Manager Research

Over the past two years we have raised various concerns around risks within the credit sector (ie corporate debt) which forms a significant part of many local income and multi-asset funds. These concerns related to a few specific risks:

• Credit markets generally have a low level of liquidity outside of the large banks. In many cases it is a ‘buy and hold’ investment which is held to maturity. 


• Investor demand has been significant as local equity and property investments have disappointed, driving investors to higher yielding income funds with low volatility. Flows into these funds have been very significant. 


• As the local economy has also been relatively weak, new bond issuance (i.e the need to raise debt financing) has been quite limited. This has meant that the price of credit has been bid up to what appear to be very high valuations as demand has outstripped supply.  Investors have accommodated this, where given our low inflation rate they have been able to lock in a high real yield, despite not necessarily being adequately compensated for the risks. 


• Many asset managers have also added income strategies to their product range, a reflection of asset flows and business growth objectives. In our view this has led to a broader range of income investors chasing a limited number of investment opportunities, often without adequate credit risk research and management capabilities. This has further exacerbated the problem. 

We are currently at a point where local companies are facing increasing levels of financial distress.  Even where not distressed, we would expect valuations of assets within a daily traded unit trust to be adjusted downwards given the issues facing our country and individual securities in particular.  This is not happening in many instances, for reasons mentioned above (low liquidity, and a ‘buy and hold’ investment approach).  Because assets are not trading, they are not repricing. 

Sasol is a good example of this, where the local bond still trades on a high valuation which hasn’t repriced, and the offshore bond traded in global markets reflects a material sell off (yields moving out over 10% in $ reflects severe distress). There are many other examples.

There is no issue here provided that a) the asset doesn’t default, and b) the income is paid.  Ultimately the debt instrument will mature and investors will be OK.  However, where there are fund outflows, what tends to happen is that liquid assets are sold first (cash deposits, money market, big four bank instruments, etc).  This leaves an increasing proportion of illiquid assets for remaining investors.  If the outflow trend continues, then we are faced with a scenario where the fund is either forced to gate (close the fund to outflows so that they can undergo a controlled process of creating liquidity), or is forced to sell assets at a realistic market price which could be far below the value carried in the fund at that point. 

Not only would this be an unfair outcome for investors, it is also misleading in terms of being able to observe the real value of the investments being bought and sold at any given time.

This is an industry wide problem which we will be following up on. We have also been focusing on this issue across the funds we research to consider any material problems which may arise. In the meantime, we urge clients to exercise caution when considering income fund investments.