Bringing in the buy side

Finding and executing genuinely innovative funding solutions has been a major focus for National Australia Bank (NAB) in recent years. To make this strategy work, the bank aims to shed light on a critical component of funding innovation: understanding investor preferences and connecting them with assets that may not be available elsewhere.

DISCUSSION CONTRIBUTORS
  • Adrian David Head of Credit Research MACQUARIE INVESTMENT MANAGEMENT
  • Andrew Gordon Director, Debt Markets NATIONAL AUSTRALIA BANK
  • Keith Jones Senior Partner and Financial Adviser AFFINITY WEALTH SERVICES
  • Mihkel Kase Portfolio Manager, Fixed Income SCHRODER INVESTMENT MANAGEMENT
  • Anne Moal Senior High-Yield Analyst PERPETUAL INVESTMENTS
  • James McNabb Portfolio Manager AQUASIA
  • Mark Todd Head of Portfolio Solutions NATIONAL AUSTRALIA BANK
MODERATORS
  • Helen Craig Deputy Editor KANGANEWS
  • Samantha Swiss Chief Executive KANGANEWS

NAB has been at the forefront of understanding the changing role of banks in corporate funding for some years. With balance-sheet capacity at an increasing premium, NAB moved early to align its corporate-finance business with borrower priorities. Its aim has been to provide funding solutions based on a genuine understanding of borrower needs and goals, in doing so moving away from a product or balance-sheet focus.

“It used to be that banks would just use their balance sheets for corporate funding, but we can no longer do this to the same extent,” says Mark Todd, Sydney-based head of portfolio solutions at NAB. “For us, this has led to a focus on thinking about how we bring customers to customers.”

The starting point, Todd explains, is the fundamental change taking place in the banking sector. This has led NAB to reassess its relationship with buy-side clients, based on the idea that the bank’s job is now to play a role between customers of all stripes. “In the past the bank worked more around how to sell particular products – whether they were mortgages or credit cards, or corporate bonds. Our business used to be product-focused, where now it is relationship-focused,” Todd says.

Over the course of the past 18 months, deal flow has reflected this approach more than ever before – in the form of increased volume of more bespoke debt transactions for unrated issuers, and in enhanced visibility of less cookie-cutter transactions in general.

Perhaps the most significant facilitator of this proliferation has been the evolution of the Australian investor base. This has come in two forms, both of which have emerged gradually but with increasing visibility when it comes to being the catalyst for successful debt deals.

One is the growth in scale of the noninstitutional bid. The other is the willingness of institutional funds – even the largest, most  traditionally mainstream funds – to engage with less liquid, more bespoke, often smaller and generally higher-yielding asset classes.

Noninstitutional demand in Australia is gradually developing from its traditional fixation with equity and
property, supplemented by term deposits as the only significant fixed-income asset. An ageing population is seeking income certainty at a time of dawning post-crisis awareness of sequencing risk and the dangers of insufficient portfolio diversification. These self-managed investors are increasingly asking advisers for fixed-income direction (see box below).

Noninstitutional investor interest continues to grow

The root cause of noninstitutional-investor interest in high-yield fixed income in Australia is this cohort’s increasing appetite for fixed income overall. The search for consistent income, capital security and asset diversity is leading a growing segment of the self-managed sector to explore, and allocate to, debt product.

CRAIG What is causing noninstitutional investors to seek out high-yield fixed-income product?

JONES There are a few things happening. There has been a hunt for yield, which has bid up all asset prices. At the same time, increasingly our clients are aware they have to move away from traditional asset classes like equity and property to generate income flow. This is particularly relevant for the retirement cohort and, for our business, for income matching in the aged-care space. The bottom line is there is underlying demand for this asset class.

The institutional-investor element appears to be more a case of the bespoke-transaction segment gaining critical mass than of investors having damascene conversions on their own account. Fund managers say they have always had appetite for high-yielding product, but today’s banking environment is bringing more supply to their doors (see box below).

Institutional-investor motivation

Australian fund managers agree that the changing shape of the bank business model is supporting higher-yielding opportunities. Their own appetite for such product is also growing.

CRAIG What appetite do institutional investors have for unrated bonds?

MOAL The way Perpetual Investments has approached high yield – and why I was hired – was as a complement to existing strategies. I do not have a dedicated high-yield fund at the moment – instead there are a couple of funds into which I can put investments. Some have up to 10 per cent invested in high yield, one has up to 50 per cent.

What appears to be emerging is more consistent support for transactions that historically could not have reliably found substantial liquidity in the Australian dollar market. NAB has arranged or lead-managed two deals of A$300 million (US$238.3 million) or more from unrated issuers since September last year (see chart below), and the bank’s Sydney-based director, debt markets, Andrew Gordon, says volume outcomes of this nature have alerted additional borrowers to the burgeoning domestic capital-markets offering.

“I have met companies that only took the meeting because A$300 million is a size that looks relevant to them – for the first time,” Gordon reveals. “Equally, there is an education process as some unrated issuers are often new to the debt-markets space. But many issuers are highly engaged and interested in the bond solution.”

The capital-markets history of one of these unrated borrowers – NEXTDC – gives an even clearer illustration of growing liquidity for this type of transaction and the virtues of persistence on the part of issuer and arranger. NEXTDC has issued three bond deals since 2014, increasing its ambitions going into the execution process and its final volume outcome on each occasion (see chart above). In part, this reflects the rapid growth of the issuer – but it also speaks to emerging demand.

Gordon says the most notable feature of market evolution NEXTDC’s 2017 transaction exposes is the growth in institutional demand for the right unrated product. The deal’s book included 11 institutional investors – all of them what Gordon describes as “typically buyers of investment-grade, rated MTNs”. He adds: “This is how we hoped the unrated market would develop – with a combination of institutional and noninstitutional buyers active in the same deals – and it is clear the institutional sector is starting to arrive in size.”

“We are naturally self-selecting the issuers to bring by volume – we want more A$100 million-plus issues so
everyone can be rewarded for the time they have to invest in doing the credit work to participate in these
transactions.”

The right product

Although NAB’s strategy is product agnostic, Gordon says in the interests of maximising liquidity for less
mainstream bond-market issuers it helps to offer the investor base a relatively familiar product format. He explains that the larger, public deals NAB has worked on are designed to be tradeable through Austraclear – and that these sit atop another set of smaller, privately placed and genuinely bespoke transactions.

In this way, the public high-yield market in Australia is about increasing the visibility of local liquidity pools by funding what is a relatively small group of corporate borrowers with suitable credit profiles and borrowing needs. Gordon reveals that the most likely source of high-yield issuance in Australia is companies with growth ambitions in the top 300 listed names – but in all likelihood outside the top 100.

“What we are trying to do is bring transactions in a bond format that can be traded,” Gordon says. “In this context we’re not even talking about institutional loans, which are less liquid still than unrated bonds and cannot access broader investor channels.”

The signs are that investors are meeting half way on the liquidity issue. They report that they are getting on the front foot when it comes to conversations with their clients about the nature of liquidity and the value of illiquidity premia (see box below). When these conversations have positive outcomes, investors can more comfortably allocate to product they expect not to offer reliable liquidity.

Liquidity: a frank and realistic approach

Investors – both institutional and noninstitutional – say the best approach to managing their clients’ liquidity expectations is to be clear about what the nature of realistic expectations should be. The hope is that doing so will help prevent irrational behaviour even under stressed market circumstances.

SWISS It is generally assumed that high-yield product is generically less liquid than investment-grade bonds. Is this a fair assessment, and if so how do different types of investors manage liquidity and discuss it with their clients?

MCNABB We are very careful to educate our clients on liquidity, especially the fact that a component of the returns we’re generating come from buying things that aren’t liquid. We’re managing expectations in this respect.

The emergence of consistent deal flow in 2016 and 2017 is the product of significant background work. The real heavy lifting, market participants acknowledge, has come over the past three or four years. Todd says NAB has been having indepth conversations with selected local institutional investors over this period, to work on mutually acceptable formats for documentation and deal execution.

“We started talking to institutional fund managers, and from that engagement they started asking how to be involved with this market on an ongoing basis,” Todd reveals. “We have taken institutional investors along for the ride – we took their views and preferences to issuers, and also focused on establishing the credibility of the names we planned to bring to market.

“In the past the bank worked more around how to sell particular products – whether they were mortgages or credit cards, or corporate bonds. Our business used to be product-focused, where now it is relationship-focused.”

Anne Moal, senior high-yield analyst at Perpetual Investments in Sydney, says her re-entry to the high-yield market three years ago coincided with a new level of energy in the sector. “It was really exciting to come back at that stage because it was the first time – after being in Australia for more than a decade – that I could see banks had an incentive to develop different products, because of the capital costs of keeping their corporate clients,” she comments. “Meanwhile, the financial crisis showed to corporates that funding solely via banks wasn’t always a good thing. There were incentives for everyone to consider the unrated market more seriously.”

Where high-yield product differs from more mainstream Australian debt offerings is the nature of the credit process investors go through to develop comfort with assets’ creditworthiness and pricing (see box below). What may be starting to develop is an Australian equivalent of the US private placement market – at least in the sense that institutional investors expect to be much closer to their borrowers on an ongoing basis in the high-yield realm. Credit analysis in this sector is weighted much more to understanding a company’s vision than is the case for investment grade.

Inside the high-yield credit process

Investors, both institutional and noninstitutional, say a close understanding of high-yield borrowers’ corporate strategies is critical in this market sector. Leveraging wider credit-analysis resources and applying shadow ratings to facilitate the deepest possible understanding tends to be a speciality of the institutional space.

CRAIG When considering unrated issuance, are investors looking for debt with an investment-grade profile even if it is from an issuer that for whatever reason has chosen not to seek a formal rating?

DAVID We have looked at companies from a low triple-B down to, say, a single-B type profile. Our appetite is based on this profile, so we need to maintain a shadow rating of what we think the rating profile is.

Gordon is keen to encourage this sort of issuer-investor engagement, in line with NAB’s view of itself as a facilitator. He explains: “We take comfort that institutional investors do their work ahead of deciding to invest at a certain price. At least 30 per cent, give or take, of our high-yield books goes to institutional investors and we’re happy to see that we’re not just pushing a price out there. There are sophisticated analysts crunching the numbers on a shadow-rating basis.”

This type of evolution in the institutional investor base supports the kind of wider market development NAB is championing. “We don’t actively pursue sub-A$50 million transactions,” Gordon explains. “This means we are naturally self-selecting the issuers to bring by volume – we want more A$100 million-plus issues so everyone can be rewarded for the time they have to invest in doing the credit work to participate in these transactions.”