Australian credit around the world: part two – US private placement investors

Westpac Institutional Bank (Westpac) and KangaNews are conducting an ambitious, year-long project to gauge the opinions of international credit investors on Australasian-origin product. In part two of the series, a group of US private placement (USPP) investors met on 31 January during the annual industry conference in Boca Raton, Florida together with Westpac’s USPP joint-venture partner, Bank of America Merrill Lynch (BAML).

PARTICIPANTS

Dave Barras Managing Director NORTHWESTERN MUTUAL CAPITAL
Bill Evans Chief Economist, Managing Director and Global Head of Economics and Research WESTPAC BANKING CORPORATION
Post Howland Managing Director, Private Capital Investors NEW YORK LIFE INVESTORS
Chris Lyons Managing Director and Group Head, Private Credit VOYA INVESTMENT MANAGEMENT
Steve Mahoney Managing Director, Debt Private Placements BANK OF AMERICA MERRILL LYNCH

Steve Monahan Managing Director and Global Head – US Debt Private Placement Group BANK OF AMERICA MERRILL LYNCH
Laura Parrott Managing Director and Head of Private Placement Originations TIAA INVESTMENTS
Liz Perenick Managing Director, Private Placements BARINGS
John Tanyeri Managing Director and Head of Private Infrastructure and Energy Finance METLIFE INVESTMENT MANAGEMENT

MODERATORS

Gary Blix Head of Corporate Origination WESTPAC INSTITUTIONAL BANK
Peter Block Head of Corporate and Non-Frequent Borrower Origination WESTPAC INSTITUTIONAL BANK

Samantha Swiss Chief Executive KANGANEWS

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POLITICS

Swiss What impact, if any, have the arrival of the Donald Trump administration and the now sharply higher-yield environment had on your investment strategies and approach so far?

HOWLAND With a Republican majority now in place, an optimist might hope that Congress would get together on passing pro-growth tax and regulatory-reform initiatives. I think the concern is the unpredictability of the new administration and whether this in and of itself will be a drag on growth and investment.

PERENICK With a new administration there can always be uncertainty. However, president Trump is coming in following a pro-business campaign which, if implemented, should be good for business and growth. This should be a great opportunity for the private-placement market, which has a proven reputation and demonstrated history of being open and providing access to issuers.

Actually, I think the uncertainty and higher interest rates you mentioned in your question are ultimately a positive for our market versus other capital markets given our buy-and-hold focus. Companies know they can come to our market and be fairly and properly heard and evaluated under all types of market conditions.

At Barings, we do not foresee any change to our strategies. We are comfortable with our portfolio and continuing to invest in the current environment.

LYONS The question is whether president Trump will get as much done as one might think with the White House and Congress aligned, or whether speaker [Paul] Ryan and some of his colleagues run against what Trump is trying to accomplish. We could end up with some kind of continued stagnation – time will tell.

Swiss Are you doing anything specific to change your strategies as a result of the uncertainty you’re anticipating?

PARROTT We are not changing our investment strategy but we are paying close attention to what the Trump administration will do with tax reform, infrastructure spending and other policy moves that could have implications for parts of our portfolio. Specifically, changes in the interest deduction and real-estate exchange exemption would affect lower-quality credits and US real-estate companies.

We are also watching our investments in the hospital space in the context of the potential repeal of Obamacare.

TANYERI From our perspective, the infrastructure push is one we are really looking forward to. Whether or not you support the current administration, one thing you can’t do is underestimate president Trump and his knowledge of the construction sector. It’s where he grew up, it’s where he came from and this is a significant competitive advantage.

We have a US$14 billion global infrastructure book and we anticipate significant growth in the US, possibly via the public-private partnership route. We think new tax-reform legislation will make the muni market a less viable option. So if president Trump pushes infrastructure more towards the private side – which I think he will do – it could result in huge stimulus for the economy, not only for job creation but also for sustainable GDP.

There have been a number of studies done recently citing the infrastructure-investment gap. For example, the American Society of Engineers, which does a study every four years, says there’s a US$1.5 trillion gap in infrastructure spend. If this need is not satisfied by 2020 it will cost the government somewhere in the neighbourhood of US$4 trillion in GDP and possibly strip 2.5 million jobs from the economy. This is a daunting number. We’re optimistic that the administration will get something done.

Covenants offer downside protection and our clients hire us to find deals that offer covenant protections and relative value. We view these as essential features of the asset class.
LIZ PERENICK BARINGS

EVANS When Wilbur Ross enunciated the policy on infrastructure before the election he spoke about US$1 trillion, and he said 75 per cent was to be commenced by the private sector. Does this make any sense? Because the only way they could do this would be to privatise a whole lot of assets and use the money raised to build a bridge that will never attract a toll.

TANYERI If you look at the Ross-Navarro plan in its entirety, it is a tax-incentive plan that really would stimulate more equity in the infrastructure sector. However, when we talk to a number of our equity partners they truly believe there is already sufficient equity out there to invest in projects. What needs to happen is the logistical system that’s in place has to be truncated to get more projects to shovel-ready status quickly. When you look at what Trump has done with the Environmental Protection Agency and deregulation, I think it’s clear that he’s already focusing on the logistical side to try to move things along.

As far as we are concerned, as a debt investor the actual US$1 trillion plan doesn’t affect us.

Evans Do you believe the administration will be able to get the plan up and running?

TANYERI As stated, I believe they will struggle to get it through Congress because anything that adds to the budget deficit will be difficult to pass. The only thing that might work is if they offer a 10 per cent tax holiday for some of the repatriated capital from the overseas tech industry.

Potentially president Trump could compromise and siphon off a piece of this for infrastructure investment. As we have seen from the number of executive orders this week, the president has the ability to move things in his direction rather quickly.

BARRAS In my career I don’t think there’s been an administration change in the US that has produced more uncertainty. On the one hand there are things that are potentially exciting, such as regulatory and tax reform and increased infrastructure spending. At the same time, the nationalistic, populist rhetoric could prove to be very counterproductive for the economy if implemented.

Moreover, one has to wonder whether president Trump will be measured and collaborative with his advisers and constituents or intransigent, simply implementing his preconceived policies notwithstanding the concerns of others.

So it’s a little bit wait-and-see. But for us as investors, the core of what we do is to identify good companies within good industries. If we can maintain this ‘true north’, things will work out. We are concerned, but this doesn’t mean we are any less willing and able to invest in this market.

Outlook for the Australian economy

Bill Evans, managing director, chief economist and global head of economics and research at Westpac Banking Corporation, says forecasts for key drivers suggest Australian growth will slow in 2018 before currency depreciation once more comes to the lucky country’s rescue.

SWISS A commodity price rebound helped Australia see out 2016 in fairly decent economic shape, notwithstanding a rare period of negative growth in the second half. What are the most important economic inputs saying about the future trajectory in Australia?

EVANS In 2016 we expected growth to be 1.5 per cent. We expect it to pick up to 3 per cent in 2017, but also that it will slow down again in 2018, to around 2-2.5 per cent.

The mining boom has slowed down substantially – it peaked in 2012 and since then mining investment has been detracting from growth. The key drivers of growth more recently have been exports, services exports such as education, health and tourism, and housing construction.

We expect that housing construction has peaked. It will probably hold its peak in 2017 but will come off fairly significantly in 2018. This is mainly because we are already seeing restrictions on Chinese investment in the Australian housing sector. We expect this will start to show up in the construction cycle by 2018. So construction will be a drag on growth.

The growth in exports will also peak in 2017. While LNG will continue to grow it will be doing so at a slower pace in 2018.

If you add all these things together – a downturn in housing construction, potential risks around exports and a slowdown in Chinese growth that will bring down commodity prices and therefore be a drag on our terms of trade – 2018 doesn’t look like a great year for Australia.
BILL EVANS WESTPAC INSTITUTIONAL BANK

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RATES ENVIRONMENT

Swiss How, if at all, has the ‘lower for longer’ rates environment affected your investment behaviour? Have you been more inclined to go out in duration, for instance, or to use any other technique to enhance return?

PARROTT Most of our investor base consists of insurance companies rather than pensions, so we are much more focused on a spread basis versus looking at an all-in interest rate. We think spreads will continue to be a good portion of the return we’re able to generate for our clients. We are really continuing to do more of the same.

Even though we can’t pump large volumes into liquid buckets, what we do have is our credit rating and the explicit guarantee of the Commonwealth of Australia.

In times of crisis, investors tend to head for the best credit available. I also think it is important to remember that large lines do not always mean actual liquidity for an investor. It does not matter how large the buckets are, the line is not liquid if the investor can’t get a price for the stock. This is what happened in the fourth quarter of 2008.

LYONS For investment-grade private placements, and representative of the lower-for-longer reach for yield, over the past three years we have seen more pension funds coming into the market. These are both defined-contribution and defined-benefit plans.

Yields have been low for so long now that people are worn out by a hold-off approach. In fact, lower for longer has really increased the investor base beyond the traditional insurance companies.

Block What about going down the credit spectrum to enhance returns?

LYONS Investors are always tempted to reach for yield by going down credit, but our view is that it would be a mistake right now to get aggressive. Investors will be better served having some dry powder to employ in future.

TANYERI I think that’s an excellent point. When you think about how far along the US credit cycle is, it has been a long upturn. So the question is would you really step down in credit quality today.

I think most people would have a difficult time making this decision and would rather go out on the curve. Making a curve bet is a lot easier than making a credit bet at this point in time. This is especially true if you think the Federal Reserve is going to raise rates, which would result in some type of inversion or flattening.

HOWLAND We are a little like banks in that we have to think about our assets and our liabilities. But we’re more like banks in slow motion as our liabilities readjust much more slowly. This means we are able to be a little more patient.

There is no doubt that the absolute level of interest rates and the quest for yield, the latter causing a real compression of credit spreads, has been a tremendous opportunity for issuers for the last few years.

Westpac Institutional Bank and Bank of America Merrill Lynch participants

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Swiss Do you see lower for longer continuing to any foreseeable horizon, or does everyone now expect inflation and thus rates to pick up?

PARROTT In general we anticipate a slow creep upwards in interest rates. However, it’s hard to say how long it will take for credit spreads to normalise. With the compression of spreads we are now 90 basis points back from where we were last summer on the 10-year but with yields that are not all that different.

MAHONEY The house view on rates right now at BAML is that the 10-year will get to 3 per cent in Q2 but soften after this, to around 2.85 per cent by year end.

It would be interesting to hear a comment from investors about a related thesis we have developed, which is that as Treasury yields move higher it gives investors some cover to take spreads tighter given the amount of cash they have to invest in the asset class.

BARRAS The consensus view is lower for longer, but I like the BAML forecast of rates creeping up to more normalised levels. I actually think an increase in rates would be positive. This might sound counterintuitive, but central banks have proven they won’t let rates increase unless the economy is on sounder footing.

At this point the outlook for the US economy appears promising and even Europe looks like it may be starting to turn the corner. As such, if economic momentum can be sustained any downside from an increase in rates will likely be more than offset by economic growth.

My main concern is that populist perspectives on tariffs and nationalism could very well result in an increase in rates that is distortive and at odds with long-term economic growth.

However, from our perspective – whether it’s lower for longer, a rational increase to normalised rates or something that is a bit out of the ordinary – our goal is to add relative value. With the public market becoming increasingly efficient, we feel the private asset classes are better positioned to add value – whether it’s private placements or real estate.

One has to wonder whether president Trump will be measured and collaborative with his advisers and constituents or intransigent, simply implementing his preconceived policies notwithstanding the concerns of others.
DAVE BARRAS NORTHWESTERN MUTUAL CAPITAL

Swiss Are there any particular asset classes that you see as having good relative value at the moment? Also, what techniques are USPP investors deploying at an individual-firm level to maintain alpha in this ongoing low-rates environment?

BARRAS Private equity has actually been very good for our group. In combination with investment-grade privates, it provides the other end of the barbell strategy we employ to add value.

Having said this, a couple of years ago we added infrastructure equity and leveraged bank loans to the mix to fill in the barbell. Both these asset classes provide attractive returns and some interesting risk-reducing benefits from an overall portfolio perspective.

LYONS For insurance companies, alpha generators tend not to be in the public asset classes, they tend to be in private placements and real estate. We also have a collateralised-mortgage-obligation arbitrage business that’s relatively unique – in fact you’ll probably find that everyone around this table has something that’s relatively unique. We will stick to what we have always excelled at and take the long-term view.

SUPPLY DYNAMICS

Swiss What about liquidity – is this a concern for USPP investors?

HOWLAND USPP is not really a secondary-trading market. I would say 95-97 per cent of our volume is primary. Where liquidity affects us is the lack of dealer inventory on the street. This means the quotes we get for our relative-value analysis have to be taken with a grain of salt because many times those quoting don’t actually hold or trade the bonds.

LYONS It’s an interesting market, in which we all invest with a buy-and-hold or a buy-and-manage strategy. This means there’s not that much secondary traffic. It masks the sell-side liquidity in the asset class.

In other words, if you need to sell a bond for portfolio reasons – not for credit reasons – there’s actually a pretty strong bid because typically there are multiple holders who are under-allocated to any given credit.

Some people ask why there’s a liquidity premium but I view it as an opportunity-cost premium. We have an excellent public-bond shop that can generate alpha and everyone else here can probably say the same. So when you buy a private you are allocating away from publics, and you’re taking away those total-return mechanisms to generate additional long-term yield. Hence the requirement for the spread premium.

BARRAS It all boils down to the fact that there is three times as much demand as there is supply in the private-placement market right now. As a result, we are scratching around to get every dollar we can and once we get an allocation we are unlikely to sell it. However, with the supply-demand imbalance if you want liquidity on a performing bond there is plenty to be had.

PERENICK We do not view illiquidity as a negative. Barings is a credit-focused shop and we have been investing in the market for a long time with a buy-and-hold focus. Our clients understand that this is unlike the public market and they rely on us to underwrite credits that will weather market cyclicality through to maturity.

To Barings, the easiest way to diminish value in a private portfolio is to employ a trading mentality and exit before maturity. We believe the best way to reap all the benefits of the asset class is to adhere to our key tenets of relative value, diversification and downside protection, and maintain our underwriting strategy with a buy-and-hold focus.

Many companies have done small public deals then watched as their bonds sit out there, don’t trade and have stagnant spread levels. It makes the relative-value discussion challenging for investors when you’re marking to bonds that don’t actually trade.
LAURA PARROTT TIAA INVESTMENTS

LYONS We run a couple of portfolios for defined-benefit pension funds. These clients want to compare the product so they can line it up with their long-duration investing in the public market.

We have to give them very long duration. To do this we won’t buy a private inside 10 years, and when it rolls down to eight years we sell it and reinvest long. So we actually have products that are predicated on our ability to sell without a huge bid-ask spread, and we haven’t experienced any difficulty doing this.

BARRAS We primarily add value on the buy through diligence and structuring with an eye to realising value over the life of the deal, be that seven or 10 years or even longer. The thing that’s interesting about the public market is that there is plenty of liquidity until there isn’t – which usually coincides with some sort of dislocation. Just talk to the people who had energy names a year ago. There was no liquidity.

I think we are very well positioned to add value on the buy and are probably not as good at adding value by calling market movements. All in all it has been a pretty effective strategy over time.

Foreign-currency investment on the rise

US private placement (USPP) investors say an area of increasing value they can offer is the ability to invest in issuers’ home currencies. They predict foreign-currency issuance in their market will continue to grow, particularly as banks are still experiencing difficulty providing swaps.

MONAHAN Another trend we are seeing is the proliferation of non-US dollar tranches, and the more sophisticated investors that can easily work across the various currencies that are liquid or semi-liquid represent a great opportunity. Because right now one out of five transactions has a non-US dollar tranche.

BLIX For Australian corporates, being able to do Australian-dollar tranches used to be number four or five on the list of factors that attracted them to the private market. In the last few years, this feature has become significantly more important in the decision-making process as they consider all-in cost.

LYONS If you go back a decade there were very few foreign-currency tranches done. Whereas in the past couple of years these tranches have comprised 15-20 per cent of the market. My personal belief is it will be hard to grow our market with US companies and in US dollars.

I don’t see our market going away from make-whole and covenants. I don’t think the investors around this table are going to give these up.

Five years from now I wouldn’t be surprised to see 35 per cent of our market issued in foreign currencies. This is the way to grow the market – to disintermediate the local markets of issuers by going longer and now also offering local-currency tranches.

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PARROTT Illiquidity in the public market has actually led some issuers to the private-placement sector. We have seen a lot of activity crossing over from publics, and part of the reason is that many companies have done small public deals then watched as their bonds sit out there, don’t trade and have stagnant spread levels. It makes the relative-value discussion challenging for investors when you’re marking to bonds that don’t actually trade.

But I think this has been beneficial to the private-placement market because companies have seen that if they come fairly regularly, even with smallish deals, this is a great market to access. Investors will take the time to get to know the credit and add to the name over time.

LYONS Towards the end of a credit cycle you start seeing the public markets doing deals that have very little real liquidity. This creates a spread compression for relative value for the private player.

It’s interesting – we have tracked this trend over 20 years and as the spread to public gets down towards bottoming out for two or three years it tends to be a pretty good predictor of a broad-based credit issue. When the public market starts to buy private bonds and call them public, it tends to be a predictor that you have a problem around the corner.

Swiss How are agents managing the supply-demand dynamic?

MONAHAN The structural oversupply of funds is real and consistent. Regarding the issue of liquidity, it only has value when it’s an important part of an investor’s strategy. What investors are saying is they don’t value liquidity as it’s not part of their strategy. Intermediaries take advantage of this a little bit because transactions are created based on what issuers believe we can do for them. This dynamic represents an opportunity to get as close to public-market execution as possible in the private market.

This is our job and it’s the nice, healthy tension we enjoy with all our investors. The trick is that while supply and demand are so far out of sequence, the power is with issuers. We keep looking for ways to bring annual private-placement volume up to US$100 billion.

Swiss Investors have mentioned that when there is so much demand, covenants can get lax and pricing goes heavily against them. How do intermediaries work through these issues?

MONAHAN It becomes very credit-specific and also alternatives-specific. If you’re a European company and you can go to the Schuldschein or the EMTN market, and you have no covenants in your bank debt, you will probably not want to do a covenanted private placement – or if you do it would have to be covenant-light.

What the private market has going for it is very long tenors and the ability to do fixed rate, which most of the world can’t do in size. Even the Australian public-bond market peters out at around 5-7 years while the average maturity done last year in the USPP market was around 13.5 years. The private market can also offer tenors way past these.

The idea of structural enhancements and documentation, and appropriately worded most-favoured-lender clauses, provides one tool we are working with to get companies to issue in what should be a covenant-acceptable format from a practical standpoint.

MAHONEY From an investor perspective we are seeing the degradation of covenants. But equally from the issuer’s point of view the change has been an improvement. Issuers that might have had to give up three meaningful financial covenants 5-8 years ago will now only need to give up two. We’ve seen the introduction of par calls at three or six months, which some of the market will do although some investors are still resisting.

As time goes on I think we’ll see more of this kind of structural embellishment that gives the issuer more flexibility and more optionality. This comes at the expense of investors but the option for them is to decline from investing in bespoke structures and be underinvested.

PERENICK It’s interesting to hear the agent side but, for Barings, covenants – which are part of the deal structure along with credit and pricing – are absolutely key to our investment decision. Covenants offer downside protection and our clients hire us to find deals that offer covenant protections and relative value. We view these as essential features of the asset class and, notwithstanding the demand picture, we are continuing to find such deals to invest in.

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AUSTRALIAN PICTURE

Blix How do you view Australian credit quality relative to other investment options available to you? What is your level of comfort about the three most commonly mentioned risk factors for Australia: the domestic housing market, commodity and China risk, and offshore funding exposure?

BARRAS We are positive on Australia. For us the wild card is always China. Even though it was an even wilder card a couple of years ago, China still has an opaque economy – you never quite know what is happening there.

But we’ve been investing in Australia for a long time and it’s one of the cornerstones of our portfolio. It has performed very well and, somewhat surprisingly, largely mirrors our portfolio overall from a sector perspective.

Our downgrade and workout experience has been more or less nonexistent. If you take a step back and look at some of the challenges for Australia – whether this means commodities or China – there are also a lot of positives. Which economy has performed as well as Australia over the past 25 years? The government regime is good and rational, and the legal system is strong and predictable. All of this makes Australia a good market in which to invest.

PERENICK Australia is a meaningful part of our portfolio, and in fact a growing one. Barings is obviously very comfortable with Australia given our decades of experience investing there. Australia represents 10 per cent of our portfolio and is a major market for Barings as a whole. We have had a local presence in Sydney in mezzanine and bank loans, and plan to add beyond this.

Having a local presence allows us to have timely information on factors such as the health of the domestic housing market, as well as commodity-and China-related risk. Again, at Barings we invest in companies that can weather cyclicality and continue to perform despite challenges.

HOWLAND We are probably a little underweight Australia at this point. I’d say Australia comprises 9-10 per cent. Institutionally we have been macro-underweight metals, mining and resources over the last couple of years. This could well be part of why we haven’t invested more in Australian companies.

Having said this, we are certainly very open to investing in the Australian market. We think a lot about how far away it is and how best to cover the different sectors in what is a very dynamic market, and we dedicate a lot of resources to being informed and being smart without having boots on the ground. It’s a vote of confidence that we can have as much exposure as we do without having people on the ground.

PARROTT We also like Australia and we have been investing in Australia for a long time. We feel comfortable with the country and there are certain aspects of the economy we really like, particularly infrastructure and real estate.

We are more overweight in Australia than some of the investors around the table, because we are underweight in Europe and the UK – which are our other sources of cross-border investment. Almost 10 per cent of our portfolio is invested in Australian companies – it is our second-largest jurisdiction outside the US.

While we are carefully watching the slowdown in China and what this will mean, as well as the lack of transparency there, we will continue to invest in Australasia. What our market does very well is fundamental credit analysis, no matter what the jurisdiction.

We don’t receive a mandate for any particular jurisdiction – we are given a certain amount of money each year to invest and achieve a particular yield. We hope to see every investment opportunity that comes to our market, start with the fundamental credit analysis and go from there.

Investors are always tempted to reach for yield by going down credit, but our view is that it would be a mistake right now to get aggressive. Investors will be better served having some dry powder to employ in future.
CHRIS LYONS VOYA INVESTMENT MANAGEMENT

BARRAS A lot of positive things have been mentioned about Australia. If you look at it from a bigger-picture perspective, yes, natural resources are important, but they are not as big a part of the economy as most people think. Also, if a country’s economy has a natural-resource orientation, it’s best to be lower on the cost curve – which Australia is – and also situated in a region that is growing faster than any other part of the world, notwithstanding one’s concerns about China.

LYONS While we pay attention to the commodity downturn, I think for the asset managers here there probably hasn’t been a lot of direct investment in commodity producers. What we have invested in is infrastructure, which you could say is the throughput mechanism for commodities. So if metallurgical coal prices fall it’s bad, but if throughput through the Dalrymple Bay coal terminals is at an all-time high, your investment is perfectly fine. This is more where our business plays.

Again, this plays to our strength of long-term value and understanding assets through the cycle. We hedge a bit on how directly tied to commodity prices we are.

About 12 per cent of our private portfolio is invested in Australian assets. It has been as high as 13.5 per cent and as low as 10-11 per cent. These are big battleships – they are hard to move. I think Australian issues comprise about 12 per cent of the market.

MAHONEY That’s correct – there was total issuance of US$5.6 billion equivalent from Australasian companies last year, compared with an overall market of roughly US$50 billion. Australia is the second-largest issuing foreign jurisdiction in this sector, after the UK. Of the 15 Australasian deals that were done last year, 10 were real estate or energy infrastructure – either electricity transmission and distribution or transport infrastructure. So it’s a pretty narrow group of industry verticals. This means if any investor had an adverse view on any one of these sectors they would have been underinvested in Australia last year.

TANYERI To echo everyone’s comments, what market has been through the Asian crisis, the tech crisis, the 2009 financial crisis and the commodity bust, and come out relatively unscathed? Australia is a tremendous market that has been incredibly resilient.

LYONS A few years ago our then fixed-income chief investment officer, who is now our chief executive, was at this conference. One economist told him Australia is a country the size of the US, there are 22 million people, and when you get over a mountain range and you stick a shovel in the ground you come up with something that somebody else wants to buy. This dynamic of natural wealth having to support a population that is so much smaller is a huge inherent advantage over the long term, for Australia over other countries.

AUSTRALIAN OUTLOOK

Evans Would it bother you if the Australian sovereign was downgraded?

LYONS If Australia was downgraded to double-A it wouldn’t change how we approach the market – at least for the private-placement business.

TANYERI I agree. I think a downgrade will probably happen, however it won’t deter us from investing in the country.

If you look at the Ross-Navarro plan in its entirety, it is a tax-incentive plan that really would stimulate more equity in the infrastructure sector. But when we talk to a number of our equity partners they truly believe there’s already sufficient equity out there.
JOHN TANYERI METLIFE INVESTMENT MANAGEMENT

LYONS The thing we’ve never been able to quantify is that mortgage laws in Australia are different when it comes to recourse to the individual.

If there is a bust in prices what happens in Australia will be very different from what happened in the US. Here, everyone thought home owners would continue to pay on their houses but they didn’t – they just gave the keys back. This gave people continued discretionary spending or income through the crisis. If US mortgages had been recourse back to the individual during the financial crisis, the downturn would have been deeper because people would have kept paying on credit cards.

Whereas in Australia, it will come back to the individual. So if there is a bust and people have trouble paying their mortgages, will the behaviour be ‘I have to continue to pay this’? In this case it will be a heavier effect on discretionary consumer spending and other businesses.

This is something that makes me a little bit nervous, and we have tried various ways to try to quantify it. It’s pretty hard – if there is a way to quantify it I would be happy to hear about it.

EVANS One of the safety valves is that serviceability – the proportion of income required to service debt, where the debt is based on a median house price – is at a record level at the moment because interest rates are so low. The kind of scenario I’m pointing out is that the interest-rate story in Australia is likely to be quite different from that in the US, in terms of the floating rate. In Australia 90 per cent of mortgages are floating rate, so any stress from interest rates seems a long way off.

One of the issues, however, relating to the point I’ve made about Chinese involvement in the residential housing market [see box], is that the Chinese can only buy new developments. Foreigners cannot buy existing property. The reason for this is that if you allow foreigners to buy existing properties they will drive up the price. Whereas if you only allow offshore investors to involve themselves in new developments, you will get some construction activity going.

This is how it has worked. But what it means is that there is now a two-tier market. The Chinese are bidding up the price of new developments because they can’t buy existing houses, but rational locals are staying in the existing side of the market because they don’t want to compete with the Chinese.

If we ever had a situation where the Chinese had to pull out en masse, the part of the two-tier market that these buyers are holding would likely come down pretty sharply. Having said this, it still only represents about 8 per cent of the market so it’s unlikely that it would trigger a massive housing bust.

The only thing that would trigger a big housing bust would be some kind of shock to the labour market. The scenario I have painted, of slowing growth in 2018, means unemployment will probably lift to 6 per cent from 5.5 per cent. In our simulations, we only start getting concerned when unemployment gets up to 11 per cent. It’s very hard to see a scenario that would lead to this kind of a rise.

The thing that has protected Australia through a lot of crises, particularly the Asian crisis, is the flexibility of the currency. During the Asian crisis the Australian dollar went to the low US$0.50s. This means we have protected ourselves from any huge shock to our export markets. I see a mini version of this happening in 2018, and this will probably sow the seeds for the next recovery.

Tanyeri Do you see the unemployment rate being the most significant factor for Australia? We are interested in whether it is tempered or exacerbated by the underemployment rate.

EVANS The underemployment rate has been rising while the unemployment rate has been falling. This has been the result of part-time jobs representing all the jobs growth. One of the factors is that Australia has pretty rigid labour laws. Businesses find it very difficult to fire someone under the labour laws, so it’s much better to have part-time workers.

What we don’t have is conditions in the economy that cause businesses to think they have to invest in employment because they might lose market share. It’s a problem in the world – and it’s why the US might well have tapped into a rich vein in the sense that businesses might start to feel this way, which will mean the cycle takes off in terms of more investment, more employment and more competition. In Australia we are a long, long way from being in this position. A big part of the reason is the rigidity of the labour laws, which unfortunately is unlikely to change.

The other big problem globally has been the flattening of the Phillips curve – whereby the level of wage inflation for the level of unemployment is way out of line. We are currently getting wage increases of less than 2 per cent, while the unemployment or the underemployment rate tells us increases should be 3.5 per cent. Everybody is dissatisfied with the lack of growth in their income, which is the other reason why there is a soft consumer story. What this means is that consumer spending is unlikely to fill the gap when the housing market turns and the export story starts to slow.

Where liquidity affects us is the lack of dealer inventory on the street. This means the quotes we get for our relative-value analysis have to be taken with a grain of salt because many times those quoting don’t actually hold or trade the bonds.
POST HOWLAND NEW YORK LIFE INVESTORS

USPP TRENDS

Block What, if any, trends are USPP investors seeing in their credit mandates? For instance, are your clients’ typical expectations on liquidity requirements, absolute-return thresholds or anything else showing any sign of changing?

BARRAS I can’t say there have been any radical changes in our investment strategy as a company. A constant theme has been to do more in the private asset classes – whether it’s investment grade, below investment grade or infrastructure. We expect to maintain our longer-term strategy of seeking relative value and investing in good companies.

We are really looking to drive alpha by investing in less liquid asset classes. Interestingly, last year pure-vanilla transactions represented only 40-45 per cent of the private-placement market. This shows that we are doing things that other markets just won’t do – whether it’s delayed draws, currency trades, projects, pseudo-projects, and so on. There are a lot of ways you can add value in this market and we are uniquely positioned to exploit this.

PARROTT I agree. As an institution, we’ve gone from investing around US$1.5-2 billion a year in the private-placement market to more than double that over the past five years.

Our entire private-capital and alternative-investments platform is where we are seeing the most interest from our general account clients given where Treasury yields are today. This demonstrates TIAA Investments’ commitment to this asset class. But it also underscores the value we bring to an investment programme through our fundamental credit research and insights that help us identify investments where there is good structure and relative value.

PERENICK Barings has not changed its strategy. We are focused on spread rather than all-in yields and continue to want to invest more in this market. Private placements have always been important for our clients as they are well matched to long-duration liabilities and offer downside protection, diversification and relative value.

As a result, we have doubled our private-debt portfolio since 2012 and are being asked to further this growth. In short, it is an asset class that has had good performance, that we know well and that our clients want to be in. So we are continuing to look for opportunities.

LYONS What the market does well is that we are very good at getting paid for understanding complexity, as opposed to just taking more risk to get more yield. Whether this means complexity regarding a difficult credit story you have to dig into or a contract monetisation where you need to have the legal resources to ensure you have access to cash flows, this market and all the participants around the table are good at it. We have been good at it for a long time, and this is ultimately where we make our money.

Everyone will do utilities and plain vanilla. But we will differentiate ourselves on investments where we are being paid to understand complexity.

HOWLAND Like everyone else here, we would love to do more in this asset class. This would be our objective every year. I think of 2016 as the year of the pep talk in a way, because our deal teams were so often disappointed trying to get into transactions, things were priced to perfection and there were rarely covenant changes.

It’s a very difficult market for investors – not just the macro side of it, because we are paid to take risk. But it’s also difficult in the sense that allocations and access to this asset class are still very scarce.

TANYERI Strategically it’s a pretty similar story at Metlife Investment Management. We are continuing to grow the asset class. Our privates portfolio is approximately US$58 billion in total, and we invested US$10.5 billion in 2016. It’s a coveted asset class for the reasons we have all discussed.

We have had really good economic times with slow and steady growth, but where this asset class really shines is in the downturns. It’s the downside protection that is afforded through our covenants and make-whole fees that helps differentiate privates from other asset classes. This is why it so appealing to a number of third parties that are becoming interested in the asset class for the first time.

The real truth and test of it is where the intermediaries can really understand what their clients need and then, with our help, design a customised financing that best suits the issuer. This could be through natural currency or longer tenors – whatever it may be, the ability to offer something that is unique can really differentiate this asset class from any other. The group of investors here has the ability to do this – understanding and structuring complex transactions is part of our DNA.

BLIX The outlook for Australasian issuance in 2017 remains positive. We are seeing a healthy pipeline of transactions across a number of sectors for the first half, including a number of debut issuers.