Solving the great Aussie corporate debt puzzle

Christopher Joye

Coolabah Capital

Today I write about the following puzzle: Over 90 per cent of the equity raised by Australian companies is funded via the domestic stock market. Yet when these same companies issue safer debt (or bonds), which have predetermined returns and rank above shares in bankruptcy, local capital is suddenly missing in action.  An extraordinary 70 to 80 per cent of all investment-grade bonds issued by our firms are funded in foreign currencies. This is not because corporates prefer to be beholden to overseas lenders. It is much more complicated sourcing money offshore and hedging that back into local currency. It also creates an enormous vulnerability in the financial system insofar as our biggest corporates have become dependent on fickle international capital, which can evaporate during crises. And it is categorically not, as some super funds claim, because the interest rates companies are prepared to pay are lower than they can earn overseas: outright credit spreads on Aussie bonds (ignoring hedging) are generally significantly higher than identical assets priced in US dollars or euros precisely because of the dearth of domestic funding. Click on that link to read the full column or AFR subs can click here. Excerpt below.

What makes this puzzle even more bizarre is that Australia possesses one of the biggest pension systems in the world: there is $2.8 trillion saved via superannuation, which targets modest returns of 3 to 4 per cent above inflation. 

The explanation lies in the asset-allocation dysfunctions created by a regulatory system that encourages super funds to chase raw, as opposed to risk-adjusted, returns.

Since compulsory super was introduced in 1992 these funds have made globally unprecedented portfolio allocations to equities while starving firms of access to non-bank credit. Indeed, Aussie super funds have the largest portfolio weights to shares and the lowest exposures to cash and bonds in the OECD. The question is why.

It certainly has nothing to do with relative returns. Since 1992 inflation has averaged 2.6 per cent annually. Low risk, BBB rated Australian corporate bonds have historically paid returns of more than 1.5 per cent annually above risk-free rates. The average 10 year government bond yield has been 5.6 per cent over this period. That implies super funds could have earned 7 per cent plus annually, or 4.5 per cent above inflation, with a fraction of the risk of shares in domestic corporate debt.

A portfolio that was solely invested in fixed-rate Aussie government bonds would have delivered 6.6 per cent annually since 1992 (given the decline in cash rates boosted total returns on fixed-rate debt). That means super funds could have delivered 4 per cent above inflation with no risk, and offered extremely attractive returns during the global financial crisis, which they failed to do.

Instead, the typical "balanced" super fund squirrels more than 80 per cent of members' money in bottom-of-the-capital structure equities with less than 20 per cent in cash and bonds, even as the population ages and risk-aversion rises. This dysfunction is exacerbated by ASIC rules that make it easier for mums and dads to invest in leveraged stocks than, paradoxically, lower risk bonds.

Australian Super's "balanced" fund currently has 10 per cent in cash, 6 per cent in credit, and 2 per cent in fixed-interest. The remaining 82 per cent is allocated across Australian equities, global equities, private equity, property equity and infrastructure equity.

The Aussie equity risk premium above the 10-year government bond yield has been circa 6 per cent since 1900 according to academic research. That suggests super funds are assuming excessive risks to meet their inflation plus 3 to 4 per cent return goals, which is borne out in their volatile performance.

Care of its massive investment in (leveraged) equities, Australian Super's balanced fund has returned 6.2 per cent above inflation since 1992. That sounds brilliant until you contemplate the downside risk.

Over 2008 and 2009 Australian Super's balanced-fund shrunk by almost 20 per cent as global equities cratered. If instead it had been 100 per cent invested in Aussie floating-rate (fixed-rate) corporate bonds, it would have delivered an impressive 7.7 per cent (13.6 per cent) return between 2008 and 2009, even after the dramatic widening in credit spreads.

Those two scenarios represent profoundly different outcomes for a retiree drawing down on savings, which is all the more germane given the 10 per cent drop in equity values in October.

At a recent roundtable luncheon hosted by Visy boss Anthony Pratt, I argued that these asset-allocation errors reflect the fact that APRA allows super funds to market themselves exclusively on raw returns.

And I presented a solution that attracted surprising support from the super fund leaders present. Read about that solution online here.



Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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