Market Insight


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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