Institutional investors have increasingly turned to alternative assets as a means of improving portfolio resilience, managing risk, and capitalising on opportunities unavailable in public markets. Australian Retirement Trust (ART) has been a key participant in this shift, developing a strategic approach to investing in unlisted assets that balances risk and opportunity.
An audience of advisers, researchers, and asset allocators gathered in Sydney last week for an intimate discussion with Haran Karunakaran, dissecting the unique opportunities and challenges facing fixed income investing today. Against a backdrop of economic uncertainty, where inflationary pressures, central bank policies and liquidity concerns intersect, Karunakaran, fixed income investment director at Capital Group, painted a nuanced picture of an asset class that is experiencing a renaissance — albeit one with caveats.
Better than hybrids, but hiding in plain sight
The decision by the Australian Prudential Regulation Authority (APRA) to phase-out bank hybrids by 2032 will require income-oriented investors to look elsewhere for that part of their income-bearing allocation that the bank hybrids have fulfilled.
If the investor qualifies as a wholesale/sophisticated investor – meaning they have a gross income of at least 250,000 per year for the past two years, or net assets of at least $2.5 million – we believe there is an alternative right under everyone’s noses, in high-quality, investment-grade Australian floating-rate notes (FRNs). And for those investors that can participate, it is a better investment proposition than the hybrids, not an alternative to them.
Access to these types of investments is provided through a managed discretionary account (MDA) that offers sophisticated investors a portfolio of direct fixed-income securities traded on the wholesale ‘over-the-counter’(OTC) market. These bonds are issued under information memorandums (IMs), not retail prospectuses. The MDA portfolio consists of securities issued in Australian dollars by Australian and global banks, companies and asset-backed securities (ABS) vehicles such as residential mortgage-backed securities (RMBS).
It would typically contain:
- Senior debt: bonds which banks issue in the wholesale market as part of their funding: as the name implies, these securities rank the highest in the capital structure
- Subordinated debt: bonds ranking below the senior debt, which banks and insurers issue as part of their ‘Tier 2’ capital, forming part of the buffer APRA requires them to have to absorb potential losses in the event of financial distress.
- Australian bank ‘covered bonds,’ which are a form of secured funding backed by both the issuer and a specific pool of asset; covered bonds are typically issued by banks and secured against pools of residential mortgages.
- Mortgage-backed securities, backed by residential or commercial property mortgages.
- Corporate bonds.
Usually, these securities are issued in the Australian wholesale market, but there may be occasions when issuers structure the bonds under the US Security Exchange Commission Regulation S (Reg S) documentation, meaning the issue is sold globally but is not offered to US buyers. The Escala MDA portfolio sometimes contains ‘kangaroo’ bonds, which are offshore banks or funding agencies issuing bonds in Australian dollars. Also, from time to time it may hold Australian hybrids.
Holding such a portfolio allows clients exposure to the depth and ready liquidity of the Australian OTC bond market, in which trading volumes average $3 billion to $4 billion a day. In normal market conditions, the underlying securities in the MDA trade on a T+2 basis (transaction-plus-two), meaning liquidity within two business days; given bank cash movements, the clients get their money back in three days. This is a stark contrast to the patchy liquidity of the ASX hybrids market, in which substantial holdings can take many days to sell in full.
Investing in the wholesale market requires a discretionary basis: typically, new issues in this market are announced at 10AM, and completed by noon. In practice, we find that this market allows us to generate strong running yields, with an added element of capital outperformance, much of which comes from the ability to participate in new issues.
The liquidity of the OTC bond market removes the concern that investors may have had about holding capital in an investment that, while offering an alluring return, is either explicitly inaccessible through its terms, or conditionally so, with respect to market liquidity (for example, while the ASX hybrid market is ‘liquid,’ in practical terms, if you wanted to sell $5 million of a particular hybrid, it could take you several weeks, and require deft handling of the ‘bid’ side of the market, to maximise your selling price.)
Liquidity concerns have caused many investors to leave the term deposit (TD) market, which was traditionally considered the best place to ‘park’ cash. Prior to the GFC, it was relatively painless to ‘break’ a TD, but after then, APRA came to view that ability as a vulnerability in banks, on the grounds that if investors started losing confidence in a bank, and pulled-out their TDs, the effect would be self-fulfilling – the banks would come under even more liquidity pressure. Accordingly, it is now much more onerous to break a TD, and all interest can in some cases be forfeited. The net impact was that banks had greater certainty of funding, but TD investors lost flexibility.
This aspect of an OTC bond portfolio should not be under-estimated, as many investors are wary of locking capital away for extended periods. For example, a client may have sold a property and have a tax bill coming up several months. The penalties for breaking a TD obviate that as a strategy, so investors need an option that gives them liquidity. TDs with authorised deposit-taking institutions (ADIs) do have the first $250,000 government-guaranteed, effectively making them AAA-rated government risk, but investors must balance this against their potential liquidity requirements – especially when the OTC bond alternative may be working harder for them in terms of yield.
Hybrids have the same capital-price susceptibilities of any listed securities, and the convertibility status is not in the hands of the investor. With investment-grade FRNs, the capital prices do not move around as interest rates move around. OTC bonds do not offer investors franking credits, but again investors must balance the lack of this attribute with the fact that the absolute downside of directly owning investment-grade bonds simply means receiving the coupons and getting your capital back at the end, with minimal capital-price fluctuations – compared to the absolute downside for hybrids, which is to get converted to equity at the wrong time.
To sum up, for eligible investors, we believe the OTC bond market makes perfect sense as an asset allocation tool, as an income strategy, and as a liquidity strategy. Far from mourning the disappearance of bank hybrids, we believe it’s time to recognise the superior investment staring everyone in the face.
