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A source of alternative income to the banks

Andrew Lockhart  |  22 Nov 2019Text size  Decrease  Increase  |  
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Australian investors are currently facing a conundrum when it comes to income generation – equities or fixed income?

Equities are losing momentum following the 10-year bull run. According to Preqin, 74 per cent of investors believe equity markets are at a peak, compared to 61 per cent at the end of 20181.

In addition, Australia is in the lowest interest rate environment in history, with the official cash rate now at 0.75 per cent per annum. Rhetoric from the Reserve Bank of Australia (RBA) indicates that investors should prepare for an extended period of low rates.

Against this backdrop, 10-year government bonds are trading very close to 1 per cent and the returns from cash and term deposits are insufficient for most investors.

This low rate, low growth environment is an issue for investors seeking to grow their assets and for those who are relying on their investments to generate an income, such as retirees and self-managed super funds.

As a result, many investors are looking beyond the traditional asset classes for potential sources of growth and income.

Other types of fixed income

In times of market uncertainty, increasing portfolio allocations to defensive investments such as fixed income is a popular strategy for both preserving capital and generating income. This is because fixed income assets typically have a low correlation to growth assets such as equities and property, meaning they perform better in down markets. The most well-known types of fixed income are government bonds and corporate bonds – debt securities issued by governments and corporations and sold to investors.

However, there is also a larger but lesser-known subsector of fixed income – corporate loans.

Corporate loans are loans given to companies for various purposes, such as funding working capital requirements, expanding and purchasing assets, completing specific projects or for commercial property acquisition or development purposes. These loans are an excellent way for businesses to focus on their growth and generate more revenue.

This type of loan was traditionally provided to companies by the banks. However, this has changed as regulation has driven up the cost of bank funding, providing opportunities for non-bank lenders.

The Australian corporate debt market is currently worth $963 billion, and these types of loans make up 75 per cent of the Australian corporate debt market2, meaning there are ample opportunities for investors to tap into the current high demand for lower cost, non-bank funding.

How corporate loans can help your income

Corporate loans can be considered a defensive investment because they provide income and capital stability, with a number of built-in protections for investors. Floating interest rates provide protection against inflation and loans are often secured and contain controls such as lending covenants which are negotiated to manage the risk.

In addition, lenders in the market typically undertake rigorous due diligence before lending and ongoing engagement with borrowers is maintained throughout the loan term to assess risks.

Another key benefit of the corporate loan market is its size and diversity. Opportunities range from lower risk senior unsecured investment grade debt investments all the way through to secured loans to sub-investment grade borrowers or higher risk investments such as subordinated or mezzanine loans that offer the potential for higher yields. Naturally, portfolio diversification is important – helping to spread risk by investing in a varied range of sectors, loan types, borrowers with differing maturity profiles. 

Given where debt sits within the capital structure of a company all such debt transactions present a lower risk investment compared with direct equity investment.

With diversification and the right management, the corporate loan market is well worth considering for investors seeking sources of regular income in a low growth and low interest environment.

Metrics Credit Partners was the first corporate loan lender in Australia to list an investment trust on the ASX in 2017, providing investors with access to a diversified portfolio of corporate loans, via the MCP Master Income Trust (ASX: MXT). The fund provides diversification to more than 100 corporate loans across industries and spanning the full credit spectrum.

MXT targets a return of the RBA cash rate plus 3.25 a year (currently 4.25 per cent net of fees) through the economic cycle, with income distributions intended to be paid monthly.

1. Prequin: Investor Update, Alternative Assets H2 2019

2. ABS, December 2018

Other diversified credit options

The following diversified credit products carry Morningstar Silver ratings and pay monthly or quarterly contributions:

PIMCO Global Credit 10884

PIMCO Global Credit has exceeded its Bloomberg Barclays Global Aggregate ex Treasury benchmark over the long term and stacks up favourably against its credit cohort. A reversal could be a headwind, which hindered returns during late 2016 and the first three quarters of 2018. Nearer-term results trailed its internal index through to 31 August 2019 but surpassed most peers with a floating rate hurdle. Interest-rate positioning, notably the short duration stance in Europe and Japan, was the main shorter-term detractor.

Emerging-markets currencies hurt as Argentina and Turkey wobbled in 2018, but sector and security selection across its corporate bonds overcame this. PIMCO’s versatility amid market dislocations included its savvy call to lift exposure to subordinated UK bank securities amid Brexit-driven volatility in 2016. Meanwhile, the shift into the energy sector in early 2016 subsequently proved beneficial. A multiyear overweighting to banks linked to a US housing recovery has also contributed strongly.

PIMCO Global Credit has a 0.61 per cent annual fee, which is about average for credit portfolios. Minimum investment: $20,000. Cash distributions: quarterly. (Tim Wong)

 

Bentham Global Credit 10751

It’s more risky than the average bond fund, but Bentham Global Income should deliver in the long run, and pay a nice income stream along the way. A differentiator is the fund’s ability to invest in syndicated loans and other esoteric corners of the fixed-income market, including collateralised loan obligations, hybrids, and high-yield bonds, areas with considerable credit and liquidity risks. Bentham seeks undervalued sectors and securities with rates they believe to be much more attractive than the risks.

The annual fee of 0.77 per cent adds a drag over and above conservative bond funds, but it’s a reasonable price compared with other high-octane strategies. Bentham’s approach comes with risks, but the conviction in their research should pay off handsomely in the long run. Minimum investment: $10,000. Cash distributions: monthly. (Alex Prineas)

 

Macquarie Income Opportunities 10715

Macquarie Income Opportunities is a credit strategy designed to deliver income, and outpace the Bloomberg AusBond Bank Bill Index, a cash benchmark. That’s an easy hurdle given the credit exposures involved here, so we place the fund in Morningstar’s Diversified Credit Category. Investment-grade corporate bonds or cash form the core, ranging from 0 per cent to 100.0 per cent. There is flexibility to roam into emerging markets (0-15.0 per cent), hybrids (0-10.0 per cent), and global high yield (0-20 per cent).

Macquarie Income Opportunities' 0.49 per cent annual fee is below the category average, adding to its appeal within the Diversified Credit Morningstar Category. While this is a wholesale fee, retail investors can gain access to the strategy directly with a minimum of $20,000. Cash distributions: monthly. (Alex Prineas)

is managing partner at Australia’s leading non-bank corporate lender, Metrics Credit Partners.

This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. 

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