The Australian Journal of Financial Planning | Volume 1 Number 2 25

Iwas standing in a corner store queue in South A f rica during a recent trip to seemy fa m i l y.While I was waiting my turn to pay, a sign hanging above the checko u tcaught my eye : “It is with great sadness and regret that we inform you of the passing of

Mr Credit, who died recently from acute bad debt.” No shopper was going to leave thats t o re without paying in full!

Gone are the days when one could actually get a shopkeeper to “ w rite it in the book”or “put it on the tab” until the next pay day. Running a tab at the pub is about thelongest you can get that type of credit these days and you will have to hand over yo u rc redit card as securi t y. C redit card s , home equity loans and ove rdraft facilities havereally taken over as modern society’s “ t a b ” .

The main difference between getting credit from the friendly shopkeeper and fro mVisa is this: the user pay s . H e rein lies one of two key points from the story aboutM r C redit that I’d like to elaborate on – credit has a price and that price va ries withthe credit wo rthiness of the borrowe r.

The other key point is that Mr Credit had a common illness but needn’t have died asa re s u l t . I’m no doctor but bad debt is a fact of life much like the common cold, I ’ds ay. Think about it – if it wa s n ’t so, the price of credit would be zero and we all knowthat there is no such thing as a free lunch.

A curs o ry glance at your credit card statement should prove that credit indeed hasa p ri c e.

L e t ’s revisit where credit risk really comes fro m . In its simplest form , c redit risk is thatrisk associated with a borrower and not necessarily with the loan or the terms of thel o a n . So to have credit ri s k , the borrower must be risky and the industry has becomeused to benchmarking riskiness in terms of sove reign or country ri s k .

This is so because, u l t i m a t e l y, a sove reign power can adjust its own income by raisingt a xe s . H aving this ability is one thing but using it re q u i res a re a s o n a ble economy tou n d e rpin the taxpaye rs ’ ability to pay. Because economic strength va ries betwe e nc o u n t ri e s , the price of credit also va ries between countri e s .

It has been a big step for inve s t o rs to make over the last two or three decades fro ms ove reign credit risk to corporate credit ri s k . Companies the world over have littlep ricing power generally and their overall economic strength really depends on astutem a n a g e m e n t . In addition, when a country defaults on a loan it is almost alway sre s t ru c t u red and inve s t o rs enjoy a healthy re c ove ry rate (in other wo rd s , their net lossis often quite limited). When a company defaults it is entirely possible that total losscould follow. That is why the price of corporate credit is higher than that ava i l a ble tos ove reign borrowe rs .

But if corporate borrowe rs are ri s k i e r, w hy are inve s t o rs attracted to this sector? The answer lies in one of our two key points: the price of cre d i t .

If the investor prices the risk corre c t l y, the re t u rns are not only acceptable bu ta l s o a t t r a c t ive.

S aving Mr Cre d i tC redit has come to mean diff e rent things for diff e rent inve s t o rs

By Deon Jo u b e rt Managing Dire c t o r, Absolute Capital Gro u p, Syd n ey Au s t r a l i a

DEON JOUBERT co-founded the Absolute

Capital Group in 2001 and holds the positions

of managing director and chief investment

officer. He began his career in 1990 and has

held positions in pension, banking, asset

management and finance organisations in

Australia and South Africa. Deon has

significant experience in asset management,

credit risk management, investment operations

and legal and compliance matters related to

these activities. He has specific experience in

structured credit, securitisation, private equity

and hedge fund portfolio management.

Deon actively participates in the finance

industry and is director on the boards of

several companies within the Absolute

Capital Group as well as Cederra Structured

Investments Limited, PINs Securities NZ

Limited, IXIS Asset Management Australia

Limited and CentraVest SPC.

He holds the qualifications of Bachelor

of Commerce, with accounting and cost

accounting majors, and a Graduate Diploma

in Applied Finance and Investment from FINSIA.

a Financial Standard publication Autumn 2006a Financial Standard publication Autumn 2006

26 The Australian Journal of Financial Planning | Volume 1 Number 2

Autumn 2006 a Financial Standard publication

In A u s t r a l i a , c o rporate credit risk has increasingly been acceptedas part of the economic landscape, as shown in figure 1. H oweve r,most inve s t o rs in Australia only access corporate credit risk inlimited quantities and then only the most highly rated cre d i t .B u tthis is increasingly changi n g .

C o rporate credit usually comes in the form of fixed intere s ts e c u rities or bonds. The overall risk of investing in fixed intere s ts e c u rities is far greater than their underlying credit risk insofar asa large pro p o rtion of their overall re t u rn is determined by a singlefa c t o r: the level and direction of interest rates.

This stru c t u re of having a fixed interest payment irre s p e c t ive ofthe prevailing interest rate stru c t u re has caused a lot of inve s t o rsto lose intere s t , p a rdon the pun, in credit inve s t i n g .1

C u rre n t l y, m a ny inve s t o rs still believe that credit is more ri s k ythan it really is due to the effect of interest rates which havenothing at all to do with the credit risk of a borrowe r.

So how are inve s t o rs ’ p e rceptions of credit changing? Let’sexamine three trends which show that inve s t o rs are getting ove rf i xed interest and getting into cre d i t .

F i rst of all, the general principles of supply and demand work aswell in the credit market as any w h e re else. The more borrowe rswant to access investor capital, the higher the price of cre d i t .What we have seen in the last two ye a rs or so is the opposite,w h e re there is ample capital ava i l a ble from inve s t o rs or lendersleading to a reduction in the price of ri s k , also known as thec re d i t s p re a d .

S e c o n d l y, and related to the above, t h e re is a growing tre n dt owa rds comparing the ri s k / rewa rd ratio of the va rious ratings ofc re d i t . C redit spreads in the lower part of what is re f e rred to asi nvestment gr a de2 and also of the sub-investment gr a de3 va ri e t y,

h ave contracted significantly in recent ye a rs , p a rtly as a result ofi n c reased capital being ava i l a ble from inve s t o rs for that typeo f ri s k .

In other wo rd s , i nve s t o rs are increasingly pre p a red to take on morerisk if they are rewa rded commensurately. This is an intere s t i n gpoint as many inve s t o rs with conserva t ive strategies cannot inve s tb e l ow a certain threshold and, as a direct re s u l t , the supply anddemand situation below that threshold favo u rs the investor insteadof the borrower in that scenario of re l a t ively scarce capital.

T h i rd l y, t h e re is a proliferation of investment products ands t r a t e gies which aim to access a purer form of credit risk andthese are flourishing due to inve s t o rs no longer wishing to acceptthe overall level of interest rate risk present in traditional fixe dincome strategi e s .

Examples include secured loans (instead of bonds), c o l l a t e r a l i s e ddebt obligations (or CDOs) and a spurt in the number ofa l t e rn a t ive investment funds which actively use credit as their focus.

If these trends demonstrate a change, then what has bro u g h tabout this change?

One of the major trends globally is the ageing population and thewidely held view is that the ageing population is exe rt i n gd i f f e rent pre s s u res on asset/liability management. As thepopulation ages, the term of the liability within pension funds theworld over is short e n i n g . That has consequences for assetallocation and portfolio constru c t i o n .

Pension funds can no longer manage their ever shortening liabilitieswith a mix of essentially cash, f i xed intere s t , equities andp ro p e rt y. Of these, the two extremes of cash and pro p e rty re m a i ns u i t a ble but at their re l a t ively low historical allocations. The lion’ss h a re of allocations historically was to fixed interest and equities andit is my opinion that these are no longer suitabl e, on their ow n , a sa means to manage liabilities which are steadily short e n i n g .

Equities are risky and, ye s , one is rewa rded for that risk but onlyover the long term , given their vo l a t i l i t y. Institutional allocationsto listed equities have dropped off in recent ye a rs after the “ t e c hbu b bl e ” s h a t t e red the long running bull marke t .

I do not suggest that equities will disappear from institutionalp o rtfolios but the allocation to equity will most pro b a bly bel ower and/or sub-divided among listed equity, p rivate equity anda l t e rn a t ive equity-based investment strategies where both longand short positions 4 a re take n .

F i xed interest allocations have also reduced in favour of otheri nvestments which inve s t o rs deem to be defensive. F i n a l l y,i nve s t o rs have realised that it is interest rate movements whichcause most of the financial heart bu rn when invested in fixe dincome and that the actual credit risk is a lesser factor in highlyrated assets.

FIGURE 1.

CREDIT AS PROPORTION OF THE UB COMPOSITE BOND INDEX

1 Fixed interest securities produce negative returns where interest rates rise.This is so because investments can be made at higher rates of interest than that of the fixed interest security with alower than current interest rate on its coupon payments. During 1994, for example, interest rates rose quickly and caused fixed interest investments to fall in value just as quickly.

2 Investment Grade usually refers to credit ratings from AAA to BBB- as rated by Standard and Poors.3 Sub-Investment Grade usually refers to ratings lower than BBB- meaning BB+ and below.4 “Long” means that an investor buys an asset with the expectation of selling at a higher price while “short” means that an asset is sold with the expectation of buying it back later at a lower

price and, in both circumstances, making a profit by doing so.5 Floating interest terms means that a security pays interest at a fixed margin over a base rate meaning that the value of such a security does not change as a direct result of a change in the

base rate as is the case with a fixed income security.6 I qualify the removal of interest rate risk here as there is always the marginal impact of interest rate changes on the reset period, or the period after which the new base rate applies. It is

possible to have slight changes in value due to this effect of resetting the base rate.

Source: UBS Australia

If the interest rate risk can be re m ove d , or diluted significantly,then better decisions can be made based on cre d i t . In a fixe di n t e rest portfolio a significant part of the inve s t o r ’s considerationrelates to duration management (the technique of managi n gp o rtfolios given interest rate expectations). That is why there hasbeen significant growth in stru c t u red credit which usually hasf l o a t i ng 5 instead of fixed interest pay m e n t s . This re m oves most6

of the interest rate ri s k .

S e c o n d l y, as previously mentioned, t h e re has been an increase incapital allocated to lower rated assets which has the effect ofdiluting the interest rate risk as the pro p o rtion of credit risk tototal risk incre a s e s . Put simply, l ower rated credit provides ani m p roved ri s k / rewa rd ratio albeit that overall risk may be higher– inve s t o rs just get paid better for taking on a bit of extra ri s k .

What does all this mean for the average investor? After all, M rC redit did die in our story.

In short , it means three things: a) there is a whole new area ofi nve s t i n g , being cre d i t , fast becoming accessible to eve ryo n e ; b )c redit with floating interest rate terms offers superior ri s k / rewa rdc o m p a red to fixed income; and c) credit risk and the othercomponents of risk associated with credit investing can bemanaged successfully.

Ye s , thankfully there is an antidote to what caused the death ofMr Cre d i t . Bad debt will occur but it needn’t be financially fa t a lto inve s t o rs .

When we talk about bad debt, we are really re f e rring to the netloss incurred where a borrower fails to meet their obl i g a t i o n st owa rd the investor or lender. It is the net effect of the default rateadjusted for the re c ove ry rate. In practice, after a borrower defa u l t sthe debt of that borrower is either sold or, in the wo rst cases, t h eb o rrower is liquidated and lenders get the break-up value of whatis left ove r.

A common misconception is that higher default ratesautomatically mean higher losses. Although there is a positiverelationship between default rates and losses, it is certainly not a1:1 ratio. T h e re are three re a s o n s , e f f e c t ive l y, w hy losses can besignificantly lower than what the default rate may suggest.

F i rs t l y, d i f f e rent assets will have different re c ove ry rates. C o m p a rethe default of a manu fa c t u ring company with that of a serv i c ec o m p a ny. It is likely that the manu fa c t u ring company has morep hysical assets, such as plant and equipment, which could be soldand would make for a higher re c ove ry va l u e.

T h e re are also structural issues which could lead to higherre c ove ry rates such as where a loan is secured against cert a i na s s e t s . A residential mortgage is such a loan where the re c ove ryrate is high because the house or unit can be sold.

S e c o n d l y, not all defaults mean that the borrower can’t pay. I nt e rms of the marke t ’s industry standard description of defa u l t , ab o rrower that re s t ru c t u res its liabilities, and there by changes thet e rms of the loan outstanding, has defa u l t e d .

W h e re many companies re s t ru c t u re their affa i rs to ensureongoing financial stability, the default rate creeps up and this oftensignals a perc e ived higher risk env i ronment to certain inve s t o rs .But it needn’t be.

T h i rd l y, as with any port f o l i o, c redit investments must bem a n a g e d . A skilled manager would know if it is wo rth hav i n ge x p o s u re to a particular borrowe r, if that borrower is likely tod e fa u l t , if it defaults what the re c ove ry value would likely be anda host of other data.

This is where Mr Credit is saved – by managing the cre d i tp o rtfolio to avoid default and subsequent financial loss.

T h e re is no magic cure here but instead, and surp rising to many,b og - s t a n d a rd portfolio management techniques. These wo u l dinclude asset allocation by re gion or industry gro u p, a s s e tselection based on ri s k / rewa rd , p o rtfolio construction hav i n gre g a rd to overall ri s k / rewa rd and dive rsification and thenm o n i t o ring and re p o rt i n g .

By focusing on stru c t u red credit assets, it is possible to negate mosti n t e rest rate risk present in traditional fixed income inve s t m e n t sand to have a clear and suitable strategy for credit inve s t i n g .

So how do managers curtail financial loss from credit inve s t i n g ?

The best feature of credit investing is that inve s t o rs can spre a dtheir investment across literally thousands of individual risks withre l a t ively small amounts invested and have a degree of flexibilityin terms of overall risk pro f i l e. This is because, in part , of thes e c u ritisation phenomenon. Let me explain.

When re f e rring to stru c t u red credit assets, we are almost alway sre f e rring to many individual credit assets which have beenbundled together in a pool and where inve s t o rs participate in thesame pool of assets but have different rights to the re t u rn fro mthat pool.

By using stru c t u red credit assets, m a n a g e rs have one of the mostp owerful portfolio management tools at their disposal.

M a n a g e rs can, for example, i nvest in a low risk pool of assets andt a ke a lower rated or junior investment position giving a higherrate of re t u rn . C o nve rs e l y, a lower risk position can be taken in apool of assets deemed to be more ri s k y.

By having the ability to select both the underlying asset and therisk pro f i l e, m a n a g e rs have an exponentially larger unive rse ofi nvestments to use for portfolio constru c t i o n .

U l t i m a t e l y, i nve s t o rs are realising that the level of interest rate ri s kp resent in traditional fixed income investments is less attractive thanp u rer credit investing ava i l a ble through stru c t u red credit assets.

T h rough access to secured loans, as opposed to unsecured bonds,and the use of securitisation techniques in stru c t u red credit assets,a select few managers globally are saving Mr Credit by avo i d i n gd e fa u l t s , maximising re c ove ry rates and diluting the effect ofi n t e rest rate movements on their port f o l i o s . Long live Mr Cre d i t !

The Australian Journal of Financial Planning | Volume 1 Number 2 27

a Financial Standard publication Autumn 2006

28 The Australian Journal of Financial Planning | Volume 1 Number 2

Autumn 2006 a Financial Standard publication