News and Insights

With Australian credit the in-vogue topic, there is no shortage of compelling pitches for why to invest. Lending against residential property or to high-quality businesses, what could go wrong? Thankfully for many, very little of late. Although that partly is due to the favourable market conditions, including rising property prices, which have seen unimproved properties typically sell for more than they were purchased for with business conditions remaining strong. We are not anticipating a sharp turnaround in the asset classes’ fortunes, although there are some areas where risk is pooling that investors should watch out for.

Before wading in, it’s important to remember that these risks can be problematic in isolation or in combination. We view many current market participants overlooking these aspects, as frankly, they haven’t been bitten by them in the last 30+ years (since the early 90’s recession). This is why we have prioritised industry tenor in managing these assets, leveraging the extensive track records of our Investment Committee with members that predate this buoyant era.

Areas where risk is pooling

1. Loans where the exit is unclear: when making any credit investment, the exit must be clearly understood. Ideally, this involves some verifiable avenue rather than a ‘refinance’, which, by nature, is difficult to forecast as lending conditions or the fundamentals on which the lending decisions are made can change. For example, if the business is no longer profitable, a refinance of a business loan becomes challenging. That risk grows based on the tenor of a loan, given it is more difficult to forecast further into the future. I.e. a 1 year loan is far less risky than a 5 year equivalent. Other elements include security for the loan, with liquid hard assets like property, wheeled assets (cars, utes etc) providing a far more robust primary or secondary exit. Crucially here, there needs to be confidence around the future value of the asset. More recently developed technology assets like electric trucks or new solar panels present significant downside risks if the technology fails, as it can, and the security is worthless. The same can apply to construction finance, where the future value, either as a performing project that was completed on time and on budget or a problematic project that wasn’t, is unknown. Large loans or loans in areas where few lenders participate reduces the ability of a refinance and, therefore, on a like-for-like basis, are riskier. This risk can compound when loans do not need to be paid down over the term of the loan and only require interest payments (not amortising loans).

2. Documentation risk: when credit markets are propelled by strong economic fundamentals and shrinking credit spreads that push the face value of credit assets higher, it’s rare to hear of skirmishes between lenders and borrowers. Afterall, everyone is happy, with lenders and investors receiving strong returns and borrowers benefiting from cheaper financing. At some stage, that harmony will no longer prevail due to a borrower or lender issue at which time, parties will need to revisit the legally documented agreements to assess their rights. In some cases, this can expose previously overlooked elements which either party could potentially exploit, typically the borrower. Recent examples include the borrower attempting to change/reduce the security pool that supports the loan and allowing further debt to be taken on (for example as reported, Pluralsight in the United States and GenesisCare locally), which can include new parties who may not have much alignment of interests with current debt holders. For example, those new lenders may trigger a default to open up all possible avenues to get their hands on any assets available, with a recent unconfirmed example playing out in Australia.

3. Highly subordinated assets: it should come as little surprise that subordinated assets primarily in the form of subordinated notes in securitisation transactions, subordinated corporate debt or second mortgages against property assets shall be a natural collection point for risk. Very simply, when investing, you need to ensure the party negotiating or making the investment decisions has significant, relevant longitudinal experience and truly understands the investment and how it will perform today and in a less kind environment.

4. Fraud: while fraud is extremely uncommon, it is part of every financial market including even the most highly regulated markets. In our experience, Australian credit markets are well developed, with significant industry experience learnt from isolated examples, which has developed specific controls and monitoring practices which should not be discounted. Irrespective of where you invest, a keen eye for telltales and domain knowledge around current industry best practice controls remains paramount.

Seek out deep understanding and experience

The purpose of these points is not to suggest that credit does not have merit—quite the contrary. Rather, it is to underscore the importance of skilled, highly experienced teams in navigating these risks effectively to extract the full value from the asset class. Too many see credit investing as a simple investment endeavour, but it requires a deep understanding and experience to manage the potential challenges. It is also one where high historical returns may be manager skill or simply, excessive risk taking. We believe if you are a specialist with deep domain expertise and have been around long enough to understand risk, these compelling pitches can translate into attractive returns over time.

As we take a broader look at Australia’s current economic position, we recognise some typical signs of a contractionary phase, such as a softening labour market, higher interest rates, and changing business conditions and sentiment. Historically, Australia’s economic contractions from peak to trough have averaged three quarters, followed by an expansion phase lasting around 15 quarters on a GDP per capita basis (Melbourne Institute Phases of the Australian Business Cycle, January 2024). With the last peak in December 2020, we are now considering when we might reach the trough and see more accommodative policies, including a lower RBA cash rate to support employment and business conditions.

The labour market will be a key indicator in this process. A tight labour market has been a significant factor in driving services inflation, which affects various sectors like healthcare, education, and hospitality, as well as consumer spending. As this dynamic shifts and households face fewer employment opportunities or lower incomes due to rising underemployment and unemployment, we expect inflationary pressures to ease, setting the stage for potential monetary policy easing and a lower RBA cash rate.

Government spending and fiscal policy will also play a crucial role in shaping employment conditions. While incremental spending may delay monetary policy easing, it’s important to balance economic perspectives with societal needs. Currently, we view fiscal policy as accommodative, which may postpone an RBA cash rate decrease.

We have observed many companies implementing cost-cutting measures and redundancies, with recruitment agencies reporting a weaker appetite for new hires. Among the circa 36,000 loans we monitor monthly, arrears rates are slightly increasing but remain within acceptable limits for all positions in the Fund. These observations, though anecdotal, align with our view and are likely to be reflected in widely discussed market data in the coming months.

We believe the conditions for RBA rate cuts are gradually forming. As noted earlier, it will take time for the data to confirm this and for the RBA to gain confidence in adopting a more accommodative policy in the medium term.

From the Fund’s perspective, this outlook calls for heightened sensitivity to areas most affected by weakening GDP, employment conditions, and contractionary policies. Our cautious approach, maintained over the past 18 months as we exited consumer loans in the portfolio, ensures the Fund’s resilience in navigating economic challenges. The Manning Monthly Income Fund has an unwavering commitment to offering investors a truly ‘through the cycle’ investment proposition, focusing on capital preservation and delivering a strong, consistent monthly income stream.

Examining the Australian economy, the case for the RBA cash rate falling in the near term remains overstated. In early 2024, we outlined two-way risk for the RBA cash rate (a chance it may rise or fall), with the likelihood of an increase fading although not dismissed. For credit investors, it remains essential to exercise caution in sectors most affected by the higher RBA cash rate and cost of living pressures. Most notably, consumer loans, which the Fund has not held for over 12 months, and construction finance/property development which the Fund is completely precluded from investing in due to the cyclical and high-risk nature of these investments. Furthermore, the case for active management, as demonstrated by the fund’s track record and varying sector exposures through time emphasises the importance of shifting away from certain market areas towards those that generally present lower risk, thereby achieving better risk-adjusted returns.

In the prior month, we assessed 14 opportunities for inclusion within the portfolio with strong market activity. These opportunities include transactions where our higher yielding fund can provide further credit support to the Manning Monthly Income Fund, lowering the investment’s risk profile.

During the month, we changed our External Valuation agent from Eticore to Nuwaru, who acts as our tax advisor and shall be complemented by an additional specialist provider in the coming weeks.

The Fund continues to grow its client base of high net worth and smaller institutional clients, resulting in further investment portfolio diversification.

The growing prevalence of credit or private credit within investor portfolios has materially contributed towards a better understanding of the asset class. As mentioned in our prior month’s commentary, investors now appreciate that credit isn’t homogenous but rather made up of differing risk-return subsectors. It has also led to investors being more skilled in asking the right questions of fund managers that operate in this space, which helps them discern who is swimming with their swimmers on and who is either blissfully unaware or neglecting to check (a reference to the Warrens Buffets quote ‘Only when the tide goes out do you discover who’s been swimming naked’).

Over our 8 years, we have suggested that investors scrutinise any potential credit fund manager by understanding, as a minimum, the following areas.

1. What does the credit fund actually invest in and am I comfortable with the risk profile of those assets? Are you financing an asset that in a variety of scenarios can be relied upon to repay the initial loan? This may involve lending to a good quality company which has predictable, stable, long-term revenue streams, a quality project that, even if it is not prima facie successful, has a residual value that can be realised or, in our case, a sufficiently robust pool of underlying loans which can be paid down to extinguish our investment amount. This assessment is the most important factor for investors, as it is the most influential factor driving potential investment outcomes.
2. What fees is the fund manager charging and how much alignment does that create between fund manager and underlying investors? Notably, does the fund manager charge fees upfront which are not passed through to investors which we believe does not create alignment? We believe only through alignment, can investors get sufficient comfort that their money is in safe hands.
3. What other incentives does the fund manager have? Are they exclusively incentivised based on the quality of the investor outcomes, or is investor capital boosting the value of the fund manager’s equity in another company? With unlimited upside for equity holders, it’s irrational to believe that those with the lending decisions will not be distracted at best or inappropriately incentivised at worst when they determine how that investor capital is used if they hold equity in the company receiving the funding.

(Our response to the above would be 1, Manning invests in a range of asset-backed portfolios which we quantitatively and qualitative assess to determine their reliance and overall credit quality. We regard this as our core competence. Despite 8 years of various cycle dynamics, we have never had a negative return from credit. 2, All fees are charged at the Fund level i.e. we do not receive any upfront fees, with our fees including a small performance fee element. We believe this structure creates the greatest alignment with investors. 3. Manning has a strict Conflicts of Interest Policy and as a guiding principle, does not take equity positions in underlying lender businesses given the innate conflicts it creates.)

As a final point, we have been impressed by the sophistication of the Australian financial advice ecosystem. We regularly face very detailed and on-point questions about our strategies. Should an investor not be confident about the answers to any of the above questions for a fund in which they invest, then we urge those investors to reach out to their trusted adviser. Seeking advice can provide reassurance and ensure you invest with a fund manager who can perform when the tide is both in and out.

As the Australian credit markets continue to grow, investors will continue to become more discerning, which, in our view, will only enhance the attractiveness of the asset class and the quality of the fund managers who succeed in it.

The Fund delivered +0.79% in May, 9.56% over 12 months and 6.94% annualised since inception (April 2016), continuing to deliver over 5% net return above the RBA cash rate.

In our eight years, credit has never been a more in favour asset class than currently experienced. Investors are drawn to the potential for higher absolute expected returns, given the higher cash rates globally, capital stability vs other asset classes, and the need for income in their portfolios. Most encouragingly, the asset class is no longer viewed as a single bucket, rather, there are underlying sectors along a risk/return continuum, much like what is seen in other asset classes. By understanding these credit sectors, investors can be more discerning about how they approach credit and identify the area best suited to their objectives.

In our view, within private markets, three main credit subsectors are prevalent within Australia, each with unique investor considerations.

1. Non-investment grade corporate loans: Companies who view credit funds as an alternative to seeking finance from a traditional bank. As a traditional bank is typically cheaper than a credit fund, these companies may look to such funds when they are outside the appetite of traditional banks, either due to credit or non-credit reasons, e.g. ESG related reasons, or the company simply wants a more flexible or timely solution. Lending decisions of the credit fund are based on the fundamentals of the company, which inform the risk/attractiveness of the loan. Leveraged finance is common within this sector, as it provides loans to assist private equity firms in purchasing companies that use significant debt capital to do so. While banks do play in this space, the key challenge in this sector is diversification as investor capital can be spread across a limited number of larger deals, meaning any one event can be impactful, and the chance of capital loss heightened if the company taking out the loan fails, given there can be few assets left to repay investors.

2. Construction finance: Involves lending to Property Developers to acquire land, seek planning approval to change or enhance the use of that asset, construct or redevelop and then sell the finished product, with financing being either a part of this process or in its entirety. Australian bank’s appetite for such lending varies significantly given the macroeconomic outlook, as highlighted in our article Elevated Stakes: Assessing the risk premium of construction finance. Lending decisions are based on the likely value of the project once completed rather than the fundamentals of the property developer’s business. Its risk profile and challenges are akin to those of the prior sector, which is around diversification and higher loss given default. Most importantly, we see Construction Finance and Non-investment grade lending as having cyclical characteristics, which can be more problematic if an investor doesn’t have diversification in their holdings (i.e. 100+ underlying loans).

3. Asset-backed securities: This involves providing wholesale finance to banks and non-banks so that they can originate loans themselves. The underlying loans secure these asset-backed securities, and thus, lending decisions are primarily made based on the quality of the lender and the underlying pool of loans. For example, a residential mortgage is viewed more favourably than an unsecured business loan on a like-for-like basis. Manning is a specialist in this sector, as it can offer yields that are nearly equivalent to those of other sectors, although it is far more robust in nature and less cyclical in its performance. For example, if the lender who receives the financing defaults, a more readily available pool of underlying assets can be realised to repay the debt. The key challenge in this sector is access to opportunities as lenders discern who they will share their information with and work with. Asset-backed financing has a long history in Australia and Manning utilise all available historical performance data which affords us the ability to robustly back-test pools of assets against future possible economic scenarios.

Across all sectors, the terms that govern how the money is extended to the recipient (company, property developer, or lender) are very important and vary significantly in nature. Manager skills via an established team with decades of experience in the space remain of the utmost importance.

As an investment house, we believe the level of capital stability an investor achieves will ultimately be based on the level of assets backing that loan. In this regard, asset-backed securities offer the strongest level of investor protection, followed by construction finance and then non-investment grade corporate loans providing the least.

At Manning we prioritise capital stability ahead of all else, a testament to this is the Fund’s 8+ year track record that has resulted in no negative months from credit/loss of capital. We are pleased to report the Fund’s portfolio of assets continues to perform strongly, and we believe, is well positioned to continue delivering strong income returns with capital stability.

The Fund delivered +0.86% in April, 9.57% over 12 months and 6.91% annualised since inception (April 2016), continuing to deliver over 5% net return above the RBA cash rate.

We are pleased to report the Fund’s portfolio of assets continues to perform strongly, and we believe, is well-positioned to continue delivering strong income returns with capital stability. Despite the Fund’s higher expected returns, our approach to risk management remains unchanged.

Monetary Policy and global cash rates once again dominate mainstream media, with no shortage of market commentators voicing their perspective. As discussed in our article ‘Arrears rising, should credit investors be concerned?’ published mid-March, we outlined the ‘two-way’ risk within the RBA cash rate setting: the chance that the RBA cash rate could rise further. More commentators now subscribe to this view, moving away from the near-unanimous belief that rates will be imminently cut, citing a material possibility that interest rates could rise further.

Investors are keen observers of interest rate settings and likely changes, given their impact on asset prices such as shares and bonds. As short-duration investors, we are not relying on correctly picking interest rate movements to drive our returns, instead, we focus on what these changes mean for the health of the Australian economy, i.e., what they say about the bigger macroeconomic picture and its implications for the Fund.

In the previously mentioned article, we explained that factors like low unemployment, low productivity growth, and high wage growth contribute to inflation over time. These slow-moving drivers of inflation take time to appear in inflation data and eventually subside. As a result, we believe the RBA cash rate will remain elevated for some time and financial challenges to continue. In other words, households and businesses experiencing financial stress now have a long road ahead before economic conditions improve.

From a credit investor perspective, given this outlook, higher quality loans and counterparties in non-cyclical areas must be favoured over assets that offer marginally higher yields.  We acknowledge that further incremental yield may be left on the table by not taking such risks, although, on a risk-adjusted basis, such decisions are prudent and consistent with our strong focus on capital preservation and unblemished 8-year credit history. As readers will be aware, the bedrock of the Fund’s investment strategy has always been to find and invest in assets that we believe will perform through the cycle. By maintaining portfolio discipline and quality, should conditions deteriorate further, an investor in the Fund is better placed to maximise the ‘through the cycle’ return potential of the asset class.

We are pleased to report a strong pipeline of new assets being considered for the Fund, with mortgages and, to a lesser extent, business loans being our preferred areas, given their powerful capital protection features. Consumer loans are less favoured.

Josh Manning, Portfolio Manager and Founder presents the Q1 2024 market update for Manning Asset Management.

The Fund delivered +0.74% in March, 9.49% over 12 months and 6.87% annualised since inception (April 2016), continuing to deliver over 5% net return above the RBA cash rate.

Past performance is not necessarily indicative of future performance. Returns are net of fees, excluding tax, and assume reinvestment of all distributions. Returns greater than one year are annualised. Inception: April 2016.

As we conclude Q1, Founder and Portfolio Manager Josh Manning summarises key themes discussed with clients throughout the quarter as below.

Portfolio Performance Review

Over the past 12 months, the fund has delivered a return of over 9.49% net of fees, with approximately 9% of that being delivered as an income-based return to our investors on a monthly basis. This performance is consistent with the return objective and philosophy of the fund. On a monthly basis, these returns have been in a very tight range from 70 to 80 basis points. We have stayed true to our label in delivering consistently over an 8-year period on our RBA cash rate, plus 5% net of fees return objective. Taking a longer-term perspective, we have exceeded that return objective by approximately 50 basis points across all time periods. This performance demonstrates our commitment to managing the risk profile in a range of economic scenarios.

Our investment model is centered around asset-backed securities or asset-backed financing. Manning provide finance to non-bank lenders in the Australian market, which is secured by a range of underlying assets that support our capital. In the event of a downturn, these assets can be used to repay our capital and interest. Over the past few years, we have focused on increasing asset security at the underlying level. This means we are seeing particularly attractive risk adjusted returns and are predominantly focused on mortgages, typically residential and in some cases, commercial. If the wholesale pool of many underlying loans fails to perform, those underlying loans are supported by a relatively low LVR property that can be sold to repay our capital. Through these security measures, we have consistently delivered on our return objective and, over the Fund’s 8 year track record, never had a negative return from credit losses.

Market Update

From a market update perspective, the Australian economy has surpassed its peak and is now in contraction territory, characterised by rising unemployment, a loosening bias by central banks, and weak business conditions. This is similar to what we are seeing in the US, UK, Europe, and China. In this environment, our focus is specifically on credit risk. We are less concerned about interest rate risk but are firmly focused on asset backing and the security of those underlying loans.

A key macroeconomic metric we have been watching and continue to watch closely is the household balance sheet. We believe this is an area where stress will be felt throughout 2024, as evidenced by the household savings ratio, which historically peaked at around 20% and is now approaching zero.
Risk Management

The DNA of our firm is firmly centered around risk management. If there was one attribute investors need to demand from their investment manager, it’s very good skills in this regard. When we talk about risk management, we’re talking about it in many ways. It’s both how we look at transactions that come across the desk, how we assess them, how we engage with different counterparties to really understand deeply their business and the assets we are financing. We endeavourer to develop a deep personal relationship with our counterparties which gives us priority access to the underlying information and allows us the ability to intimately understand the risks within each individual transaction.

Investment Outlook

The investment outlook will continue to have a number of known and unknown risks. As a fund manager, it’s our role to identify and manage those within the asset class. We continue to have a bias towards proven sectors of the Australian credit markets which have long track records. We note the emergence of a range of new credit funds in the Australian market that typically have a shorter track record and less experienced investment teams that may not have a track record in managing credit portfolios through varying market conditions.

We continue to ask for non-negotiable, proven risk management protections. For example, investing in sectors that do perform through the economic cycle and really avoiding those where we do think there is significant embedded risk. Examples of those could include corporate loans where there isn’t a secure underlying asset that’s protecting that loan or construction finance where there is significant project risk and the ‘as is’ and ‘completed’ valuations of those properties can be extremely high. Our focus remains also on diversifying broadly and seeking suitable protections in our legally documented financing warehouses that provides us certain rights should the portfolio or broader market deteriorate. Manning has a range of very seasoned investment professionals that have over a hundred collective years of experience in this asset class. We believe this is a key market advantage not just in delivering investors market leading risk adjusted returns, but also in protecting investor capital on the downside.

With Australia’s population forecasted to reach over 29 million by 2030, driven by net migration of around 500,000 per year, the demand for new housing is at record highs. The Australian Government announced in August 2023 a target of 60,000 new dwellings per quarter for the next 5 years, well above the long run average of 39,000 per quarter. It is unsurprising that we are seeing an increase in demand for construction finance and an increasing concentration of construction loans within private credit fund portfolios. What is less understood, is how much risk is this adding to an investor’s portfolio? And what amount of additional return justifies this risk? To answer this, we need to understand the nature of construction finance and consider the risks of this type of lending in the context of the Australian market.

Understanding Construction Loan Dynamics

Put simply, a construction loan is a type of financing used for the purpose of building new residential / commercial structures or extensive renovations. These loans cover various costs associated with construction, including land purchase, materials, labour costs and other project-related expenses. The terms of construction loans can vary but terms are typically less than 24 months. The amount advanced by the lender is typically based on the expected completed valuation of the project. For example, a residential property may be purchased for $1,000,000 in its current state by a developer who has plans to knock down and replace the existing property with townhouses with a total completed valuation of $2,000,000. If a lender advances 70% against the final valuation, i.e. $1,400,000, there may be a period through the construction phase where the value of the loan is greater than the value of the property it its current form. Should a borrower default occur in this stage, the lender, and hence the credit investor, may experience a loss of capital.

The Risk of Uncontrolled Variables

We see several key risks that contribute to the possibility of a loss investor capital:

1. Uncertainty of Economic Conditions: The economic environment at the start of the project is different from the environment in which the completed project may be sold. This increases the likelihood that the true completed value deviates from the original valuation.

2. Material and Labour Costs: We have seen rising interest rates, increasing labour and raw material costs, all of which can significantly reduce the profitability of a project, eroding the borrower’s equity and increasing the potential loss of investor capital. Additionally, there is the risk of defects either during or after the construction period that result in costly remediation before an Occupancy Certificate can be issued.

3. Delays: Construction delays can occur for several reasons, including material availability, skilled staff shortages, builder solvency, weather and disputes between the developer and builder or the builder and sub-contractor. Delays can materially increase the cost (e.g. labour and interest on the construction loan) and reduce the economic viability of the project.

4. Financing Risk: If the construction project is not finished within the loan term or fails to achieve the specified milestones, there is a possibility that financing expenses will rise or lines of credit may be revoked, affecting the project’s completion.

5. Regulatory Change: Projects may be modified or cancelled because of changes to building requirements or zoning rules. This can significantly impact the final project valuation and expose credit investors to capital losses.

Whilst the lender has the protection of the loan to value ratio and progressively drawdown funds as the construction project moves through the various stages, there is no getting around the fact that these risks exist and are beyond the control of the lender and credit investors.

This poses the questions, ‘if construction lending is riskier, why aren’t we seeing more issues in Australian credit portfolios?’ For the better part of the last decade (with the exclusion of COVID, where banks provided mortgage payment holidays and the Government released unprecedented stimulus into the economy), the Australian property market has largely experienced what would be considered “good times”. Borrowers have experienced extended periods of record low interest rates; we have seen arrears rates at all-time lows and a surge in asset values. When times are good and assets are performing well, it is easy to lose sight of the risk-adjusted return of a fixed income portfolio, with the primary focus turning towards the headline return figure.

A Historical Perspective

With the last financial crisis over a decade in the rear-view mirror, and the ‘fading affect bias’ enabling us to forget the “bad times”, it is important to remind ourselves where pockets of pain were felt in recent Australian history, reflect on the risk within our credit portfolios, and evaluate if we are being compensated for this risk. In the wake of the GFC, whilst Australia got through better than most developed nations, Suncorp Metway provides a great insight into a credit ‘pain pocket’. In June 2012, 53.9% of the loans within Suncorp Metway’s $2.35bn Construction & Development Loan Advances book were impaired, i.e. assets that are no longer worth what they are listed at on the balance sheet and expected to incur some loss of capital. This increased from 2.3% 5 years prior. In 2012 the Construction & Development Loan Advances book comprised only 4.7% of the total Gross Credit Risk exposure but accounted for 60.5% of total impaired assets. For context, the Real Estate Mortgage Loan Advances book impaired assets peaked at 0.1% in 2009 and Total Gross Assets saw an impaired asset peak of 4.8% in June 2011.

More recently, an eye watering 2,400+ construction companies in Australia entered administration between since July 2021. To put this in perspective, this means that construction company defaults comprise nearly 27% of all company defaults in Australia since July 2021. This data, sourced from ASIC in March 2024, paints a vivid picture of the challenges faced by the construction industry.

What Risk Premium is Fair?

All of this is not to suggest there is no place for construction finance in the Australian market. In fact, government policy and population forecasts dictate that it is necessary. The question we need to ask ourselves is, what extra rate of return should we be expecting in a credit portfolio for taking on construction risk? Based on history in the Australian market and the current headwinds in the construction industry, we would argue an extra 1-2% (versus returns of diversified credit funds, such as the Manning Monthly Income Fund) does not hit the mark on a risk adjusted basis.

Co-authored by Samuel Evans – Senior Investment Analyst at Manning Asset Management