Why Are Super Funds Ignoring The Private Debt Market?

There is a puzzle in Australian super funds' asset-allocation decisions. The private debt market dominated by the big banks is 1.4 times the size of the Aussie sharemarket and offers much lower risk returns that mostly exceed super funds' performance targets, and yet they have almost no exposure to it.

Instead, super funds have loaded members up to the gills with much higher probability of loss local shares, global shares, property equity, private equity and infrastructure equity (yes, all bottom-of-the-capital-structure "equity"), which collectively account for 63 per cent of the $2.3 trillion in super savings.

Around 23 per cent of all super fund money is squirrelled away in Australian Stock Exchange equities alone, which is 1.7 times the size of their allocation to domestic fixed income (13.4 per cent) according to Foresight Analytics.

Yet it is not widely understood that Australia's private debt markets are 1.4 times larger than the $2 trillion ASX.

Data published by the RBA reveals there is $2.8 trillion worth of private loans sitting on bank balance sheets that super funds (and other non-banks) could contest. These include $1.7 trillion of residential mortgages, $150 billion of personal loans and credit cards, and $900 billion of business loans.

Most super funds target returns of 3 per cent to 4 per cent above inflation. If we assume long-term consumer prices appreciate at their historical annual pace of 2.5 per cent, that implies super funds are targeting total returns between 5.5 per cent and 6.5 per cent.

The RBA says that current average bank lending rates to small businesses with and without a residential property securing their loan are 6.45 per cent and 7.30 per cent, respectively.

The average personal (credit card) interest rates are 14.5 per cent (19.75 per cent). And the average discounted owner-occupier (investor) home loan rate is 4.45 per cent (5.05 per cent).

Investment grade

If a super fund accumulates a nationally diversified portfolio of home loans, personal loans and business loans, the implied weighted-average credit rating is demonstrably investment-grade (indeed, likely above the ultra-low risk "A" band).

That indicates that the likelihood of actually realising a loss across this portfolio is exceptionally modest, and a tiny fraction of the probability of loss in the Aussie shares that super funds irrationally prefer.

The biggest bank killers over time are "asset-liability mismatches". Banks borrow very short-term deposits (liabilities) with average terms of typically less than three months to make exceedingly long-term loans, the most popular of which are 30-year residential mortgages.

When a bank's creditors want to suddenly call in their debts (deposits), the institution faces an inherent solvency crisis: it cannot possibly repay all these deposits, which account for 60 per cent of bank funding, as and when they fall due, and is therefore trading insolvent, given it has committed this money to the multi-year loans it has advanced.

This is why we have a central bank, which serves as a lender of last resort, furnishing emergency liquidity support to banks running massive disconnects between the tenor of their assets and liabilities that can trigger crises under the definition of solvency in the Banking Act.

By contrast, a super fund's liabilities (member savings) are long-term commitments that under the law cannot be withdrawn until workers obtain retirement age. A super fund has, as a result, much lower liquidity needs than a bank and is in a vastly superior position to commit to long-term loans.

Since debt ranks higher up the capital structure than equity, it has intrinsically lower risk with a narrower distribution of possible payoffs. It is consequently easier to value with less underlying uncertainty.

Wonky asset allocation

For a decade this columnist has argued that super fund asset allocations are skew-whiff, with entirely unwarranted portfolio biases to listed and private equity that cannot be rationalised by their official return targets.

It is noteworthy that these inflation plus 3 per cent to 4 per cent return goals are miles below estimates of the 6 per cent risk premium equities offer over and above cash rates (where cash rates are normally significantly above inflation rates).

This is partly the fault of the dastardly ranking systems the Australian Prudential Regulation Authority allows to be published on super funds' performance, which are predicated on raw returns with no attempt to adjust those returns for the risks assumed when delivering them.

Savers get no accompanying information on super funds' volatility or worst historical drawdowns, or risk-adjusted metrics like the "star ratings" Morningstar sensibly uses to rate investment funds. (These star ratings reflect sophisticated risk-adjusted estimates.)

If you are always judged purely on raw returns relative to peers, you are motivated to take the biggest possible risks, which explains why our super funds have among the highest portfolio weights to equities of all countries in the OECD.

Over and above the $2.8 trillion of private debt on bank balance sheets, super funds can also avail themselves of the $1.1 trillion of investment-grade bonds the RBA says have been issued in Australia by non-government entities.

These include highly rated and liquid bonds issued by banks and corporates, and asset-backed bonds secured by home loans, personal loans and trade receivables.

The RBA has previously estimated that the annual secondary turnover ratio associated with investment-grade corporate and financial debt in Australia is around 50 per cent, which is almost identical to the secondary liquidity reported by the ASX.

Primary liquidity is much stronger in debt markets, with the total value of new investment-grade bond issues each year about five times size of IPOs on the ASX. This is important for institutional investors, which often seek to get set in large lots in primary as opposed to secondary issues.

There are, of course, important risks. It is not clear that super funds possess anything remotely like the internal skill sets to accept and reject personal, business and residential credits, which banks have spent years honing.

They will almost always be better served by delegating this responsibility to specialist non-banks and investment managers acting on their behalf. The looming Latitude listing is one example of a very successful non-bank in this space.

Another problem is that it can be difficult accurately revaluing private (as opposed to investment-grade) debt portfolios over time if there is no secondary market for these assets.

This could lead some super funds to underestimate their risks until such a time as they are suddenly apparent, as we saw with super fund exposures to illiquid infrastructure equity during the global financial crisis.

Christopher Joye

Financial Review

24 November 2017

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