Market Insight


Reviewing the Five Cs
Thursday, April 13, 2017


Interestingly, name recognition (knowledge of the issuer) is the first and most important of thefiveCs. In this respect, retail investors have a major advantage in assessing credit risk, over investors in the subsection of the corporate bond market that is the domain of small, unrated corporate bond issuers.

What are the five Cs of credit?

  1. Character 
  2. Capacity 
  3. Capital 
  4. Collateral 
  5. Conditions 

Character
When considering the first of the five Cs, character, a lender needs to know whether the borrower is trustworthy. Will they do what they say they are going to do, in all respects related to the loan?

Will interest payments be made on time and the principal repaid at the maturity of the loan? Will the money borrowed be used for the stated purpose?

When considering a corporate bond issue, investors should be concerned about corporate governance. Corporate governance determines the behaviour of the company and its officers.

Is the borrower a good corporate citizen? Are there instances where the company has not done the right thing by investors or stakeholders, even though it may have been acting legally?

Has the company been caught-up in any scandals? Is it involved in any activities or industries that you as an investor, would prefer not to be exposed to?

Too often, it seems that character is an afterthought, with more attention paid to the remaining four Cs.

Capability
Capacity is about the financial position of the borrower and the borrower’s ability to generate sufficient future cash flow to service the loan.

From the financial statements of the borrower, a good assessment can be made of a company’s solvency and liquidity. Its profit and loss and cash flow statements will show whether the company is consistently profitable and generates sufficient cash flow toservice the bonds to be issued, along with all its existing borrowings.

Capital
Capital relates to the purpose of the borrowing. What are the proceeds of the bond issue going to be used for and how much of its own money is the company going to contribute to the project?

This is about having skin in the game. It provides a wonderful incentive to the company to ensure that its project is successful, and that the project will not be abandoned when difficulties are encountered.

However, with bond issues there is often no specific project to which the funds raised will be applied. “General corporate purposes”, is frequently the stated use.

This simply means that the money raised from the sale of the bonds will be used to fund day to day activities. In this case, investors need to be satisfied that the company itself is sufficiently well capitalised and is too reliant on debt to fund its balance sheet.

Collateral
Collateral provides lenders with a second source of repayment, should a borrower fail to meet its obligations and default on the loan. Collateral is the security offered by the borrower (a charge over land and buildings, plant and equipment, guarantees from a creditworthy third party), which can be sold or called on by lenders to recover their capital and any outstanding interest, when the borrower defaults.

Typically however, few bond issues come with security, and if they do, the security will be shared equally with other lenders, including the company’s bankers. Most bond issues are unsecured and can rank behind secured lenders, such as the company’s bankers.

Investors need to be satisfied with the adequacy of the security offered or be comfortable with being unsecured or ranking behind other creditors to the company.

Conditions
Conditions is the fifth C, that was later added to the first four. This refers to the terms and conditions attached to the loan that are either imposed by lenders on the borrower or in the case of bond issues, are offered by the issuer to investors.

Banks will often impose conditions on corporate loans, particularly where the borrowing is being undertaken for a specific purpose. But more generally, there will be conditions such as maintaining a minimum level of capitalisation, a maximum level of gearing, and minimum level of interest cover and debt serviceability.

The sale and purchase of significant assets may also be restricted, if not prohibited.

Conditions are less common in bond issues. Financial undertakings in relation to gearing, interest cover and debt serviceability may be offered but often there will be no significant conditions at all.

Investors need to be aware of the conditions offered and decide whether they are satisfactory or not. Where no conditions are offered, investors must be comfortable that they are providing the company with funds that it can use in any way it pleases.

This is where, combined with an absence of collateral, character or corporate governance becomes absolutely critical: there must be trust that the borrower will be responsible and honour its obligations to bond holders. This trust should not be misplaced.

The five Cs remain fundamental to credit risk assessment
Introductory banking courses still cover the five Cs of credit. The approach to credit risk assessment typically appears early in the course and then the course content moves on to discuss “more exciting” topics.

Banking students and practitioners may not think much more about the five Cs thereafter. Focus will switch to assessing the macro-economic environment, industry risk, earnings and cash flow projections and calculating relevant financial ratios.

But why is this information being gathered, where does it sit in the decision making process?

A similar treatment may be given to the five Cs in finance and investment courses. And of course retail investors may never hear of them, unless they are particularly diligent about managing their own investment portfolios, and do not simply rely on the recommendations of advisors.

Yet, upon reflection, it is clear that the five Cs set out the framework for everything that a lender or investor needs to consciously consider before making a decision. In an era of information overload, application of the framework allows information to be categorised into what is useful for decision making and what is irrelevant.

In the past information asymmetry has posed a hurdle for lenders and investors to overcome, and considerable work may have been required to do so. And perhaps because of the amount of work involved, the reason for gathering the information was not forgotten, and unnecessary effort was not expended.

Today, with 100 page plus prospectuses, and not to mention the font of all knowledge, the internet, only the most obscure borrowers can remain a mystery to potential lenders. But there may be too much information.

The five Cs set out what a lender/investor needs to know. Consciously applying the framework can only improve the decision made and decision making efficiency.

Philip Bayley

Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

The five Cs of credit
Thursday, April 13, 2017


Many years ago, as a young banker, I was introduced to the five Cs of credit (although at the time, it was the four Cs, which later grew to become five). It was a time in which credit ratings were virtually unheard of in Australia, and there was no corporate bond market to speak of.

Yes, there was a market for Commonwealth and state government bonds but both institutional and retail investors gave little thought to credit risk. The bonds were considered default risk free and institutional bond investors were focused exclusively on duration risk, which was a big consideration in the late 70s and early 80s.

In the absence of credit ratings and credit scoring, the five Cs of credit were used by bankers and other lenders, as a decision making framework for assessing the creditworthiness of a borrower and the suitability of a loan for the purpose for which it was being sought. These days, it is not clear that the five Cs are consciously applied to lending decisions made by banks and institutional investors, and it is likely that the framework is not used at all, by retail investors.

But it is worth reviewing the five Cs of credit because the fundamentals of lending have not changed. No new ways have been invented for lenders to lose money.

Applying the five Cs of credit to corporate bonds

Let’s consider the application of the five Cs in the context of corporate bond markets: wholesale and retail.

In the wholesale market, institutional investors require bond issuers to have an investment grade credit rating. This requirement provides a measure of creditworthiness from which the required rate of return on the bonds is inevitably determined.

The implication of this is that institutional investors do not conduct their own independent assessment of creditworthiness. Yet, rating agencies consistently state that the rating assigned to an issuer is merely an opinion, and that investors should make their own independent assessment of creditworthiness.

Since the GFC, financial regulators have been singing this tune, long and loud.

In a small sub-sector of the wholesale market, sub-investment grade companies issue unrated bonds to middle market investors such as, family offices, charities, churches, hospitals, universities, private schools, endowment funds etc., and so-called sophisticated investors. The rates of return offered on these bonds are determined by the sponsoring brokers and offered to investors on a take it, or leave it, basis.

Given that it is rare for one of these bond issues to fail, it can only be concluded that many investors do not undertake any form of independent credit risk assessment. Either that or the sponsoring brokers are very good at assessing the creditworthiness of the issuers.

The situation is little different in the retail corporate bond market. New issues are presented on a take or leave it basis, and undertaking their own independent credit risk assessment would not be feasible for most investors in this market.

Investors place significant reliance is on the name of the bond issuer: do they know the issuer; is it a familiar and trusted name? And, once more, the return for risk offered by the sponsoring broker(s) is taken at face value.

REVIEWING THE FIVE Cs

Interestingly, name recognition (knowledge of the issuer) is the first and most important of the five Cs. In this respect, retail investors have a major advantage in assessing credit risk, over investors in the subsection of the corporate bond market that is the domain of small, unrated corporate bond issuers.

What are the five Cs of credit?

  1. Character
  2. Capacity
  3. Capital
  4. Collateral
  5. Conditions

Character - When considering the first of the five Cs, character, a lender needs to know whether the borrower is trustworthy. Will they do what they say they are going to do, in all respects related to the loan?

When considering a corporate bond issue, investors should be concerned about corporate governance. Corporate governance determines the behaviour of the company and its officers.

Is the borrower a good corporate citizen? Are there instances where the company has not done the right thing by investors or stakeholders, even though it may have been acting legally?

Has the company been caught-up in any scandals? Is it involved in any activities or industries that you as an investor, would prefer not to be exposed to?

Too often, it seems that character is an afterthought, with more attention paid to the remaining four Cs.

Capability is about the financial position of the borrower and the borrower’s ability to generate sufficient future cash flow to service the loan.

From the financial statements of the borrower, a good assessment can be made of a company’s solvency and liquidity. Its profit and loss and cash flow statements will show whether the company is consistently profitable and generates sufficient cash flow toservice the bonds to be issued, along with all its existing borrowings.

Capital relates to the purpose of the borrowing. What are the proceeds of the bond issue going to be used for and how much of its own money is the company going to contribute to the project?

This is about having skin in the game. It provides a wonderful incentive to the company to ensure that its project is successful, and that the project will not be abandoned when difficulties are encountered.

However, with bond issues there is often no specific project to which the funds raised will be applied. “General corporate purposes”, is frequently the stated use.

This simply means that the money raised from the sale of the bonds will be used to fund day to day activities. In this case, investors need to be satisfied that the company itself is sufficiently well capitalised and is too reliant on debt to fund its balance sheet.

Collateral provides lenders with a second source of repayment, should a borrower fail to meet its obligations and default on the loan. Collateral is the security offered by the borrower (a charge over land and buildings, plant and equipment, guarantees from a creditworthy third party), which can be sold or called on by lenders to recover their capital and any outstanding interest, when the borrower defaults.

Typically however, few bond issues come with security, and if they do, the security will be shared equally with other lenders, including the company’s bankers. Most bond issues are unsecured and can rank behind secured lenders, such as the company’s bankers.

Investors need to be satisfied with the adequacy of the security offered or be comfortable with being unsecured or ranking behind other creditors to the company.

Conditions is the fifth C, that was later added to the first four. This refers to the terms and conditions attached to the loan that are either imposed by lenders on the borrower or in the case of bond issues, are offered by the issuer to investors.

Banks will often impose conditions on corporate loans, particularly where the borrowing is being undertaken for a specific purpose. But more generally, there will be conditions such as maintaining a minimum level of capitalisation, a maximum level of gearing, and minimum level of interest cover and debt serviceability.

The sale and purchase of significant assets may also be restricted, if not prohibited.

Conditions are less common in bond issues. Financial undertakings in relation to gearing, interest cover and debt serviceability may be offered but often there will be no significant conditions at all.

Investors need to be aware of the conditions offered and decide whether they are satisfactory or not. Where no conditions are offered, investors must be comfortable that they are providing the company with funds that it can use in any way it pleases.

This is where, combined with an absence of collateral, character or corporate governance becomes absolutely critical: there must be trust that the borrower will be responsible and honour its obligations to bond holders. This trust should not be misplaced.

The five Cs remain fundamental to credit risk assessment
Introductory banking courses still cover the five Cs of credit. The approach to credit risk assessment typically appears early in the course and then the course content moves on to discuss “more exciting” topics.

Banking students and practitioners may not think much more about the five Cs thereafter. Focus will switch to assessing the macro-economic environment, industry risk, earnings and cash flow projections and calculating relevant financial ratios.

But why is this information being gathered, where does it sit in the decision making process?

A similar treatment may be given to the five Cs in finance and investment courses. And of course retail investors may never hear of them, unless they are particularly diligent about managing their own investment portfolios, and do not simply rely on the recommendations of advisors.

Yet, upon reflection, it is clear that the five Cs set out the framework for everything that a lender or investor needs to consciously consider before making a decision. In an era of information overload, application of the framework allows information to be categorised into what is useful for decision making and what is irrelevant.

In the past information asymmetry has posed a hurdle for lenders and investors to overcome, and considerable work may have been required to do so. And perhaps because of the amount of work involved, the reason for gathering the information was not forgotten, and unnecessary effort was not expended.

Today, with 100 page plus prospectuses, and not to mention the font of all knowledge, the internet, only the most obscure borrowers can remain a mystery to potential lenders. But there may be too much information.

The five Cs set out what a lender/investor needs to know. Consciously applying the framework can only improve the decision made and decision making efficiency.

 

Philip Bayley

Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

 

Measuring Impact Investing
Thursday, November 17, 2016


Impact Investing Australia released a report that presents the first attempt to capture the impact of green and social benefit investing in Australia.

The International Capital Markets Association recently announced updates to the Green Bond Principals, which included expansion of the range of acceptable uses for green bond proceeds to include projects with social objectives.

Thus, social benefit bonds and green bonds are now considered together, within the context of the benefits that each provide to society as a whole.

 

The report prepared by Impact Investing Australia, "Benchmarking Impact: Australian Impact Investment Activity and Performance Report 2016", observes that in 2015, funds raised or being utilised for socially beneficial projects are dominated by green bonds issued by Australia’s major banks. Indeed, ANZ had A$600 million of green bonds outstanding and nab had A$300 million, at the cut-off date.

Green bonds are nevertheless important, because the bonds introduce social impact investing to institutional investors, who can provide substantial funds to the sector in the future. The report also notes that aside from the impact of these green bond issues, over 60,000 vulnerable Australians benefited from the capital that was deployed during the year.

The greatest impediment to participation in impact investing is difficulties with measuring outcomes. The inconsistencies in global measurements are highlighted in the report, while the report attempts to make a strong contribution to measuring impact in the Australian context.

Thus, the report presents the first set of aggregated, market-based data on the performance of Australian impact investment products. Over time, the data collected should shape expectations for the financial and impact performance of impact investment products.

Looking at the performance of the 15 impact investment products domiciled and active in Australia, as at 30 June 2015, the aggregate value of the products was A$1.2 billion. It is clear that the green bonds issued by ANZ and nab account for 75% of this aggregate value.

The funds raised from these bonds were aimed at environmental outcomes. The remaining funds were aimed at social outcomes.

Of the 60,000 beneficiaries of these social outcome projects, 126 schools were supported, 319 jobs were created, 1,072 people with disabilities were supported and 669 mental health sessions were delivered. As for environmental outcomes, 4,493 tonnes of e-waste was diverted from landfill, 11,501 MWh of renewable energy was generated, and 3.9 tonnes of CO2 was avoided.

Measuring financial performance, the report finds that financial returns from all projects have been positive. Where debt has been provided directly, returns range from 5.4% to 17%, bond returns range from 3.25% to 12%, and returns on real assets employed range from 0% to 12.6%.

The report concludes that investors are finding ways to measure social impact as well as financial returns. However, more work is needed to develop meaningful metrics that inform better understanding of the value that is being created.

Philip Bayley

Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

 

Turning Green
Wednesday, November 16, 2016


In the Australian corporate bond market, institutional investors have been able to buy green bonds or climate bonds, as they are sometimes referred to, since the World Bank issued green bonds in April 2014. That said, the market has not turned green, issuance has been limited to five issues that have raised a total of $2.3 billion, to date.


Green bonds have been beyond the reach of retail investors, until now, however. The Australian Corporate Bond Company - creator of exchange traded bonds (XTBs) listed on the ASX - has just released 10 new XTBs, including two green XTBs.

What are green bonds?

Green bonds are bonds issued to fund green projects, are certified to be in compliance with international climate bonds standards, and are aimed at socially responsible investors. Apart from the World Bank, the German development bank, KfW, nab, ANZ and Westpac have issued green bonds in the domestic market.

Green bonds generally do not provide issuers with cheaper funds in the Australian market, as the bonds price at the same level as the issuer’s ordinary bonds, but arguably provide the opportunity to reach a broader range of investors.

However in 2015, there was an issue of asset backed securities that achieved more favourable pricing than an identical tranche of securities that were not certified green.

Around the world, green bonds are gaining popularity and the definition of green is expanding.


Green bonds issuance

Last week, a global rating agency reported that record green bond issuance of US$26.1 billion dollars was seen in the third quarter of this year, and annual issuance was poised to exceed US$80 billion. Renewable energy projects accounted for 38% of the issuance, energy efficiency 24%, and clean transportation 17%.

It was further noted that in June, the International Capital Markets Association announced updates to the Green Bond Principals, which included expansion of the range of acceptable uses for green bond proceeds to include projects with social objectives. Social benefit bonds have also been issued in Australia but the relatively few issues have been largely restricted to sophisticated, socially responsible investors.

XTBs created by the Australian Corporate Bond Company were launched in May last year. At the time, 17 separate classes of XTBs were listed on the ASX. Each class of XTBs represented an underlying corporate bond obtained from the wholesale market.

The underlying bonds offered are senior ranking, unsecured bonds issued by Australian listed companies and are more than one year old. Investors benefit from being able to buy senior ranking bonds, which are exceptionally rare among the other debt securities listed on the ASX, from the continuous disclosure requirement imposed on the Australian companies, and from the seasoning of the bonds in the wholesale market.

The initial XTBs covered bonds issued by Aurizon Holdings, BHP Billiton, Crown Resorts, Dexus Property Group, General Property Trust, Incitec Pivot, Lend Lease, Mirvac Group, Novion Property Group, Scentre Group, Stockland Trust, Telstra, Wesfarmers and Woolworths. The XTBs function in the same way as an exchange traded fund.

The latest listing of another 10 XTBs takes the total offering to 49 and the new XTBs are backed by bonds issued by ANZ, Bank of Queensland, Macquarie Bank, nab, and Westpac. The green bonds that have been included are the ANZ, June 2020, bonds and the nab, December 2021, bonds.

The ANZ, June 2020, bonds carry a fixed coupon of 3.25% per annum and based on its listing price, will yield 2.326 per annum until maturity. The nab, December 2021, bonds pay a coupon of 4.00% per annum and come with a prospective yield to maturity of 2.539% per annum.

The ticker codes for these XTBs are YTMANZ and YTMNA1. The ticker codes for all XTBs begin with YTM, typically followed by three letters representing the issuer of the underlying bonds.

Brokers such as Bell Potter and Morgans, include the XTBs on their daily fixed income rate sheets. Each XTB has a face value of $100.00.

Philip Bayley

Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

Coming of Age or Ringing of the Bell?
Tuesday, October 25, 2016


For the first time, the Australian government has issued a 30 year bond. Many would argue that this is a coming of age for the domestic bond market.

For a long time, the government bond yield curve did not extend much beyond ten years. And indeed, if the then Federal Treasurer, Peter Costello, had his way, we would have had no government bond yield curve at all - from the early part of this century onwards.

The government was net debt free and Costello was keen to use surplus cash holdings to repay all outstanding government debt. However, the local financial market was in uproar at the proposal.

Without any risk free assets, how would the market function?

Firstly, there is the problem of how to price riskier debt obligations, when there is not a risk free benchmark to use. And secondly, what high quality bonds could be used for repo transactions with the Reserve Bank?

A then (and possibly still) nascent corporate bond market would have been stillborn.

Fortunately, Peter Costello was persuaded from taking the puritanical high road, and instead used the surplus cash to establish the Future Fund, which has been a great success. And for the government bond market, the decision has seen it go from strength to strength, aided of course, by a simultaneous ballooning in government debt since the GFC.

Longer term debt trend in post GFC
It is in the post-GFC years that most of a lengthening in the government bond yield curve has taken place. Bonds with terms to maturity of 15 years, 20 years and 25 years, have been progressively introduced - along with other maturities in between. Now we have a 30 year bond, which brings us into line with other large and developed economies around the world.

For governments, such long term debt instruments facilitate long term planning for economic development and ease the task of debt management on a year to year basis. For the economy as a whole, it has much the same benefits: Development of long term infrastructure is easier to price and to finance, and long term liabilities such as life insurance and annuities can be more effectively hedged.

Innovation in new long term debt products will inevitably follow. Imagine having a 30 year, fixed rate mortgage.

Of course, if we lived in some other countries, it wouldn’t be necessary to imagine. But fixing interest rates for 30 years can be an advantage or disadvantage depending on where we are in the interest rate cycle and whether you are a borrower or a lender.

Ringing of the Bell
This brings us to the ringing of the bell. Ringing the bell is a mythical event that occurs when a bull market reaches its peak and it is time to stop buying and start selling. In this case, does the introduction of a 30 year Australian government bond (coincidentally) coincide with the peak in a global bond market rally that has been going on for just as long?

Interest rates peaked in the late 80s and for the most part have been in decline since then. The declining trend accelerated after the tech wreck in the early part of this century and with the introduction of the Greenspan put.

This was followed by quantitative easing brought on by the GFC and the eurozone crises; and more recently, the move into negative interest rates by the European Central Bank, the Bank of Japan and others, as quantitative easing has failed to stimulate economic growth. But even as this move is aimed at currency depreciation to stimulate export growth, it has failed, as investment will not take place if positive returns cannot be generated.

There is a growing realisation that negative interest rates do not work and only succeed in destroying the profitability of banks and insurance companies.

Global bond markets are starting to acknowledge the likelihood that interest rates have gone as low as they will go and that the longer term direction is now upwards. The bell may well have been rung: yields globally have been rising for the last month or so.

But to underline the excesses of the peaking of the long global bond bull market, at the end of June this year, there was US$11.7 trillion of negative yielding sovereign debt on issue around the world, according to a global rating agency. It was in this environment that Ireland and Belgium were able to sell 100 year bonds at yields of just 2.35% and 2.3% per annum respectively, according to a recent report from ANZ.

Moreover, Italy, which may not be too far away from Greece, both geographically and economically, was able to sell €500 billion of 50 year bonds at a yield of 2.8% per annum, against an order book of €18.5 billion!

The bell may well have rung and for the Australian government selling $7.6 billion of 30 year bonds now, at a yield of 3.27% per annum may be the cheapest long term funding it will see for a very long time. But the buyers of the bonds may prefer to remain in blissful ignorance rather than consider just where the 10 year Australian government bond yields were 30 years ago - in the late 1980s.

Philip Bayley

 

Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

 

Assessing an operator’s capabilities in supporting effective asset performance
Wednesday, June 01, 2016


Australia Ratings’ Operational Capability Assessment provides an independent view on an operation’s capability to support its asset in performing as expected. Such capability is assessed via a ranking - from ‘Superior’ (highest strength capability) to ‘Failure to Perform’ (lowest strength capability).

Despite operations and businesses having strategies, opportunities and risks that are unique to themselves, there are general operational aspects on which a comparison can be made. A benchmark can be used to help compare an operation’s capability and effectiveness in supporting asset performance - both financial and operational.

Benchmarking Operational Capability

To illustrate, let us look at a scenario: An investor is considering different assets (in which to invest in) – a unit in a managed fund and a trade receivables system. The two types of income-producing assets cannot be directly compared when considering the potential risks to the reliability and stability of the income being produced. This is because they are utilised under different types of operations. However, after all key factors to the respective operations have been reviewed; an overall assessment of each operation’s capability to support its assets can be used by an investor or other counterparties for comparative purposes.

The table below outlines the two different operations mentioned above – AssetWatch Trade Receivables and La Trobe Financial Asset Management. The two assets have unique operational risks. We assessed the key factors (from Superior to Failure to Perform) relative to each operation and determined an overall strength of the capability of these operations to effectively support their income-producing asset. These overall assessments provide an investor or other counterparties an opportunity to benchmark against prescribed investment objectives.

Table 1: Operational Capability Assessments are comparable

Operational Capability Assessment rankings AssetWatch Trade Receivables La Trobe Financial Asset Management
Ownership, Performance and Outlook Superior Very Strong
Experience and Skill of Management and Staff Superior Very Strong
Governance N/A Very Strong
Governance – AssetWatch Operation^ Very Strong N/A
Governance – Trade Receivables Financing Facility Origination^ Superior N/A
Risk Management and Compliance Superior Very Strong
Custody of Fund Assets* N/A Very Strong
Investment Management* N/A Strong
Fund Liquidity* N/A Strong
Asset and Data Security Superior Strong
Information and Data Systems and Technology Superior Strong
Financial Adequacy and Stability Adequate Strong
Overall Operational Capability Assessment Superior Strong

^Key factors that are particular to the operation of AssetWatch. *Key factors that are particular to the operation of La Trobe Financial Asset Management.

Determining Operational Capability

A variety of general operational factors, including those that are specific to the operation, are reviewed by Australia Ratings to determine the strength of an operation’s capability and effectiveness in supporting an asset’s performance. These key factors include:

  1. Ownership, Performance and Outlook – shareholder support and equity strength; historical performance of the operation as well as expected future direction are considered. The support for an operation will be stronger where an operation has demonstrated strong equity support for its operations and consistent positive performance.
  2. Experience and Skill of Management and Staff – the degree of expertise, training, efficiencies, reliability and turnover of staff, with particular consideration to key management and staff are considered. The greater the experience, skill and development, the more likely the support for the operation will be strong.
  3. Governance – the structure and responsibilities of the Board are reviewed. Stronger support for the operation will emanate from a clear separation of interests and independent oversight.
  4. Risk Management and Compliance –documented policies and practices of the operation that support a minimal risk environment and a compliant environment are considered. Relevant regulatory, legal, industry and internal requirements are reviewed. The tighter the controls to minimise risk and noncompliance, the stronger the support for the operation.
  5. Asset and Data Security – policies and practices on securing the income-producing assets and relevant data are reviewed. Regularity and results of tests undertaken to determine the effectiveness of those practices are also considered. An operation’s capability will be stronger if the security proves to be effective.
  6. Information and Data Systems, and Technology – the process of collecting, storing, accessing and utilising information and data; and the effectiveness of these processes in supporting the needs of the operation are considered. Stronger support for the operation tends to come from newer electronic systems and programs and those systems and programs that communicate to and complement related system and programs effectively.
  7. Financial Adequacy and Stability – the financial profile of an operation relative to the ongoing financial needs of the assets are reviewed. The support for an operation will be stronger if the financial profile includes consistent profitability, sound capital management and very strong liquidity in the medium term.

Depending on the type of operation being assessed, adjustments are made to reflect the individual nature of an operation, including:

  • Australia Ratings determines the degree of importance of these factors for that operation to operate effectively.
  • If an operation depends greatly on one factor over another, the degree of consideration is adjusted accordingly.
  • Any other key factors that are unique to the operation are also taken into account.

The collective consideration of all the listed factors will achieve an overall assessment of the strength of an operation’s capability and it is this assessment that enables comparative exercises. Despite operations varying in type, Australia Ratings’ independent Operational Capability Assessment will facilitate the ranking of these operations in order of strength of capacity to support the performance of their relevant income-producing assets.

Find out more about Operational Capability Assessment.

Daniela Crisafi, Director, Australia Ratings 

The role of credit ratings in less developed markets
Tuesday, May 31, 2016


Credit rating agencies (CRAs) play an important and powerful role in well-developed corporate bond markets. The credit ratings assigned to issuers and issues are significant determinants of the price that issuers will pay to buy bonds.

Credit ratings are measures of default risk and thereby provide pricing benchmarks for investors. Other benchmarks used to price bonds include the size of the issue, the term to maturity, secondary market liquidity, accrued interest etc.…

The critical role played by CRAs has ensured that they are regulated at both a national and international level. CRAs have been regulated by the Securities and Exchange Commission in the United States since 1975. Internationally, regulation is co-ordinated by IOSCO – the International Organization of Securities Commissions - with substantial moves being made toward global harmonisation since the GFC.

But national regulation and/or a lack of market development can work against CRAs and the use of credit ratings. The reputation of CRAs and therefore the influence of credit ratings may take many years to develop.  Some of the larger global CRAs have a history that dates back to 100 to 150 years.

Recognising the role of CRAs in well-developed bond markets, academics Raghav Dhawan and Fan Yu, set out to test the influence of CRAs in the less developed Chinese bond market.

In their 2015 paper “Are Credit Ratings Relevant in China’s Corporate Bond Market?”, published in The Chinese Economy, they test the influence of Chinese CRAs that haven’t had the same luxury of time to develop their reputations and influence, as their American counterparts.

Bond markets really only emerged in China in 2005, when the People’s Bank of China (PBOC) removed a requirement for all bond issues to be guaranteed by a state-owned bank. Removal of the state guarantee from bond issues forced investors to consider default risk for the first time, and provided Chinese CRAs with an opportunity to prove their value.

Dhawan and Yu say that prior to the removal of the state guarantee, China’s CRAs had little to do but rubber stamp the bond issues with their highest ratings. Credit ratings were purely “ornamental”.

However, since the transformation of the Chinese bond market, the influence of Chinese CRAs has been uncertain. There have been reports of corruption and a willingness to assign inappropriate credit ratings in order to win business.

While the operation of CRA’s is regulated by the PBOC, which has licenced the operation of only four CRAs, it is hard not to think that where there is smoke, there is fire. The ratings that have been assigned to bond issuers are limited to just three: ‘AAA’, ‘AA+’ and ‘AA’.

But Dhawan and Yu note that it is empirically difficult to test the relationship of the rating to default risk. Initial bond issues were from firms of the highest credit quality and (up to the time of their research) defaults were non-existent.

Using credit ratings assigned by China Chengxin International Credit Rating Co. Ltd. (49% owned by Moody’s Investors Service) Dhawan and Yu test the influence of credit ratings as pricing benchmarks. They find that despite the limited history of credit ratings in China, investors are using credit ratings to tier the pricing of corporate bonds accordingly.

Credit ratings are found to be significant determinants of yield spreads between ‘AA+’ and ‘AA’ rated bonds, relative to ‘AAA’ rated bonds. After controlling for the other determinants of bond yields, average yields on ‘AA+’ rated bonds are found to be 21bps wider than yields on ‘AAA’ rated bonds, and average yields on ‘AA’ rated bonds are found to be 88bps wider.

Philip Bayley
Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

Helicopter Money or Nation Building
Wednesday, May 11, 2016


According to the World Economic Forum, “helicopter money is a reference to an idea made popular by the American economist, Milton Friedman, in 1969”. In a paper titled, “The Optimum Quantity of Money”, Friedman drew an analogy of a helicopter flying over a community and dropping $1,000 in bills from the sky, as a means of stimulating economic growth and inflation.

The basic principle is that to raise economic output and inflation, the most effective tool available to a central bank is to give money directly to everyone.

Helicopter money as a driver for economic growth

Following on from quantitative easing and the introduction of negative interest rates in much of Europe and Japan to no avail, there is now a view - and even an expectation - that helicopter money is the next tool to be deployed by the relevant central banks.

In a speech given to the Credit Suisse Global Markets Macro Conference in New York last week, Glenn Stevens, Governor of the Reserve Bank, said that monetary policy as implemented so far, has promoted portfolio substitution as intended - pushing investors to search for yield, but it has had debateable impact in pushing consumers and businesses to respond by purchasing real goods and services. 

Moreover, it is a recognition that monetary policy can only go so far that has prompted the consideration of helicopter money. If implemented, helicopter money would be a use of fiscal policy or fiscal and monetary policy combined.

It would effectively be a transfer of money from government to individuals. And if initiated, could be very difficult to stop.

It is also an economic taboo and illegal in some countries. Stevens asked, are we that desperate?

Forces driving down returns to savers
Writing in the Financial Times recently, economics columnist, Martin Wolf, argued that the world is suffering from a glut of savings relative to investment opportunities. Monetary policy is not responsible for negative interest rates but merely reflects the economic reality that market forces are driving down returns to savers – their money is worth very little.

Weak private investment, reductions in public investment, slowing growth in productivity and huge debt both public and private, have interacted to lower the real equilibrium interest rate, and as a result, nominal interest rates too.

Stevens acknowledged this point in his speech, noting that we have to face up to the question of whether trend growth is lower and if so, what can be done. He is one of the few to observe that demographics may be a contributing factor to lower trend growth - the ageing population is contributing to the trend. And if we don’t want to do anything about this, we will have to accept a low growth future and lifestyles that will be less than expected.

There is some evidence that this acceptance is already underway.

A plausible alternative
If we don’t want to accept this future, then action needs to be taken to address growth impediments such as undercapitalised banks, over leveraged households and businesses, to provide incentives for risk taking of the right kind, and to remove practices that impede productivity and the re-allocation of capital.

Stevens argued that we are not that desperate that the use of helicopter money should be seriously considered. For many governments there must still be infrastructure projects that can be funded through bond issuance and which will produce returns comfortably above their cost of funding.

Recent talk of building very high speed rail links along the eastern seaboard of Australia comes to mind. Surely, if there was a time for this long held pipe dream to become a reality, now is the time.

The cost of such a nation building project that will provide social and economic dividends well beyond anything that the NBN will achieve, and which should rank with the Snowy Mountains Scheme, will never be lower.

Philip Bayley
Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

The unfulfilled potential of impact investing
Wednesday, March 23, 2016


Impact investing is a developing approach to investment that is attracting the interest of not only individuals, not-for-profit organisations and charitable foundations, but institutional investors as well.

Impact investing is defined as an investment approach that intentionally seeks to create both a financial return and positive social or environmental impact that is actively measured. As such, green and social benefit bonds fall within the definition, and while the former has attracted the most funds to date, interest in the latter is considerable and opportunities to invest are eagerly awaited.

A global institutional framework has been established to guide the development of impact investing and Australia is a part of this.

Australia joins global effort to drive impact investing

Impact Investing Australia was established in 2014 and formed the Australian Advisory Board on Impact Investing to participate - along with other national advisory boards - in the Global Social Impact Investment Steering Group. The global steering group is focused on how to drive impact investing to take off, locally and as part of the global market.

Impact Investing Australia's investor survey

Impact Investing Australia recently released its inaugural annual investor survey. The survey covers 123 Australian investors active in the sector.

By number, individuals account for 8% of the respondents, not-for-profit organisation (28%), charitable foundations (28%), and institutional investors (36%). By funds under management, the institutions accounted for A$331 billion of the A$333 billion that the respondents represented in total.

If nothing else, the institutional interest indicates the potential of the sector. Among the key findings of the survey are the following points:

More than two thirds of all investors expect impact investing to become a more significant part of the investment landscape in the coming years.

Active impact investors invest mostly in the impact areas relating to children and/or issues affecting young people and clean energy. They are also interested in opportunities to address housing and homelessness.

Most investors expect competitive market rates of return from their impact investments but some are open to below market rates of return.

Active impact investors expect well-documented evidence of social impact; many also want third-party verification of impact and/or reporting that aligns with global standards.

The last point highlights a key area of development that has yet to occur and until it does, is a constraint on the development of the sector.

Investors and potential investors have an unmet need for financial services and advice that incorporate social and environmental impact. To be precise, there is a lack of reliable research, information and benchmarks and no recognised investment framework for impact investing.

Read Impact Investing Australia – 2013 Investor Report.

Philip Bayley

Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

 

The value of bonds in an investment portfolio
Sunday, December 20, 2015


Any investment text will tell you that bonds are an essential asset class in a balanced investment portfolio. Bonds add negatively correlated diversity to a portfolio and reduce the volatility of the returns generated by the portfolio, or so the theory goes.

As we know there is theory and then there is practice, and practice will not always produce the results predicted by theory. Moreover, from a traditional portfolio construction perspective, investors have quite a bit of discretion over how far their practice diverges from theory.

To give a simple explanation of what is meant by this: theory considers a portfolio invested in just two asset classes. Investors can hold risky equities – shares in the ownership of companies, and risk free assets – government bonds.[1]

Not surprisingly, the characteristics of the assets in this portfolio are consistent with the characteristics of such assets found in the American market. The shares will pay little or no dividends and will be held for expected capital growth, and the bonds will pay regular fixed rate coupons.

Thus the shares will allow the capital value of the portfolio to grow, while the bonds will generate income to meet an investor’s recurrent expenditure or other income needs. This is good while economic conditions remain stable.

In addition, bonds can also provide a portfolio with a cushion or buffer, when economic conditions are not stable. The capital value of bonds that pay a fixed coupon will move up and down as market interest rates change.

If economic growth is strong, it could well be inflationary and the central bank will raise market interest rates to curb economic growth and offset inflationary risks. If market interest rates rise, then the capital value of a fixed coupon bond will fall because the value of the fixed coupon paid is below current market expectations.

Thus, in a strongly growing economy the value of the shares held in the portfolio should increase but the capital value of the bonds in the portfolio will offset this to the extent that the capital value falls.

In this situation, it is tempting to consider not holding bonds. But in a long term investment portfolio, as all portfolios should be, the value of bonds as something more than a source of income, becomes apparent when the economy turns down.

In an economic downturn, the central bank will cut interest rates to stimulate economic growth. Share prices will be falling as economic growth falls but the capital value of the bonds will increase as market interest rates fall below the value of the coupon paid.

Thus, an appropriate allocation to bonds within an investment portfolio can maximise returns while minimising the overall risk of the portfolio. This is the theory and the trick is to work out what the appropriate proportional allocation to shares and bonds is.

Leaving aside proportional asset allocation, retail investors in Australia can put theory into practice. Retail investors can construct an investment portfolio that contains shares listed on the ASX, and to the extent that Australian companies tend to pay larger dividends than US companies, so much the better, the shares should not exhibit the same price volatility.

Australian investors can also add fixed coupon, Australian government bonds (the risk free assets) to their portfolios, as these too are listed on the ASX. These Australian government bonds will have the same performance characteristics that are expected in the theoretical investment portfolio.

However, in this new post-GFC world of historically low interest rates, government bond yields do not look very attractive, with (at the time of writing) yields ranging from 0.00% to 3.57% per annum for bonds with terms to maturity ranging from next year to 2037.

To boost returns, retail investors can look at bonds issued by Australian companies, that are listed on the ASX. But doing so will introduce two forms of risk not yet considered: one is interest rate risk and the other is credit risk.

Virtually, all of the debt securities listed on the ASX pay floating rate coupons rather than fixed rate.[2]  This is a key difference because the cushioning effect of changes in the capital value of bonds, as market interests move up and down, is lost.

Floating rate coupons move up and down with market interest rates and capital value will remain stable, all other things being equal.

Thus, in a rising interest rate environment, investors can expect to earn more income but will earn less as interest rates fall. Just like with bank term deposits in recent years.

This brings us to credit risk.

The lower the credit quality of the company issuing the debt securities, in other words the greater the likelihood that the issuer may default over the life of the debt securities, the higher the coupon that should be paid when the debt securities are issued, to compensate for the inherent credit risk.

Similarly, greater compensation will be demanded by the market if an issuer’s credit quality should decline while its debt securities remain outstanding. If an issuer’s credit quality declines after issuance but before the debt securities mature, the capital value of the debt securities can be expected to fall.

This is just like holding shares. If a company’s earnings outlook deteriorates, then the price of its shares will fall.

The key difference though, in this case, is where you rank in the capital structure of the company. Where you rank in the capital structure will determine your expected loss on your investment should the issuer default.

If the issuer defaults and is eventually wound-up, shareholders can expect to be wiped-out but the holders of senior ranking debt may be repaid in full. Holders of subordinated debt and deeply subordinated hybrid notes may suffer varying degrees of capital loss.

The further down an investor ranks in the capital structure of a company, the more equity-like their investment becomes and the portfolio benefits of holding bonds/debt securities will be steadily eroded.

Furthermore, as a debt security moves closer to equity, more equity-like characteristics will emerge, such as the flexibility to suspend coupon payments. Suspended coupon payments may be cumulative and eventually paid or they may be non-cumulative and simply lost.

A practical demonstration of these credit risks comes from examining the performance of the ASX-listed debt securities indices compiled by Australia Ratings. The indices are accumulation indices and therefore take into account income from coupons paid, as well as changes in the capital value of the debt securities.

The indices are new, having been compiled from just the end of February this year, with a base of 100. As at the end of October, the value of the hybrid debt securities index had fallen to 95.47, providing hybrid investors with a total negative return of more than 4.5% over the period.

The subordinated debt securities index stood at 100.56, after have moved below 100 in September.  Subordinated debt securities investors have earned very little over the period.

Senior debt securities investors however, have been the winners showing a positive return of 4.94% as the senior debt securities index increased to 104.94. Thus, as risk aversion increased over the course of the year, returns to debt securities investors varied accordingly.

But to put this into perspective, think about the returns to shareholders over the same period. The S&P/ASX200 index stood at 5929 points at the end of February, and finished October at 5239 points, a loss of 11.6% excluding dividends paid over the period.

While returns to debt securities investors would have varied with changes in the credit quality of individual companies, Crown Resorts, Origin Energy and Woolworths come to mind, an overall increase in risk aversion over the period hit those securities lower in a company’s capital structure, the hardest.          

Under the ASX debt and hybrid research scheme, Australia Ratings has been engaged to rate listed debt securities. These ratings combine two very useful assessments for debt securities investors.

The first component of a debt securities’ rating is an assessment of the credit risk of the issuer and takes the traditional form of a credit rating ranging from ‘AAA’ in the case of the highest quality issuer such as the Commonwealth government, to ‘BB’ for issuers of intermediate risk.

The second component is a Product Complexity Indicator (PCI), which is colour coded to reflect where a debt security ranks in the capital structure of an issuer and the complexity of the terms and conditions that come with that. The PCI colours range from GREEN for simple senior ranking bonds/debt securities, to RED for the most complex and subordinated hybrid notes.

In between, subordinated debt securities with deferrable but cumulative coupons will typically be assigned a YELLOW PCI, while those with non-cumulative deferrable coupons will receive an ORANGE PCI.

A full list of the credit ratings and PCIs assigned by Australia Ratings to ASX listed debt securities can be found at www.australiaratings.com.


[1] Government bonds will only be risk free if denominated in the currency of the country concerned.

[2]   The term debt securities is used rather than bonds, for the riskier debt issued by companies. This is done simply to differentiate from government bonds.

 

 

 

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