Arrears rising, should credit investors be concerned?

The proliferation of fixed income and credit options within Australia over the last 2-3 years has been immense. With higher cash rates and volatility of other asset classes, this has been a welcome development. But can their remarkably strong returns continue, particularly as arrears rise within the major bank portfolios and the employment market alongside the broader economy softens? This article attempts to translate this broad question into something more specific and actionable for those who invest in Australian credit.

Three primary ways credit investors can lose money:

(Other risks, such as reinvestment risk and liquidity risk are prevalent, although less salient, in today’s environment.)

• Default risk: this is the risk that the borrower will be unable to make the required payments on their debt, leading to a default. When a borrower defaults on a loan or bond, the investor may not receive the interest payments or principal repayment they were expecting, leading to a loss.
• Interest rate risk: this occurs when the interest rates in the market rise after an investor has purchased a fixed-rate debt security. The value/price of fixed-rate securities falls when interest rates rise and the longer the maturity date, the greater the volatility.
• Credit rating risk: an unforeseen event occurs, decreasing the creditworthiness of the counterparty and causing the value of the bond to fall.

When thinking about each, it is crucial to consider both the probability and the potential severity of a particular risk or outcome. In the most extreme scenarios, where the investment result is binary—either success or failure—I crudely refer to these as “red or black” transactions. Red investors get their return and, in some cases, believe it was a wise investment. Black, the investor loses their money. If your potential upside is the espoused interest rate or yield to maturity (call it 5 – 15%) and the downside is 100% loss of capital, red/black investment propositions are an easy no. Providing an investor can understand how bad it could get and then what the upside and downide is considering the likelihood of each with little cause for concern, prima facie, it’s worth a deeper look.

Default risk: An influential factor on investment terms

Default risk plays an influential role in determining the terms on offer for a proposed investment. Some fund managers solely trade the changes in such perception, given its influence on the asset’s price. In my view, everything has a risk of default, so investors need to understand what that risk is and how that could change on a relative basis, thereby impacting the asset's price. One could ask, what would need to go wrong before this counterparty is at risk of default? Mapping such scenarios out, assessing probability and then asking how bad each scenario could get provides a good sense of default risk. As a word of caution, I don’t subscribe to the view that ‘we have never had a problem with such borrowers’ or ‘we have never lost money’ as the gold standard in this space. I say this as some offerings in Australia have short track records (under five years). Over that time, asset prices have primarily risen, meaning assets used as security are often sold at a very healthy price, and broader economic conditions have been far more accommodating than investors should assume going forward. A more rigorous assessment, as suggested above, is that standard.

Interest rate risk: The two way bet

I recently wrote about interest rate risk (sometimes referred to as duration risk) and the careful use of it given how it is used within one’s portfolio. (See 4 potholes fixed income investors need to avoid in 2024). While many believe interest rates locally shall fall, it’s important to note that inflation, for the prior two years, has remained uncomfortably above the RBA’S 2-3% Consumer Price Index target, risking a high inflation psychology being embedded. Unit Labour Costs Growth sits at circa 7% with low and on some measures, negative labour productivity, which creates a two-way risk for Australia’s significant service-based economy (chance rates could rise or fall), particularly with the RBA having very little appetite for a surprise in inflation readings. Additionally, Australia’s peak cash rate has been lower than other advanced economies reducing any urgency in moving lower. In short, taking interest rate risk is not a free lunch with two-way risk (of duration adding or subtracting from returns) and must be carefully considered.

Credit risk: Often overlooked and unpredictable

Credit rating risk is an area most investors overlook. Ask any experienced stockbroker in Australia for examples of strong-performing companies that one day misstep and come under significant financial stress. You can expect a long list to follow. We also see transactions in the market that arise due to a ‘market opportunity’ that requires debt finance. Given the difficult-to-predict nature of events (M&A activity, regulatory or legal change, economic downturn, natural disaster, cyber-attack, key personnel etc) that lead to a reduction in a bonds credit rating, assessing how bad it could get is equally difficult. Having said that, certain counterparties are more susceptible to such event, such as those with less consistent access to capital (low internal capital reserves, volatile earnings with high fixed costs, lack of stable bank credit lines or, at worst, unprofitable) or parties who undertake project-based endeavours which are far more susceptible to negative developments. As an investor, you can either actively avoid such event-natured counterparties and/or diversify your portfolio to minimise the impact that any event risk would have on it.

Arrears: How bad are they?

Arrears locally have risen of late off what have been astonishing low levels. For example, in late 2022, after the RBA started hiking interest rates, 90+ day Prime mortgage arrears (borrower three months or more behind in mortgage repayments) fell to circa 0.3%, approximately half their decade average. At December 2023 end, they finished at 0.4%, which is a significant circa 25% increase yet below long-term averages. If we consider arrears for both Prime (high-quality borrowers) and Non-conforming (often less high quality), arrears are above medium-term averages yet below prior highs. With Rating Agencies expecting arrears to peak in 2024, expect to hear more commentators jump at the chance to show the significant relative increases in arrears, which should only be considered taking a longer-term perspective (not month-to-month).

So, are arrears good or bad for a credit investor? Intuitively, rising arrears can increase the above risks for investors, increasing default risk, interest rate/duration risk, credit spreads, and events that lead to credit rating downgrades. Counterintuitively, the perceptions of this will drive better investment terms in new deals to attract investors and, therefore, can be the most attractive assets. In our experience, the superior terms offered on new transactions with a less rosy outlook, and assuming one is sensible in the areas they invest and risk is taken on, often more than compensate for the feared risk. In essence, we relish the current environment with far less room for downside surprises.