Australian credit around the world: part two – US private placement investors
Westpac Institutional Bank (Westpac) and KangaNews are conducting an ambitious, year-long project to gauge the opinions of international credit investors on Australasian-origin product. In part two of the series, a group of US private placement (USPP) investors met on 31 January during the annual industry conference in Boca Raton, Florida together with Westpac’s USPP joint-venture partner, Bank of America Merrill Lynch (BAML).
POLITICS
Swiss What impact, if any, have the arrival of the Donald Trump administration and the now sharply higher-yield environment had on your investment strategies and approach so far?
Actually, I think the uncertainty and higher interest rates you mentioned in your question are ultimately a positive for our market versus other capital markets given our buy-and-hold focus. Companies know they can come to our market and be fairly and properly heard and evaluated under all types of market conditions.
At Barings, we do not foresee any change to our strategies. We are comfortable with our portfolio and continuing to invest in the current environment.
Swiss Are you doing anything specific to change your strategies as a result of the uncertainty you’re anticipating?
We are also watching our investments in the hospital space in the context of the potential repeal of Obamacare.
We have a US$14 billion global infrastructure book and we anticipate significant growth in the US, possibly via the public-private partnership route. We think new tax-reform legislation will make the muni market a less viable option. So if president Trump pushes infrastructure more towards the private side – which I think he will do – it could result in huge stimulus for the economy, not only for job creation but also for sustainable GDP.
There have been a number of studies done recently citing the infrastructure-investment gap. For example, the American Society of Engineers, which does a study every four years, says there’s a US$1.5 trillion gap in infrastructure spend. If this need is not satisfied by 2020 it will cost the government somewhere in the neighbourhood of US$4 trillion in GDP and possibly strip 2.5 million jobs from the economy. This is a daunting number. We’re optimistic that the administration will get something done.
As far as we are concerned, as a debt investor the actual US$1 trillion plan doesn’t affect us.
Evans Do you believe the administration will be able to get the plan up and running?
Potentially president Trump could compromise and siphon off a piece of this for infrastructure investment. As we have seen from the number of executive orders this week, the president has the ability to move things in his direction rather quickly.
Moreover, one has to wonder whether president Trump will be measured and collaborative with his advisers and constituents or intransigent, simply implementing his preconceived policies notwithstanding the concerns of others.
So it’s a little bit wait-and-see. But for us as investors, the core of what we do is to identify good companies within good industries. If we can maintain this ‘true north’, things will work out. We are concerned, but this doesn’t mean we are any less willing and able to invest in this market.
Outlook for the Australian economy
Bill Evans, managing director, chief economist and global head of economics and research at Westpac Banking Corporation, says forecasts for key drivers suggest Australian growth will slow in 2018 before currency depreciation once more comes to the lucky country’s rescue.
EVANS In 2016 we expected growth to be 1.5 per cent. We expect it to pick up to 3 per cent in 2017, but also that it will slow down again in 2018, to around 2-2.5 per cent.
The mining boom has slowed down substantially – it peaked in 2012 and since then mining investment has been detracting from growth. The key drivers of growth more recently have been exports, services exports such as education, health and tourism, and housing construction.
We expect that housing construction has peaked. It will probably hold its peak in 2017 but will come off fairly significantly in 2018. This is mainly because we are already seeing restrictions on Chinese investment in the Australian housing sector. We expect this will start to show up in the construction cycle by 2018. So construction will be a drag on growth.
The growth in exports will also peak in 2017. While LNG will continue to grow it will be doing so at a slower pace in 2018.
RATES ENVIRONMENT
Swiss How, if at all, has the ‘lower for longer’ rates environment affected your investment behaviour? Have you been more inclined to go out in duration, for instance, or to use any other technique to enhance return?
Even though we can’t pump large volumes into liquid buckets, what we do have is our credit rating and the explicit guarantee of the Commonwealth of Australia.
In times of crisis, investors tend to head for the best credit available. I also think it is important to remember that large lines do not always mean actual liquidity for an investor. It does not matter how large the buckets are, the line is not liquid if the investor can’t get a price for the stock. This is what happened in the fourth quarter of 2008.
Yields have been low for so long now that people are worn out by a hold-off approach. In fact, lower for longer has really increased the investor base beyond the traditional insurance companies.
Block What about going down the credit spectrum to enhance returns?
I think most people would have a difficult time making this decision and would rather go out on the curve. Making a curve bet is a lot easier than making a credit bet at this point in time. This is especially true if you think the Federal Reserve is going to raise rates, which would result in some type of inversion or flattening.
There is no doubt that the absolute level of interest rates and the quest for yield, the latter causing a real compression of credit spreads, has been a tremendous opportunity for issuers for the last few years.
Westpac Institutional Bank and Bank of America Merrill Lynch participants
Swiss Do you see lower for longer continuing to any foreseeable horizon, or does everyone now expect inflation and thus rates to pick up?
It would be interesting to hear a comment from investors about a related thesis we have developed, which is that as Treasury yields move higher it gives investors some cover to take spreads tighter given the amount of cash they have to invest in the asset class.
At this point the outlook for the US economy appears promising and even Europe looks like it may be starting to turn the corner. As such, if economic momentum can be sustained any downside from an increase in rates will likely be more than offset by economic growth.
My main concern is that populist perspectives on tariffs and nationalism could very well result in an increase in rates that is distortive and at odds with long-term economic growth.
However, from our perspective – whether it’s lower for longer, a rational increase to normalised rates or something that is a bit out of the ordinary – our goal is to add relative value. With the public market becoming increasingly efficient, we feel the private asset classes are better positioned to add value – whether it’s private placements or real estate.
Swiss Are there any particular asset classes that you see as having good relative value at the moment? Also, what techniques are USPP investors deploying at an individual-firm level to maintain alpha in this ongoing low-rates environment?
Having said this, a couple of years ago we added infrastructure equity and leveraged bank loans to the mix to fill in the barbell. Both these asset classes provide attractive returns and some interesting risk-reducing benefits from an overall portfolio perspective.
SUPPLY DYNAMICS
Swiss What about liquidity – is this a concern for USPP investors?
In other words, if you need to sell a bond for portfolio reasons – not for credit reasons – there’s actually a pretty strong bid because typically there are multiple holders who are under-allocated to any given credit.
Some people ask why there’s a liquidity premium but I view it as an opportunity-cost premium. We have an excellent public-bond shop that can generate alpha and everyone else here can probably say the same. So when you buy a private you are allocating away from publics, and you’re taking away those total-return mechanisms to generate additional long-term yield. Hence the requirement for the spread premium.
To Barings, the easiest way to diminish value in a private portfolio is to employ a trading mentality and exit before maturity. We believe the best way to reap all the benefits of the asset class is to adhere to our key tenets of relative value, diversification and downside protection, and maintain our underwriting strategy with a buy-and-hold focus.
We have to give them very long duration. To do this we won’t buy a private inside 10 years, and when it rolls down to eight years we sell it and reinvest long. So we actually have products that are predicated on our ability to sell without a huge bid-ask spread, and we haven’t experienced any difficulty doing this.
I think we are very well positioned to add value on the buy and are probably not as good at adding value by calling market movements. All in all it has been a pretty effective strategy over time.
Foreign-currency investment on the rise
US private placement (USPP) investors say an area of increasing value they can offer is the ability to invest in issuers’ home currencies. They predict foreign-currency issuance in their market will continue to grow, particularly as banks are still experiencing difficulty providing swaps.
MONAHAN Another trend we are seeing is the proliferation of non-US dollar tranches, and the more sophisticated investors that can easily work across the various currencies that are liquid or semi-liquid represent a great opportunity. Because right now one out of five transactions has a non-US dollar tranche.
BLIX For Australian corporates, being able to do Australian-dollar tranches used to be number four or five on the list of factors that attracted them to the private market. In the last few years, this feature has become significantly more important in the decision-making process as they consider all-in cost.
LYONS If you go back a decade there were very few foreign-currency tranches done. Whereas in the past couple of years these tranches have comprised 15-20 per cent of the market. My personal belief is it will be hard to grow our market with US companies and in US dollars.
I don’t see our market going away from make-whole and covenants. I don’t think the investors around this table are going to give these up.
Five years from now I wouldn’t be surprised to see 35 per cent of our market issued in foreign currencies. This is the way to grow the market – to disintermediate the local markets of issuers by going longer and now also offering local-currency tranches.
But I think this has been beneficial to the private-placement market because companies have seen that if they come fairly regularly, even with smallish deals, this is a great market to access. Investors will take the time to get to know the credit and add to the name over time.
It’s interesting – we have tracked this trend over 20 years and as the spread to public gets down towards bottoming out for two or three years it tends to be a pretty good predictor of a broad-based credit issue. When the public market starts to buy private bonds and call them public, it tends to be a predictor that you have a problem around the corner.
Swiss How are agents managing the supply-demand dynamic?
This is our job and it’s the nice, healthy tension we enjoy with all our investors. The trick is that while supply and demand are so far out of sequence, the power is with issuers. We keep looking for ways to bring annual private-placement volume up to US$100 billion.
Swiss Investors have mentioned that when there is so much demand, covenants can get lax and pricing goes heavily against them. How do intermediaries work through these issues?
What the private market has going for it is very long tenors and the ability to do fixed rate, which most of the world can’t do in size. Even the Australian public-bond market peters out at around 5-7 years while the average maturity done last year in the USPP market was around 13.5 years. The private market can also offer tenors way past these.
The idea of structural enhancements and documentation, and appropriately worded most-favoured-lender clauses, provides one tool we are working with to get companies to issue in what should be a covenant-acceptable format from a practical standpoint.
As time goes on I think we’ll see more of this kind of structural embellishment that gives the issuer more flexibility and more optionality. This comes at the expense of investors but the option for them is to decline from investing in bespoke structures and be underinvested.
AUSTRALIAN PICTURE
Blix How do you view Australian credit quality relative to other investment options available to you? What is your level of comfort about the three most commonly mentioned risk factors for Australia: the domestic housing market, commodity and China risk, and offshore funding exposure?
But we’ve been investing in Australia for a long time and it’s one of the cornerstones of our portfolio. It has performed very well and, somewhat surprisingly, largely mirrors our portfolio overall from a sector perspective.
Our downgrade and workout experience has been more or less nonexistent. If you take a step back and look at some of the challenges for Australia – whether this means commodities or China – there are also a lot of positives. Which economy has performed as well as Australia over the past 25 years? The government regime is good and rational, and the legal system is strong and predictable. All of this makes Australia a good market in which to invest.
Having a local presence allows us to have timely information on factors such as the health of the domestic housing market, as well as commodity-and China-related risk. Again, at Barings we invest in companies that can weather cyclicality and continue to perform despite challenges.
Having said this, we are certainly very open to investing in the Australian market. We think a lot about how far away it is and how best to cover the different sectors in what is a very dynamic market, and we dedicate a lot of resources to being informed and being smart without having boots on the ground. It’s a vote of confidence that we can have as much exposure as we do without having people on the ground.
We are more overweight in Australia than some of the investors around the table, because we are underweight in Europe and the UK – which are our other sources of cross-border investment. Almost 10 per cent of our portfolio is invested in Australian companies – it is our second-largest jurisdiction outside the US.
While we are carefully watching the slowdown in China and what this will mean, as well as the lack of transparency there, we will continue to invest in Australasia. What our market does very well is fundamental credit analysis, no matter what the jurisdiction.
We don’t receive a mandate for any particular jurisdiction – we are given a certain amount of money each year to invest and achieve a particular yield. We hope to see every investment opportunity that comes to our market, start with the fundamental credit analysis and go from there.
Again, this plays to our strength of long-term value and understanding assets through the cycle. We hedge a bit on how directly tied to commodity prices we are.
About 12 per cent of our private portfolio is invested in Australian assets. It has been as high as 13.5 per cent and as low as 10-11 per cent. These are big battleships – they are hard to move. I think Australian issues comprise about 12 per cent of the market.
AUSTRALIAN OUTLOOK
Evans Would it bother you if the Australian sovereign was downgraded?
If there is a bust in prices what happens in Australia will be very different from what happened in the US. Here, everyone thought home owners would continue to pay on their houses but they didn’t – they just gave the keys back. This gave people continued discretionary spending or income through the crisis. If US mortgages had been recourse back to the individual during the financial crisis, the downturn would have been deeper because people would have kept paying on credit cards.
Whereas in Australia, it will come back to the individual. So if there is a bust and people have trouble paying their mortgages, will the behaviour be ‘I have to continue to pay this’? In this case it will be a heavier effect on discretionary consumer spending and other businesses.
This is something that makes me a little bit nervous, and we have tried various ways to try to quantify it. It’s pretty hard – if there is a way to quantify it I would be happy to hear about it.
One of the issues, however, relating to the point I’ve made about Chinese involvement in the residential housing market [see box], is that the Chinese can only buy new developments. Foreigners cannot buy existing property. The reason for this is that if you allow foreigners to buy existing properties they will drive up the price. Whereas if you only allow offshore investors to involve themselves in new developments, you will get some construction activity going.
This is how it has worked. But what it means is that there is now a two-tier market. The Chinese are bidding up the price of new developments because they can’t buy existing houses, but rational locals are staying in the existing side of the market because they don’t want to compete with the Chinese.
If we ever had a situation where the Chinese had to pull out en masse, the part of the two-tier market that these buyers are holding would likely come down pretty sharply. Having said this, it still only represents about 8 per cent of the market so it’s unlikely that it would trigger a massive housing bust.
The only thing that would trigger a big housing bust would be some kind of shock to the labour market. The scenario I have painted, of slowing growth in 2018, means unemployment will probably lift to 6 per cent from 5.5 per cent. In our simulations, we only start getting concerned when unemployment gets up to 11 per cent. It’s very hard to see a scenario that would lead to this kind of a rise.
The thing that has protected Australia through a lot of crises, particularly the Asian crisis, is the flexibility of the currency. During the Asian crisis the Australian dollar went to the low US$0.50s. This means we have protected ourselves from any huge shock to our export markets. I see a mini version of this happening in 2018, and this will probably sow the seeds for the next recovery.
What we don’t have is conditions in the economy that cause businesses to think they have to invest in employment because they might lose market share. It’s a problem in the world – and it’s why the US might well have tapped into a rich vein in the sense that businesses might start to feel this way, which will mean the cycle takes off in terms of more investment, more employment and more competition. In Australia we are a long, long way from being in this position. A big part of the reason is the rigidity of the labour laws, which unfortunately is unlikely to change.
The other big problem globally has been the flattening of the Phillips curve – whereby the level of wage inflation for the level of unemployment is way out of line. We are currently getting wage increases of less than 2 per cent, while the unemployment or the underemployment rate tells us increases should be 3.5 per cent. Everybody is dissatisfied with the lack of growth in their income, which is the other reason why there is a soft consumer story. What this means is that consumer spending is unlikely to fill the gap when the housing market turns and the export story starts to slow.
USPP TRENDS
Block What, if any, trends are USPP investors seeing in their credit mandates? For instance, are your clients’ typical expectations on liquidity requirements, absolute-return thresholds or anything else showing any sign of changing?
We are really looking to drive alpha by investing in less liquid asset classes. Interestingly, last year pure-vanilla transactions represented only 40-45 per cent of the private-placement market. This shows that we are doing things that other markets just won’t do – whether it’s delayed draws, currency trades, projects, pseudo-projects, and so on. There are a lot of ways you can add value in this market and we are uniquely positioned to exploit this.
Our entire private-capital and alternative-investments platform is where we are seeing the most interest from our general account clients given where Treasury yields are today. This demonstrates TIAA Investments’ commitment to this asset class. But it also underscores the value we bring to an investment programme through our fundamental credit research and insights that help us identify investments where there is good structure and relative value.
As a result, we have doubled our private-debt portfolio since 2012 and are being asked to further this growth. In short, it is an asset class that has had good performance, that we know well and that our clients want to be in. So we are continuing to look for opportunities.
Everyone will do utilities and plain vanilla. But we will differentiate ourselves on investments where we are being paid to understand complexity.
It’s a very difficult market for investors – not just the macro side of it, because we are paid to take risk. But it’s also difficult in the sense that allocations and access to this asset class are still very scarce.
We have had really good economic times with slow and steady growth, but where this asset class really shines is in the downturns. It’s the downside protection that is afforded through our covenants and make-whole fees that helps differentiate privates from other asset classes. This is why it so appealing to a number of third parties that are becoming interested in the asset class for the first time.
The real truth and test of it is where the intermediaries can really understand what their clients need and then, with our help, design a customised financing that best suits the issuer. This could be through natural currency or longer tenors – whatever it may be, the ability to offer something that is unique can really differentiate this asset class from any other. The group of investors here has the ability to do this – understanding and structuring complex transactions is part of our DNA.
KANGANEWS SUSTAINABLE FINANCE H2 2021
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