For decades, institutional investors have accessed the more mature private credit markets of Europe and North America, with corporate credit investments providing an attractive, defensive pillar to their portfolios. Until recently, similar corporate credit investments in Australia have been difficult for investors to access, dominated by the internal balance sheets of large banks.
These conditions are changing, with the dynamics between banks, borrowers, non-bank lenders and investors evolving to establish this new asset class to become a valuable and defensive tool for use in investor portfolios.
What is corporate credit?
‘Corporate credit’ is the practice of lending to a company, on negotiated terms, in return for an interest rate that is typically set as a margin above the risk free, or bank bills rate. Some exchange traded corporate credit investments are available, such as corporate bonds or hybrid securities but in Australia, the breadth and depth of this market is limited. They are also susceptible to the impacts of general trading conditions on the stock exchange. An alternative is to invest with a manager who can identify, design and implement privately negotiated loans to quality corporate borrowers.
Companies need access to borrowed capital to support growth and efficient returns to their shareholders. Until recently, Australian companies have had few options but to seek this financing from large banks. Non-bank lenders, which in the corporate credit arena are typically specialist credit fund managers, have evolved to provide investor access to privately negotiated corporate loans that can offer stable and attractive, income returns.
How does corporate credit compare to other asset classes?
Corporate credit — particularly unlisted corporate credit — is considered to be ‘defensive’ and quite different to other asset classes.
Typically, a credit investment will benefit from being higher in the capital structure of a company, meaning that a credit investor is entitled to receive a return of capital before equity investors, and can call on assets of a company for repayment of outstanding amounts. These features, along with other elements negotiated by the manager when agreeing loan documentation, provides stronger features for capital preservation than many other investment types.
Further, private loans are not traded on a market, which means that their value doesn’t fluctuate during the course of a loan. In return for lending capital, investors receive a contractually agreed interest rate, normally set as a margin over the Australian bank bills index. The size of the margin over bank bills will vary, depending on how ‘secure’ the loan is considered to be and the quality of the borrower’s business. A credit manager will negotiate this rate to achieve an attractive return to their investors for the risk taken, while also working to ensure the borrower is well positioned to pay not only the interest but repay the loan in full when due.
Why is it considered ‘defensive’?
Private corporate credit investments are considered ‘defensive’ because:
- Capital is preserved by the requirement for companies to pay creditors ahead of shareholders, so borrowers have greater rights if a company faces difficulty.
- Interest due on a loan is contractual – a company must meet its financing obligations or there will be legal consequences.
- Interest rates are typically set as a margin over Australian bank bills. This typically provides investors with a premium to compensate for the risk profile of the loan and also the less liquid nature of the investment. Importantly, as a floating rate loan, corporate credit investments will deliver higher income as interest rates or inflation rises, protecting investor portfolios through a range of conditions.
With the market for Australian credit evolving, not all private credit investments will be reliable ones. Successful credit investing requires careful borrower selection and loan negotiation to protect capital and ensure a fair return for risk taken. Decades of experience through market cycles is required and only expert assessment of many opportunities can achieve a complementary and robust portfolio to meet investors’ needs.