Non-government debt, also known as credit or corporate bonds, is a key part of the broader fixed income universe. Historical performance data shows that credit has favourable risk and return characteristics that can complement an allocation to cash, government debt, and riskier assets such as equities. However, credit is a broad church, with a wide array of borrower profiles, instrument structures, risk levels and potential return outcomes. What we aim to do in this article is introduce a mind map of this ecosystem, to allow investors to better understand the opportunities and the wide range of risks available. In subsequent articles we will explore different segments in more detail.
There are several options for retail or SMSF investors to access non-government debt:
- There is a small number available through the ASX, including over-the-counter bonds offered by the XTB company in a trust structure.
- A range of corporate bond funds including ETFs and managed funds that are also listed on the ASX and Fixed Income News Australia, with its ETF and Managed Fund Finders are a great way to discover what is available.
- The other avenue for those that qualify as wholesale investors is to access small over-the-counter parcels via a bond dealer or broker such as Australian Bond Exchange, Cashwerkz or FIIG Securities.
One thing to be very cautious with is the concentration risk from holding a small number of debt securities. Because the upside is limited with debt, i.e. at best a hold to maturity investor will earn is the coupon or the interest and no more, there is what we call an asymmetric risk profile. Unlike equities, if one investment goes bad, there is little scope in a pure corporate bond portfolio for your other investments to increase their return to compensate. Limited upside, but the possibility of complete write-off, makes diversification important.
So, if we acknowledge that a diversified portfolio of debt instruments is superior to a single investment or just a handful, what kind of non-government debt funds are out there? As a general rule, the higher the promised interest return, the higher the risk of principal loss. Along this spectrum, a great variety of credit assets reside.
Aside from government bonds, which are (usually) the lowest risk form of fixed income, other low risk income generators are investment-grade bonds and the senior tranches of asset-backed securities. As readers are no doubt aware, credit rating agencies express opinions on the creditworthiness of borrowers, through credit ratings. Entities with a rating of AAA down to BBB (from Standard & Poor’s) or Aaa to Baa (from Moody’s) have much lower default and loss rates historically than entities with weaker ratings. Of course, this also means the rates of interest are very low in the current market, which may not suit investors starved of dividend or term deposit income.
Funds which contain low loan-to-value, secured real estate debt could also be regarded as lower risk, although the borrower concentration in these funds is generally much higher than a corporate bond fund. Interest rates, or annual returns, in this area range from 0.5% over cash (or government bonds) up to a maximum of around 2% over cash (or government bonds). Clearly these rates are subject to change and the prevailing market conditions.
Stepping out along the risk and return spectrum, we then enter the world of slightly higher returning debt, which still offers generally low risk to capital, but with more volatility along the way and some risk of defaults in the borrower pool. For perspective, this universe comprises rated and non-rated issuers, with a credit quality ranging from around weak BBB (equivalent) down to the single B area. The compensation for the investor given some risk of defaulting borrowers is of course a higher interest rate, which will help compensate for any modest principal impairment, leaving a positive return overall.
The types of debt which fall into this category include emerging market bonds (government and corporate), junior or mezzanine securitised debt, direct loans to “mid-market” corporate borrowers, and global high yield bond funds (principally US and European borrowers). These asset classes should really be accessed solely through professionally managed funds or diversified passive vehicles like ETF’s, each of which would have a collection of different borrowers and industries over which to spread the risk. The local Australian universe of such debt is relatively limited, but is growing quickly. There are many global funds which operate in these segments, so it pays to do your research into the experience and quality of the manager offering the product. Investors should expect returns (interest rates) in this area to range from 2% over cash (or government bonds) per annum, up to 7% or 8%.
Finally, the highest returning, and therefore most risky, forms of debt investment fall into the most esoteric category. Here we see a range of strategies variously called “special situations” or “credit opportunities”, “venture debt” or “distressed”. While rarely rated in a formal sense, investors can consider this universe to be in the single B quality area, through to defaulted or recovering issuers.
For investors considering these sectors, they must be very aware of the potential risks (100% principal loss) and more complex structures, which can produce handsome equity-like returns. Convertible notes, debt with equity warrants attached, non-dilutive growth capital will all feature in this arena (see glossary for more information). Overseas markets like the US and Europe have much more developed markets for this type of investment, which can blur the line between debt-like and equity-like risk.
Returns of 20% plus are not uncommon in this space for specific assets, though a more standard low to mid teens return profile is typical at the overall fund level.
If we look at distressed debt specifically, this is a sector which will feature more prominently in Australia in the coming years. That is due to the recession currently being experienced (the worst since the Great Depression) and the consequent rise in business failures.
Distressed debt investors look for businesses which generally have some redeeming features, but are undergoing a liquidity crunch or similar stressful event, which has resulted (or will likely result) in a failure to honour debt obligations, or a breach of lending covenants on existing facilities. In these circumstances, there may be an opportunity for new investors to negotiate with the business and its current lenders, to seek a solution allowing some on-going business activity, but an attendant restructure of the balance sheet. The terms for the new debt will be more attractive for lenders than those of the debt being retired or extinguished in the restructure, but with an increased risk. This is a specialist field, where prior overseas experience is especially useful. Given the 29 years of positive growth enjoyed in Australia until mid 2020, there have been less opportunities for local investors to become comfortable with the techniques involved in distressed debt, compared to overseas markets.
The nature of corporate bond or debt returns, coming primarily from income and not capital gains, means that diversification is even more important than it is for equities. And like any investment, thorough background research is essential before committing to an individual asset or a particular fund. Professional assistance will easily pay for itself in the medium term, particularly for those investors chasing higher yields.
Glossary of Terms
A convertible note is short-term debt (generally less than three years) that converts into equity. In the context of a seed financing for example, the debt typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. More generally, it is a debt instrument with either automatic or optional conversion into equity, on terms agreed up front between investor and issuer.
Debt Plus Warrants
A common technique used by lenders to riskier or early stage businesses. The lender increases return potential by incorporating some equity upside into the lending instrument. This is achieved by attaching a stock (equity) warrant to the debt. A warrant gives the holder the right to purchase a company’s shares at a specific price and at a specific date. However, it is not an automatic conversion and the exercise of the warrant still requires fresh capital to purchase the equity under the agreed terms.
Debt or equity with the specific aim of catalysing a phase of faster growth, rather than simply funding a business in a steady state. Often used to refer to transformative capital which is event-driven.
Funding which avoids a business raising fresh equity capital from a third party, thereby diluting the stake of the current equity owners by reducing the proportional ownership.
Debt which is provided to earlier stage businesses, which are experiencing rapid revenue growth, but may not yet return positive net profits. Venture debt is often structured to be short-term and with the aim of being replaced with lower cost, longer term debt (or even equity), once a business reaches a given profitability level. See also Growth Capital.