Income investing: Get set for the biggest challenge of 2021

The end of JobKeeper on 28 March will leave Australian business owners with an $85 billion funding hole, as the tablecloth is yanked out from underneath them. But what will this mean for their investors? 

Well - it depends.

“The challenge for fixed income and equity investors in 2021 is assessing which businesses got a temporary uplift in 2020, and which got a sustainable uplift,” said Victor Rodriguez and Pete Robinson, head of fixed income and head of investment strategy, CIP Asset Management.

The specialist non-bank lender and fixed income manager – part of the Challenger group – has been providing capital to institutional clients for around 20 years. It has only recently dived into the retail market, opening its products to end-investors. The team saw a need for a broader range of investment products, particularly those holding less liquid assets, in the increasingly “liquidity obsessed” markets of recent times.

“We think that end-investors are now much more open to considering the trade-off between liquidity and returns,” said Rodriquez and Robinson.

In the following wire, they explain the lightning liquidity crunch that rocked credit markets last March, and why such occurrences are likely to increase in both severity and frequency. They also express their view on buy-now-pay-later company Afterpay (ASX: APT); discuss how investors can position their fixed income allocations to minimise risk; and detail where they do (and don’t) see opportunity ahead.

After nearly two decades of managing fixed income investments for institutional clients, why have you only now started targeting end-investors?

This really comes down to two factors. Firstly, we believe that end-investors should have access to a broader range of appropriately designed investment products than what is currently available to them.

In particular, end-investors have not been able to access less-liquid parts of the credit market because the overwhelming majority of fixed income funds provide for daily liquidity. We believe this obsession with daily liquidity comes at the expense of returns.

Secondly, necessity is the mother of invention. The low-interest-rate environment necessitates some reflection on the role of a traditional fixed-income strategy. Put simply, what is the role of fixed income when traditional strategies offer a yield that is barely above zero after fees? As a result, we think that end-investors are much more open to considering the trade-off between liquidity and returns.

What happened to credit markets in March 2020, and has that liquidity crunch passed?

It is important to highlight that this liquidity crunch of March 2020 was not limited to credit markets. In fact, in some respects the liquidity crunch in government bond markets, while more short-lived, was even more concerning.

We’ve been surprised how quickly people have forgotten that during the week of 16 March, Australian government bond yields increased by 50 basis points before ending March roughly where they started. It was only after unprecedented central bank intervention that conditions normalised.

Fast forward to today, and the liquidity crunch of a year ago has passed and conditions have normalised. However, the reality is that liquidity crunches are occurring with greater frequency and severity. In our view, liquidity conditions are strongly linked to market expectations of central bank activity. This is one of the reasons why we like to say we feel QuEasy about Quantitative Easing.

How much has the “illiquidity premium” required by fixed income investors increased in recent years? Is this driven largely by the events that have occurred since last February?

We define the “illiquidity premium” as the excess return generated on an illiquid investment over and above the return on a liquid investment of similar risk and tenor. So, the illiquidity premium is really a function of the opportunity in public markets as well as private.

Through the cycle, we’d say that a 2% excess return per annum is a rough estimate of the illiquidity premium. We say “through the cycle” because the illiquidity premium is not constant; sometimes you are rewarded for providing liquidity and sometimes you are not.

In our view, it pays to be in a strategy that can allocate to opportunities across the liquidity spectrum, buying public bonds when illiquidity premiums are low or negative and rotating into private markets when illiquidity premiums are high. 

To illustrate, in March and April of 2020 there was no illiquidity premium. Arguably the illiquidity premium was negative because public markets were so dislocated and driven by forced/motivated selling by funds that needed liquidity. As government and central bank interventions have driven public markets back to pre-COVID levels we have seen the illiquidity premium expand back to more normal levels.

Looking forward, we think there will be a lot more opportunity in private markets as banks return to form with respect to their credit underwriting standards. We think more and more borrowers are going to find that what the banks are offering to them doesn’t meet their needs and alternative lenders will step in to fill the breach.

When will we see an end to the “TINA” mentality that’s been driving equities demand for so long, particularly from income investors?

In short, we have no idea! This being said, as an alternative lender, the TINA (there is no alternative) acronym jumps out to us because we are an ALTERNATIVE lender so we’d argue there are alternatives, particularly for income investors.

The other factor that we think is worthy of consideration from the TINA advocates is how much that mentality is dependent on the level of interest rates. Nominal interest rates might not be an alternative right now but if they keep increasing, they soon could be.

What affect will the switching-off of JobKeeper in March have on local fixed-income investors?

In a direct sense, the switching off of JobKeeper will cause businesses to have to replace $85 billion of government funds with private money. That may come from earnings rebounding to pre-COVID levels, raising equity capital, retrenching staff or borrowing.

JobKeeper enabled businesses to continue as a going concern, keeping staff employed and earning a wage. Those same employees and business owners were then able to spend that money in the wider economy supporting other businesses. The challenge for fixed income and equity investors in 2021 will be assessing which businesses got a temporary uplift in 2020 and which got a sustainable uplift.

What’s your view on the growing number of listed companies that remain unprofitable? How do they fare within your screening process?

Our view on these companies is that with few exceptions alternative lenders aren’t really relevant to unprofitable businesses at high valuations. Where there is huge volatility in potential future outcomes, a debt investor’s view of a business should be materially different to the equity investor. This disconnect can lead to situations where the cost of equity is cheaper than the cost of debt.

Look at Tesla. They have a negative net debt position and the lowest debt to asset ratio since 2013. Equity is a cheaper form of capital for them and many other listed equity businesses today.

However, even if this wasn’t the case, we’d still be reluctant to lend to businesses that cannot demonstrate consistent, sustainable normalised earnings. The one exception to this is where parts of a business do generate consistent, sustainable normalised earnings even where the wider business does not. Afterpay is actually an example of this; the underlying Buy-Now-Pay-Later product they issue can be financed via securitisation markets without exposing the lender to the valuation/credit risk of the headstock.

How do you assess the deals that get put in front of you, and why is the rejection rate so high?

You cannot assess deals in a vacuum, so seeing deals is a key part of the assessment process. By originating a high number of relevant transactions, we can quickly form a judgement on which deals work and which don’t. That’s the first reason why the rejection rate is so high.

The next reason we only proceed with a small proportion of deals relates to our risk management culture. In private markets, you cannot necessarily bank on secondary market liquidity to sell a deteriorating position. This means the standards around risk management must be higher in private markets than in public.

An example of this culture is the separation of duties between the person assessing the value of a transaction and the person assessing the credit risk. Banks have known for years that the person originating the transaction should not be the person underwriting the risk. A clear separation of duties is crucial in ensuring the risk of a transaction is assessed appropriately. This feeds into the assessment of value as well; as private deals are not rated by external rating agencies, a properly independent assessment of risk can allow investors to form a view on the size of the illiquidity premium.

Further, when considering the assessment of private deals versus public it’s important to note the level of detail that lenders receive when conducting due diligence on private companies. When it comes to private borrowers, there is really no limit as to the granularity of information that can be sought. Because of this, the credit assessment process tends to be far more intensive for private borrowers than public.

Lastly, structure and terms tend to play a far greater role in private deals than public. As a private lender, we have the ability to engage with the borrower to mitigate risks in the transaction through structural protections. This might include requiring a corporate borrower to reduce leverage below a certain level before paying any dividends, or making acquisitions, or trapping rental payments to a commercial real estate borrower until the weighted average lease expiry exceeds a certain date.

Where do you see the most opportunity in fixed income – asset-backed real estate; financials; non-financials; and of these, public or private debt?

We’re credit investors, so we’re much more comfortable talking about what we don’t like rather than what we do like! Right now, we don’t like public markets and we particularly don’t like financials where valuations are close to pre-GFC levels.

On the private side, it’s important to highlight that the opportunity set for alternative lenders is framed by those areas where a bank may find it more difficult to lend. Importantly this isn’t about credit risk necessarily.

Banks may find a loan difficult because of the regulatory capital cost, the bespoke terms of the loan or the speed with which a response is required. Right now, the banking system is flush with deposits, but risk aversion remains high. Add to this the fact that their pre-existing cost of capital challenges remains in place. As such, banks tend to be very aggressive in lending to less capital-intensive areas such as owner-occupied residential mortgages and investment-grade corporate loans. On the flip side, they’re far less competitive in other areas such as private equity sponsor-backed corporate loans.

Want to learn more?

Pete and Victor aim to provide diversified sources of income by seeking opportunities in both the public and private sectors, whilst maintaining capital stability. For further information, use the contact form below or visit their website.