The following is intended to provide a current overview of the Australian credit landscape and the opportunities which Carrara is currently seeing and expects to continue into the first quarter of next year.
Evolving Credit Landscape
The past few months have seen spreads in the Australian credit market steadily migrating wider due to a number of global and domestic factors. The most significant of which, in our opinion, has been an overall reduction in liquidity due to:
- Increasing base rates,
- A near halt in equity capital market activity, and
- Deteriorating expectations of economic activity.
The widening of spreads is to be expected at this stage in the economic cycle and we expect further stress in the credit market to develop as economic pain and interest rates continue to grow.
How best to take advantage of this environment is considered below.
Perhaps the most impactful event throughout an obligor’s credit cycle is the ability to refinance. Deep relationships and well-established treasuries with considered repayment profiles can be dismissed as inconsequential in good times, but borrowers with short-dated treasuries and few financing relationships are often the first to show signs of distress when capital markets recede or are impacted by shocks. By way of example; two private debt offers from Metro and Zip Money were pulled during October 2022 due to unrelated events in the UK only to return to market in November when markets calmed. Likewise, in 2008, several real-estate investment trusts (REIT) collapsed due to unsustainable financing and the entire REIT market was heavily impacted – despite some
REITs having very modest and/or long-dated obligations.
We believe these events present excellent opportunities for experienced investors, who have the ability to conduct detailed diligence and understand the inherent risks in each individual deal.
Pricing benefit through regulatory asymmetry
A significant number of participants in the credit market, including Australian banks, are heavily regulated institutions, and depending on their jurisdiction (e.g. Australia, US, EU etc) face a number of regulatory and possibly accounting constraints. As a consequence, these types of institutions can become forced sellers for a number of reasons, including:
- Inability to comply with reasonably expected near term demand under theVolcker Rule,
- Stale inventory constraints,
- Accounting reclassifications that can taint an entire portfolio due to one position being held too long.
Accordingly, these participants can, from time-to-time, present very attractive credit investment opportunities with favourable pricing for nimble and pragmatic investors.
Structural features will often result in either increased protection or increased risk. Importantly, these features are not always well understood given the complex and bespoke nature of the deals which often have transaction documents exceeding 200 pages.
Detailed due diligence and an understanding of how these features can behave and trigger other features or covenants is key to a complete understanding of each position. By way of example; two discrete securitisation positions with the same originator, same issuer, same underlying assets and same attachment point can behave very differently in stressed situations due to differences in the underlying cashflow mechanics. This can result in very different risk profiles and as corollary should imply differentiated pricing. Manifestly, this is not always the case, demonstrating a misunderstanding and mispricing of the inherent risk.
These opportunities always tend to exist, however it is typically only in stressed environments when these cracks are apparent and the opportunity set for investors improves significantly.
We are of the view that security (if any) backing debt positions can be extraordinarily consequential when a position is distressed. The secured property or collateral must be considered in the context of several factors, namely market for the collateral, price impact of disposal, asset coverage or loan-to-value ratio, intercreditor rights (where other secured creditors are concerned) and general enforcement considerations. All these factors may go to the value of the debt position and may also impact the behaviour of the obligor. Having experience in this area to execute efficiently is crucial in optimising returns – as should enforcement be required a ham-fisted approach can result in material value destruction.
We are of the view that 2023 will present excellent opportunities for the discerning credit investor given:
- Ongoing macro-economic and corporate stress,
- Structural factors in the mortgage, auto and commercial property sectors,
- Ongoing pressure in the equity capital markets, and
- Balance sheet optimisation for large holders of corporate credit.
Further to this, we see the potential for an increase in insolvencies and liquidations in 2023 with an increase in directors availing themselves of Insolvent Trading Safe Harbour already being seen in the local market.
Accessing the Opportunity
Carrara Capital, via the Carrara Global Opportunities Fund, allocates capital across a range of asset classes and underlying investment strategies, which are managed by a number of highly experienced portfolio managers.
Carrara’s Managing Director and Head of Credit Opportunities, Brendan Scarf, was previously the Head of Global Market Structuring at Deutsche Bank and has participated in well over $10 billion of deployed capital investment. He is regarded as one of Australia’s foremost experts in the space. Brendan has worked in London, New York and Sydney and believes the environment developing in credit markets is one of the best he has seen anywhere in the world.
Importantly, as a multi-strategy hedge fund which is designed with the aim to have a low correlation to equity markets, Carrara can judiciously allocate capital and is not subject to the same regulatory and balance sheet requirements that many of the larger institutions, such as banks, are. If you are interested in exploring the credit space in more detail, understanding the upcoming opportunity better or knowing more about Carrara, please feel free to get in contact with us.
This document has been prepared by Carrara Capital Pty Ltd (ABN 64 632 280 383), a Corporate Authorised Representative (CAR #001292378) of Carrara Investment Management Pty Ltd (ABN 67 637 149 387), AFS Licence (526072).
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