Corporate loans, a lower risk alternative to hybrids?
Most investors know diversification is important for reducing the overall risk of their portfolio and riding out the ups and downs of the financial market. Still, achieving a well-diversified portfolio that also delivers good returns can be easier said than done for individual investors who don’t have access to the same range as their institutional counterparts.
Self-managed super funds are heavily weighted to three main asset classes – shares, direct property and cash. The average SMSF has 27% of its funds allocated to cash or term deposits, according to the latest data from the Australian Taxation Office, whereas pooled super funds have only 7% in cash.
In the current economic environment, interest rates are expected to stay lower for longer. Many investors know they need to put that cash to better use to achieve sufficient returns that will provide them a comfortable retirement, but have limited options when it comes to investing in fixed income.
For industry and retail superannuation funds, the answer to this dilemma has been significant allocations to fixed interest products such as bonds and asset-backed securities.
Hybrids – Better return than cash, but high risk
The main type of fixed interest product available directly to individual investors has been hybrid securities – highly complex products that have some characteristics of debt and some characteristics of equity – including capital notes, convertible preference shares or subordinated notes.
Australian companies, mostly the four major banks, have issued billions of dollars of hybrid securities in recent years that have been popular with retail investors, however concerns are now rising about whether these products are appropriate for the average retail investor.
In fact, Greg Medcraft, the outgoing chairman of the Australian Securities and Investments Commission, recently said hybrid securities were a “ridiculous” product for retail investors, warning they are the first line of defence if a bank gets in financial trouble.
In the U.K., banks have been banned from issuing hybrid securities to retail investors because of their high risks and complex structure, which makes them difficult to understand.
Hybrid securities are designed so that the investor takes all the risk, not the company that issued the debt.
Some of the characteristics of hybrids that make them high risk include:
Trigger events and payment suspensions: If a company experiences financial difficulty, the hybrids can be converted into shares, which may be less than the investors’ initial outlay, or written off completely. Some offers allow the company, at its own discretion, to suspend interest payments. The missed interest can be repaid later, but the investor is left out of the pocket in the meantime, and the suspended payments can hit the capital price of the security.
Subordination: If the company becomes insolvent, hybrid securities generally rank behind senior bondholders and other creditors. This means hybrid investors are among the last to get their money back, if there’s any left once the other creditors receive their due.
Early repayment at the issuer’s discretion: Hybrid securities can often be redeemed at the issuer’s discretion, either at certain points in time or under predetermined conditions.
Long terms: Some hybrid investments have extremely long terms. Subordinated notes can have terms of up to 60 years, with the issuer, not the investor, having the option of early redemption.
Corporate loans – A similar return to hybrids, but with less risk
A fixed income investment providing similar returns to hybrids, but with less risk, is corporate lending. MCP is launching a product that makes corporate lending accessible to individual investors for the first time.
The corporate loan market is the biggest fixed income market for corporate Australia and offers highly attractive returns, but has traditionally been dominated by the major banks and inaccessible to retail investors.
Direct loans comprise more than 75% of Australian corporate debt, with about 85% of that provided by the banks.
Some of the benefits of corporate loans are:
Regular payments and stable capital value: Corporate loans have floating interest rates, typically set at a margin over the bank bill swap rate, and there is no option to suspend payments. The reliable interest rates are backed up by covenants and controls that result in stable capital value and low loss rates.
Senior ranking: Corporate lenders are senior to shareholders and hybrid security holders, so they are among the first to receive their money if the issuing company becomes insolvent.
Fixed term: Corporate loans typically have tenors of 3-5 years, so you know when you’ll be getting your money back. Cash is paid at maturity. There are very limited circumstances where early repayment can be demanded by the issuer.
Investor demand for a greater variety of investment options is driving innovation. Access to the corporate loan market is another step toward a more equal playing field where individual Investors and self-managed funds can access more of the range of asset choices enjoyed by big money managers. Anyone looking to diversify their portfolio and employ their cash for higher returns, without relying on complicated and risky hybrid securities, would do well to consider allocating some of their capital to corporate loans.