As the property market continues to soften across Australia, unexpected consequences affecting high income-paying investment funds could affect thousands of self-managed superannuation funds, along with mum-and-dad investors who have invested directly.
Supposedly safe returns from fixed-interest funds have prompted the corporate regulator to warn investors to ensure they fully understand the significant risks supporting those income payments.
Most of these income funds fall under the classification of “private credit”, where promoters take money from retail and wholesale investors and, in turn, on-lend the money to others.
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To attract investors, the rates offered are higher than alternative fixed-income investments used by risk-averse investors such as term deposits and fixed rate annuities. The higher rates paid to the investors in private credit are supported by charging higher rates to those borrowing the money.
In a simplified example, a bank might pay a depositor 4.5 per cent a year and then lend that same money to a first-homebuyer at a rate of 6.5 per cent. The 2 per cent difference, or “spread”, covers operating costs and the profit for the bank.
A private credit provider offering investors 6.75 per cent with a similar spread must be charging borrowers 8.75 per cent on the loan.
Independent financial planner Andy Darroch said the very existence of the private credit market should be a warning sign for potential investors.
“Almost everyone that borrows money from a private credit provider is going to be someone that the banks won’t lend money to,” Mr Darroch said.
“The reason they have to pay more can be summed up in two words — risky borrower.”
Many borrowers accessing private credit in Australia are property investors and developers who have relied on the booming market to cover the construction and interest costs of their speculative investments.
When the growth of those investments stalls, or even declines in value, the risk of the borrower being unable to cover the outstanding debt rises significantly.
The Australian Securities and Investments Commission has put the private credit sector on notice that it is closely monitoring its end-of-year reporting.
“The sector is facing its first real test. Tighter liquidity, emerging borrower stress and signs of credit deterioration are testing valuations, governance and investor disclosures,” ASIC said.
To generate the higher returns for investors, most of the invested money in a fund must be on-lent, leaving a relatively small amount in cash to meet withdrawal requests. Withdrawals can also be covered by new money flowing into the fund.
Serious problems arise if the pool of new investors dries up and there’s an increase in withdrawal requests.
“There’s a fundamental timeline mismatch between the expectations of investors and where the money’s invested,” Mr Darroch said.
“Their invested money is often tied up in loans running for years, and you can’t just call in the mortgages to meet unexpected withdrawal requests.”
When withdrawal requests exceed the available cash, funds are often “frozen”, with withdrawals dependent on available cash. When that liquidity squeeze is combined with loan repayment defaults, withdrawal requests can be severely restricted.
This scenario has already been playing out in the US, with some very large private credit funds severely restricting the amounts investors can access.
“The problem here is that by the time you hear about any liquidity issue, the withdrawal restrictions are already in place,” Mr Darroch said.
ASIC’s notice makes it clear that “active surveillances across wholesale and retail funds are well progressed and multiple enforcement investigations are under way”.
“We’ve seen this all play out before, and history has a nasty habit of repeating itself. Getting your invested capital back is much more important than an extra half a per cent return on the money,” Mr Darroch said.
Many advisers are recommending that clients reduce their exposure to the sector.
