr Wood said.

“Asset quality in Australia at around its historical best and places the big four’s reported asset quality at near world-record levels. In other words, it cannot get much better.”

The “logical extension" of this is that asset quality can only get worse from here, Mr Wood said.

“What we are seeing now may be simply a start of a trend towards historically normal bad loan levels,” he said.

More than 40 per cent of Australia's debt is owed by households – much of which is in the form of residential property mortgages, Mr Wood said.

Sixty per cent of the big banks' loan books is made up of residential property loans, he said.

“Bank losses from residential property defaults should be largely mitigated by property collateral pledges, mortgage insurance and creditor protection laws in Australia,” Mr Wood said.

“A turning of Australia’s credit cycle may have begun. The risk of this turning into a major economic issue sits with the household sector.

“Given stable economic growth and low interest rates this does not appear to be a major imminent risk.

“Right now [Australian dollar denominated] corporate bond investors, in general, are getting well-rewarded for the risk of default. In turn, this should help deliver solid returns for investors over the coming 12 months,” Mr Wood said.

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