SMSFundamentals | Oct 11 2019
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Finding Yield In A Low Rate World
With term deposit rates around 1.5%, the ten-year bond rate at 0.9%, inflation at 1.6% and stock market volatility ever present, where can one invest for both safety and income in today’s interest rate environment?
By Greg Peel
As Australian banks evoke the usual howls of disgrace by not fully passing on RBA interest rates cuts to mortgage holders, persistently ignored are the retirees who seek to rely on “risk-free” investments to both preserve capital and provide a reasonable income. Gone are the days of surviving happily on bank term deposits (guaranteed by the government) or government bonds.
Both are currently offering negative real yields (after inflation).
The stock market offers attractive yields, such as ~6% (fully franked) yields on bank shares, and real estate investment and other investment trusts can offer even better yields (albeit not necessarily franked). But the stock market cannot offer any form of safety in terms of capital preservation. While some stocks are more defensive than others, the GFC showed sometimes this just doesn’t make a difference.
Are there alternatives?
Yes there are, and we’re not talking gold. Gold is supposedly the ultimate capital preservation investment but pays no income, and the GFC sparked an initial sell-off in gold as stock market investors desperately tried to cover their margin calls.
There are several active fund managers who specialise in debt as an investment, with a view to providing a risk/reward balance amenable to the retiree or any other investor seeking a comfortable balance of capital preservation and income, or risk/reward. Increasingly such investments are packaged into trusts that are listed on the stock exchange.
Research house Independent Investment Research (IIR) has analysed several recent listings and selected a handful it sees worthy of recommendation. The following outlines those recommendations.
MCP Master Income Trust ((MXT))
Manager: Metrics Credit Partners
Listed: October 2017
Loan Type: corporate, diversified by borrower, industry and credit quality
Credit quality: A to BB
Targeted annual return: RBA cash rate plus 3.25% (4.00% currently) net of fees
MCP Master Income Trust provides retail investors an alternative to the majority of accessible fixed income funds, which are largely engaged in secondary market bond trading. In contrast, the Manager’s investment strategy is very hands-on transactional, with the focus on originating transactions, conducting detailed bottom-up due-diligence, structuring the loan and managing the loan life-cycle thereafter. As such, the Manager’s ability to successfully structure and manage transactions that meet the investment objectives and avoid credit defaults is critical. In this regard, the analysts note a strong track record of providing a stability of capital and predictability of income.
IRR notes this track record has been established during a period of relatively benign economic conditions, although the investment team boasts substantial experience over the full economic cycle, including through the GFC. Historically the Manager’s underlying wholesale funds have consistently and, generally, materially exceeded the respective funds’ target returns. Furthermore, the monthly returns profile has been characterised by a high degree of stability.
IIR ascribes the MCP Master Income Trust a Recommended Plus rating. MXT represents something of a unique investment proposition for Australian retail clients, providing exposure to a diversified portfolio of direct-lending corporate loans and by way of a liquid LIT (listed investment trust) structure. It does so through a portfolio created and actively managed by a team with a deep skill set and a track-record of delivering a risk-return outcome in excess of target levels and without a single negative month or credit loss (albeit during a period of benign credit markets).
Gryphon Capital Income Trust ((GCI))
Manager: Gryphon Capital Investments
Listed: May 2018
Loan Type: floating rate asset-backed securities (ABS) with a particular focus on residential mortgage-backed securities (RMBS)
Credit quality: Up to 50% of the portfolio may be invested in non-investment grade securities
Targeted annual return: RBA cash rate plus 3.50% (currently 4.25%) net management fee of 0.72%
The Trust is suitable for those seeking an investment with a regular income stream. The Trust will provide access to ABS and RMBS, which is typically only available to the institutional market and will be the only listed vehicle on the ASX that provides access to a portfolio of ABS and RMBS. ABS and RMBS are tradable securities and therefore the Trust may experience capital gains or losses, however IIR expects returns to be largely income. While the Trust provides an alternative fixed income investment, investors should be aware of and comfortable with the risks associated with ABS and RMBS. Up to 50% of the portfolio may be invested in non-investment grade securities which carry a higher level of risk than investment grade securities.
Residential mortgages have historically had low levels of defaults and delinquency rates have remained low throughout previous crises. This combined with the credit enhancements of RMBS has resulted in no defaults historically on Australian issued RMBS. A significant shock to the residential housing market may nevertheless negatively impact the performance of the Trust and may result in capital loss.
IIR has assigned the Trust a Recommended rating. The Manager has a robust investment process with strict investment criteria. Prior to the establishment of the Trust, the Manager only managed portfolios on behalf of institutional investors. The Manager has a focus on capital preservation and will only invest in RMBS that pass the 1 in 200 year event as defined by APRA’s Probable Maximum Loss (PML), which imply a national house price decline of over 40%. To be eligible for investment, securities must not be expected to incur a capital loss when the 1 in 200 year event is applied.
NB Global Corporate Income Trust ((NBI))
Manager: Neuberger Berman (Australia)
Listed: August 2018
Founded: 1997 (in the US)
Loan Type: corporate (US 60%, Europe 20%, Emerging markets 20%), diversified by individual, industry, geography and credit quality
Credit quality: B and BB, occasionally suitable BBB and CCC
Targeted annual return: 5.25% plus moderately growing net asset value
Neuberger Berman is an independent, 100% employee-owned investment management firm headquartered in New York, and which has approximately US$300 billion in assets under management. Neuberger Berman’s non-investment grade team has a 20+ year track record managing high yield corporate bonds, beginning with the U.S. high yield market in 1997 and subsequently expanding into Emerging Market high yield corporate bonds and European high yield corporate bonds, as those markets developed in size and sophistication.
The Manager seeks to provide its target return with a strong emphasis on capital preservation and downside risk mitigation and, historically, has delivered on this performance objective. More broadly, the Trust has the ability to fill a gap in many domestic retail investor portfolios. For many retail investors, the income component of the portfolio tends to be both domestically focused and often significantly equity biased, with a degree of hybrids to achieve an income stream. In the analysts’ view, a fundamental benefit of the Trust’s investment strategy is that many domestic investors may be able to benefit from at least a comparable returns profile but in doing so significantly diversify the income component of their portfolio by geography, industry and credit quality tier.
IIR warns non-investment grade bonds tend to have a higher probability of default and this risk tends to cluster around specific events/economic environments.
IIR ascribes a Recommended Plus rating to the NB Global Corporate Income Trust. IIR has conviction in the Manager’s ability to at least achieve the stated investment objectives over the foreseeable future. This is based on a comprehensive, proven and repeatable investment process, a broad and highly qualified investment team, strong risk-management processes, and a long-term track-record of generating “alpha” (return independent of the market return) primarily by mitigating downside risks in less benign market environments. IIR believes the investment processes, with a strong emphasis on downside risk mitigation, accords well with the investment objective of stable and consistent income and a moderately accretive net asset value.
Partners Group Global Income Fund ((PGG))
Manager: Partners Group Private Markets (Australia)
Listed: September 2019
Founded: 1996 (in Switzerland)
Loan Type: corporate, predominantly US and European private companies with a substantially smaller allocation to Australian and Asia Pacific companies.
Credit quality: 60-100% B to BB, 0-20% B- to CCC+, 0-25% “special situation” loans from senior first lien to mezzanine
Targeted annual return: RBA cash rate plus 4.00% (currently 4.75%) net of fees
The Trust provides exposure to a diversified portfolio of private debt investments to predominantly large to mid-sized companies through direct lending and broadly syndicated loan (BSLs) investments. It will seek to do so through both active origination in primary issues and secondary market trading. The objective of the Trust is to provide monthly income with a focus on capital preservation.
IIR would generally characterise the Trust as sitting at the mid to lower end of the private debt risk-return spectrum and can be expected to deliver a relatively stable level of income that at least meets the performance with a relatively low degree of capital downside. This view is based on a combination of: i) the Manager’s focus on a diversified portfolio of senior secured first lien loans; ii) a focus on middle-market companies in generally resilient industries and generally characterised by dominant market positions, competitive advantages, barriers to entry and strong/stable cashflow profiles; iii) borrowers backed by quality Private Equity sponsors with considerable equity invested in the borrower; iv) solid and prudent underwriting, facilitated by wide deal sourcing channels based on long-standing relationships; v) a track-record of relatively stable interest rate spreads (read, income distribution stability), and; vi) a track-record of very limited capital losses on both first and second lien loans since commencing in the private debt asset class in 2006.
As a sub-investment grade market, investors should expect that there may be periods of net asset value volatility (yet which may have no impact on either income stability nor default risk in the underlying loans).
IIR ascribes a Recommended rating to the Trust. Partners Group is a solid investment manager that plays to its relative abilities, which translate to income stability and capital preservation, rather than stretching for yield and capital upside by moving up the private debt risk-return spectrum. In this regard, IIR has a high degree of conviction in the Manager’s ability to at least achieve the stated income objectives over the foreseeable future.
A key concern is while Partners Group has an established track-record in private debt and all three sub-strategies that make up the Trust (and has provided this data to IIR), each pre-existing fund and client mandate is different to the Trust in terms of its fund structure, weighting to the different investment strategies, use of leverage, geographical focus and other factors. As such, no fund is exactly comparable to the Trust’s structure and investment strategy and no past performance track-record is directly comparable. This detracts from overall information transparency, particularly in relation to patterns of performance (volatility, drawdowns, consistency) and relative performance (vs benchmarks, peers).
Moelis Australia Fixed Income Fund (listing pending)
Manager: Moelis Australia Asset Management, subsidiary of Moelis Australia ((MOE))
Listed: pending, second half 2019
Loan Type: commercial, accounts receivable and consumer lending products diversified by market segments, borrowers, industries, credit qualities and origination channels
Credit quality: n/a
Targeted annual return: RBA cash rate plus 4.00% (currently 4.75%)
Loan categories will include inventory funding (accounts receivable), specialised debtors (commercial), strata funding (consumer), personal lending (consumer), and, to a lesser degree, senior secured financing property loans (real estate).
The Fund benefits from a material co-investment by Moelis Australia, structured to prioritise investor returns and significantly reduce investor risk. Moelis has committed to invest, alongside the Fund, an amount equal to 10% of the Fund’s capital, on terms that provide investors with the benefit of a capital buffer and income priority through what is referred to as a credit enhancement structure. Specifically, Moelis’ capital will first absorb any realised losses, providing a buffer to protect investor capital, hence there is strong alignment of interest between investors and Moelis. Moelis will only ever receive a return on its co-investment if investors have been paid the Target Return and capital buffer is equal to 10% of the Fund’s capital.
Moelis Australia is particularly well placed to identify, pursue, manage and deliver on specific credit investment initiatives capable of delivering attractive through-cycle, risk-adjusted returns with strong downside protection. The addition of the credit enhancement structure, prioritising income and capital to investors by creating a significant downside buffer to both, forms a very low risk investment vehicle characterised by an expectation of consistent monthly income and strong capital downside protection. As such, from a risk perspective IIR views the Fund sitting between the relatively low returns from cash and government bonds but materially below the risk of a well-managed corporate debt investment mandate.
IIR ascribes a Recommended Plus rating to the Moelis Australia Fixed Income Fund. The ability to identify and the analysts’ confidence in the Manager’s ability to capably pursue and manage the credit initiatives that comprise the underlying portfolio of the Fund are testament to Moelis Australia’s market leading expertise in certain credit segments. It provides IIR with confidence of the Manager’s ability to deliver on outsized returns relative to risk and to preserve capital.
While the credit enhancement caps investors participation in the upside, it serves to create a very low risk investment vehicle, with an expectation of highly predictable and consistent income and strong capital downside protection, making the Fund highly suitable for its intended place in an investor’s overall investment portfolio.
KKR Credit Income Fund (listing pending)
Manager: KKR Credit (Australia), affiliate of Kohlberg Kravis Roberts & Co (US)
Listed: pending, November 2019
Loan Type: traded credit securities, mainly bank loans and high-yield bonds, B to CCC
Credit quality: sub-investment grade
Targeted annual return: 6-8% net of fees (including performance fee)
The Trust provides exposure to two underlying credit investment strategies, specifically a long-term target portfolio allocation of 50-60% to the Global Credit Opportunities Fund (GCOF) and a long-term target allocation of 40-50% to the European Direct Lending (EDL) investment strategy, via the soon to be launched KLPE II fund. GCOF, which is based on KKR Credit’s Opportunity Credit Strategy (OCS), is managed according to a high conviction, market-driven opportunistic investment strategy with 60 to 80 core credit investments. It invests in a portfolio of sub-investment grade (‘sub-IG’) traded credit securities, mainly bank loans and high yield bonds.
The underlying OCS has an 11- year track record and has performed exceptionally well across the full credit cycle. KLPE II is a European direct lending strategy targeting upper middle-market companies in Western Europe by largely first lien, senior secured private debt, with a very selective provision of second lien secured facilities. The EDL strategy has a 7+ year track record and has generated a realised unlevered internal rate of return of 13.4% p.a. and a weighted average all-in-yield of 8.5% pa to date. While the two strategies differ, they are united by a common KKR wide philosophy, fundamental bottom-up investment process and access to KKR-wide resources.
Strong underwriting skills, cautious credit selection, and prudent full credit cycle portfolio management translates into consistency of income and the minimisation of default loss. IIR has a high degree of confidence in KKR Credit and the Trust delivering a stable and consistent monthly distribution and, over the long term, generating accretive net asset value. While there are distinct differences in the two underlying strategies, both are based on the same fundamental bottom-up assessment of cash flow variability and debt serviceability, driven by a mindset acutely aware of the asymmetry of downside risks in debt investments.
Importantly, both underlying strategies are not only well positioned to perform well in a late-cycle credit environment but to capitalise on any fall-out from a potential end of cycle credit environment.
IIR ascribes a Recommended Plus rating to the KKR Credit Income Fund. IIR has a very high degree of conviction in the Manager’s ability to at least achieve the stated investment objectives over the foreseeable future and continue to generate well above broad market performance over the medium and long term. KKR Credit ticks every box with respect to track record, resources, and mandate flexibility. The risks in debt currently are not only cyclical but structural, with significant market inefficiencies in the traded sub-IG market and a general deterioration in underwriting in the private debt market (and an influx of untested managers that lack full cycle resources). In such an environment, the dispersion in performance by investment manager and strategy is not only likely to increase, but is almost guaranteed to do so while ever the current structural market inefficiencies persist.
KKR Credit, with its full cycle tested deep fundamental bottom-up credit assessment and flexible and market-driven opportunistic strategies is well placed to continue its excellent track record of outperformance.
IIR warns of the potential for heightened net asset value volatility and notes the performance fee has the potential to elevate total fees to a level above the majority of ASX-listed credit trusts.
In addition, stockbroker Morgans notes the Trust aims to invest in strategies representing diversified portfolios of primary loans, bonds, notes (fixed and floating) and other debt securities and financial instruments, including senior secured loans, traded senior secured bank loans and high-yield bonds. Access to KKR’s credit strategies offered through the Trust is intended to provide investors with investment opportunities that are not available elsewhere and will supplement investors’ existing portfolio holdings of equities, hybrid products and cash products.
Morgans does not provide a recommendation as yet.
Independent Investment Research, “IIR”, is an independent investment research house based in Australia and the United States. IIR specialises in the analysis of high quality commissioned research for Brokers, Family Offices and Fund Managers. IIR distributes its research in Asia, United States and the Americas. IIR does not participate in any corporate or capital raising activity and therefore it does not have any inherent bias that may result from research that is linked to any corporate/ capital raising activity.
IIR was established in 2004 under Aegis Equities Research Group of companies to provide investment research to a select group of retail and wholesale clients. Since March 2010, IIR (the Aegis Equities business was sold to Morningstar) has operated independently from Aegis by former Aegis senior executives/shareholders to provide clients with unparalleled research that covers listed and unlisted managed investments, listed companies, structured products, and IPOs. IIR takes great pride in the quality and independence of our analysis, underpinned by high caliber staff and a transparent, proven and rigorous research methodology.
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Research analysts are not directly supervised by personnel from other areas of the Firm whose interests or functions may conflict with those of the research analysts. The evaluation and appraisal of research analysts for purposes of career advancement, remuneration and promotion is structured so that non-research personnel do not exert inappropriate influence over analysts.
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This publication has been prepared by Independent Investment Research (Aust) Pty Limited trading as Independent Investment Research (“IIR”) (ABN 11 152 172 079), an corporate authorised representative of Australian Financial Services Licensee (AFSL no. 410381. IIR has been commissioned to prepare this independent research report (the “Report”) and will receive fees for its preparation. Each company specified in the Report (the “Participants”) has provided IIR with information about its current activities. While the information contained in this publication has been prepared with all reasonable care from sources that IIR believes are reliable, no responsibility or liability is accepted by IIR for any errors, omissions or misstatements however caused. In the event that updated or additional information is issued by the “Participants”, subsequent to this publication, IIR is under no obligation to provide further research unless commissioned to do so. Any opinions, forecasts or recommendations reflects the judgment and assumptions of IIR as at the date of publication and may change without notice. IIR and each Participant in the Report, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as, an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any opinion contained in the Report is unsolicited general information only. Neither IIR nor the Participants are aware that any recipient intends to rely on this Report or of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors should obtain individual financial advice from their investment advisor to determine whether opinions or recommendations (if any) contained in this publication are appropriate to their investment objectives, financial situation or particular needs before acting on such opinions or recommendations. This report is intended for the residents of Australia. It is not intended for any person(s) who is resident of any other country. This document does not constitute an offer of services in jurisdictions where IIR or its affiliates do not have the necessary licenses. IIR and/or the Participant, their officers, employees or its related bodies corporate may, from time to time hold positions in any securities included in this Report and may buy or sell such securities or engage in other transactions involving such securities. IIR and the Participant, their directors and associates declare that from time to time they may hold interests in and/or earn brokerage, fees or other benefits from the securities mentioned in this publication.
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