Hotspots of risk in Australia's credit markets

With Australian credit the in-vogue topic, there is no shortage of compelling pitches for why to invest. Lending against residential property or to high-quality businesses, what could go wrong? Thankfully for many, very little of late. Although that partly is due to the favourable market conditions, including rising property prices, which have seen unimproved properties typically sell for more than they were purchased for with business conditions remaining strong. We are not anticipating a sharp turnaround in the asset classes' fortunes, although there are some areas where risk is pooling that investors should watch out for.

Before wading in, it’s important to remember that these risks can be problematic in isolation or in combination. We view many current market participants overlooking these aspects, as frankly, they haven’t been bitten by them in the last 30+ years (since the early 90’s recession). This is why we have prioritised industry tenor in managing these assets, leveraging the extensive track records of our Investment Committee with members that predate this buoyant era.

Areas where risk is pooling

1. Loans where the exit is unclear: when making any credit investment, the exit must be clearly understood. Ideally, this involves some verifiable avenue rather than a ‘refinance’, which, by nature, is difficult to forecast as lending conditions or the fundamentals on which the lending decisions are made can change. For example, if the business is no longer profitable, a refinance of a business loan becomes challenging. That risk grows based on the tenor of a loan, given it is more difficult to forecast further into the future. I.e. a 1 year loan is far less risky than a 5 year equivalent. Other elements include security for the loan, with liquid hard assets like property, wheeled assets (cars, utes etc) providing a far more robust primary or secondary exit. Crucially here, there needs to be confidence around the future value of the asset. More recently developed technology assets like electric trucks or new solar panels present significant downside risks if the technology fails, as it can, and the security is worthless. The same can apply to construction finance, where the future value, either as a performing project that was completed on time and on budget or a problematic project that wasn’t, is unknown. Large loans or loans in areas where few lenders participate reduces the ability of a refinance and, therefore, on a like-for-like basis, are riskier. This risk can compound when loans do not need to be paid down over the term of the loan and only require interest payments (not amortising loans).

2. Documentation risk: when credit markets are propelled by strong economic fundamentals and shrinking credit spreads that push the face value of credit assets higher, it’s rare to hear of skirmishes between lenders and borrowers. Afterall, everyone is happy, with lenders and investors receiving strong returns and borrowers benefiting from cheaper financing. At some stage, that harmony will no longer prevail due to a borrower or lender issue at which time, parties will need to revisit the legally documented agreements to assess their rights. In some cases, this can expose previously overlooked elements which either party could potentially exploit, typically the borrower. Recent examples include the borrower attempting to change/reduce the security pool that supports the loan and allowing further debt to be taken on (for example as reported, Pluralsight in the United States and GenesisCare locally), which can include new parties who may not have much alignment of interests with current debt holders. For example, those new lenders may trigger a default to open up all possible avenues to get their hands on any assets available, with a recent unconfirmed example playing out in Australia.

3. Highly subordinated assets: it should come as little surprise that subordinated assets primarily in the form of subordinated notes in securitisation transactions, subordinated corporate debt or second mortgages against property assets shall be a natural collection point for risk. Very simply, when investing, you need to ensure the party negotiating or making the investment decisions has significant, relevant longitudinal experience and truly understands the investment and how it will perform today and in a less kind environment.

4. Fraud: while fraud is extremely uncommon, it is part of every financial market including even the most highly regulated markets. In our experience, Australian credit markets are well developed, with significant industry experience learnt from isolated examples, which has developed specific controls and monitoring practices which should not be discounted. Irrespective of where you invest, a keen eye for telltales and domain knowledge around current industry best practice controls remains paramount.

Seek out deep understanding and experience

The purpose of these points is not to suggest that credit does not have merit—quite the contrary. Rather, it is to underscore the importance of skilled, highly experienced teams in navigating these risks effectively to extract the full value from the asset class. Too many see credit investing as a simple investment endeavour, but it requires a deep understanding and experience to manage the potential challenges. It is also one where high historical returns may be manager skill or simply, excessive risk taking. We believe if you are a specialist with deep domain expertise and have been around long enough to understand risk, these compelling pitches can translate into attractive returns over time.