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The Australian bank regulator, APRA, is proposing to phase out Alternative Tier 1 capital (‘AT1’ or ‘Hybrid’) securities for local banks. As existing AT1 paper reaches its call date, the last being in 2032, banks will be required to replace it with Tier 2 capital. By 2032 bank AT1 securities will cease to exist, which leaves a bit of a hole in retail investors investment universe. In this piece I discuss a couple of viable alternative asset classes to AT1, and a couple of our funds that invest in this space. AT1 securities were an attractive investment for retail investors because of their higher yield vs perceived risk. They generated higher income than term deposits, and generally were less volatile than ordinary equity, and provided a more stable and predictable income stream than dividends. At the height of the covid related market panic major bank AT1 prices fell 20% on average, while major bank shares fell 40% - 50%). Bank bonds on the other hand, both senior and Tier 2, fell only 2% - 3%. Per the announcement last week ( LINK ), APRA has determined that AT1 capital is no longer fit for purpose. In time, as the capital layer is phased out, retail investors will need to find an alternative. Looking at the income and capital characteristics of AT1 securities, two alternatives come to mind. Firstly, Tier 2 securities issued by the banks – which will replace AT1, and then secondly Residential Mortgage-Backed Securities (‘RMBS’), which I’ll touch on in turn below. Both are generally restricted to wholesale investors, so retail investors would need to look at a fund to gain exposure. Two of our funds, the Mutual Credit Fund (‘MCF’) and the Mutual High Yield Fund (‘MHYF’) both hold these securities. Tier 2 capital, or subordinated debt as it is also known, currently ranks senior to AT1 in a bank’s capital stack. Apart from ranking, the main difference is that Tier 2 is a debt instrument, whereas AT1 is a hybrid, with equity characteristics. Tier 2 coupons are contractual, they can’t be deferred, such would be an event of default. AT1 distributions are deferrable without triggering a default. Tier 2 paper is often issued with a ten-year maturity, but with a five-year call option, which to date has always been met by Australian banks. Returns have been historically lower than AT1, but also less volatile as Tier 2 holders benefit from the buffer provided by the AT1. As AT1 is phased out, Tier 2 will effectively assume the ‘buffer’ role of AT1 and as such should be priced accordingly – higher yielding all other things being equal. This re-pricing will likely be a gradual process rather than rapid given the length of the transition period. The schematic below details a simplified bank balance sheet. Liabilities represent the various sources banks use to fund their lending activities, or their assets. Further, to the right we have prevailing spreads for each layer of funding. This is the margin above the bank bill swap rate (‘BBSW’) that determines the coupon paid on these securities. The levels listed here ignore the pricing action seen in recent days as the AT1 spread has tightened as investors scramble to buy what they can before they are phased out. The other alternative is Residential Backed-Mortgage Securities, or RMBS, specifically the mezzanine traches of these structures. In a simplistic sense, a bank’s balance sheet resembles one big RMBS structure. The bank’s assets are loans, predominantly first ranked mortgages, and the funding used to lend against these houses consists of deposits, senior bonds, subordinated bonds, and AT1. The interest on the mortgages is used to pay the interest on the funding sources, with the margin reflecting profitability, which is paid out to equity holders as dividends. For RMBS, the asset side is the same, first mortgages, while on the funding or liability side we have RMBS tranches rated as high as ‘AAA’ (deposit like risk) down to mezzanine tranches rated ‘BBB’ ‘BB’ or ‘B’ (AT1 like risk). As with banks, the interest income from the left side pays the interest expense on the right side. The balance goes to equity – although there are some structural features that prevent dividends being paid to the mortgage originators (banks) until RMBS holders are paid. The schematic below should look similar to the simplified bank balance sheet above. In the bank example, should mortgages begin to fail in sufficient scale, equity and AT1 capital is designed to absorb losses (i.e. a capital loss for holders). Similarly, in an RMBS structure, the same situation would see the equity tranche absorb losses, and then the ‘B’ rate tranche, the ‘BB’ rate tranche and so on. The A$ RMBS market dwarfs both the AT1 market (~$33bn) and the Tier 2 market (~$20bn) in outstanding securities at around ~$200bn. Rated tranches of RMBS structures attract higher spreads compared to equally rated ‘vanilla’ bonds. For example, an ‘AA’ rated RMBS is pricing around BBSW+175 bps, with a maturity of around 3.5 years, compared to say major bank senior paper (‘AA-‘) around BBSW+70 bps. Further down the stack, ‘BBB’ RMBS is at BBSW+200 bps vs BBSW+140 – 150 bps for equally rated vanilla bonds. The extra premium available on RMBS is compensation for perceived complexity risk and liquidity risk, although both are moderating as the market matures. Now, how do retail investors invest? Both are restricted to wholesale investors, so the best way is through a fund, managed by a team of handsome and highly skilled investment professionals with over 100 years of collective experience. And here’s one I prepared earlier. Mutual Limited was established in 2010 and manages $3.5bn across four retail funds and over a dozen wholesale mandates. The firm has a prudent investment philosophy, focusing on bank paper and RMBS / ABS. I’ve personally been investing in RMBS since 1999. Two of our funds are active in the RMBS / ABS space, with a summary of each fund below: The Mutual Credit Fund launched in early 2020, more than doubling in size since launch. The fund invests in senior and subordinated (Tier 2) bonds issued by APRA regulated entities, so banks and insurers, with minimum holding of 60% (currently 70%). The fund can also hold up to 30% in RMBS or ABS securities, with a current holding of 22.2%. The fund is required to be at least 80% invested in investment grade rated paper (currently 90%). MCF returned 8.75% net over the past 12 months.  The Mutual High Yield Fund was established over 5 years ago. The fund has a heavy focus on RMBS / ABS assets, a growth market which has been driven by banks withdrawing from select lending markets, with the void filled by non-bank lenders. The RMBS / ABS market is their prime source of funding. RMBS / ABS allocations are at 42%, down on target of levels of 65% - 75% because the fund has enjoyed strong inflows that are still in the process of being deployed. MHYF returned +11.60% net over the past 12 months.

Late last year APRA announced it was reviewing whether AT1 securities were fit for purpose as effective loss absorbing capital.  A review that was triggered by the collapse of Credit Suisse earlier in 2023, and specifically the treatment of AT1 investors, who were wiped out, while equity investors were left whole. An outcome that contravened the natural order of all things’ regulatory capital.  Recall, Australia is one of the only developed markets where AT1 securities are available to retail investors.  In most similar jurisdictions, AT1 investing (direct) is restricted to wholesale investors. This retail presence in Australian markets represented an area of concern for APRA, specifically whether ADI’s had the intestinal fortitude to use AT1 for loss absorption as per its initial intended purpose should the proverbial hit the fan.   APRA has today announced it is proposing the phasing out of AT1 within bank capital stacks, replacing it mainly with Tier 2 capital (subordinated debt) and a smidge more CET1. The minimum prudential capital requirements remain unchanged, at 13.75%, just the composition has changed - simplified. The proposal is for existing 1.5% AT1 requirement to be replaced by 1.25% Tier 2 and 0.25% CET1 for large banks and all AT1 with Tier 2 for smaller banks.  If implemented as proposed, the changes would be phased in from January 2027 through to 2032, when the last existing AT1 line is due to be called.  Essentially, upcoming AT1 calls will be refinanced with Tier 2 as they roll off.    To maintain an orderly transition, APRA will not expect to approve regulatory calls on these instruments earlier than their documented call dates. Basically, existing AT1 securities will continue to do their thing before eventually rolling off, with the last few lines not due to be call for another 7 years yet. To this end, we note the price of ANZ’s Mar-24 issued AT1, has rallied +0.5% on the day, with traded volumes well below average. Similar for WBC’s Dec-23 issued AT1, up +0.8% on the day, with lower than usual volumes. Over the very near term, we perhaps see a better bid for AT1, but in time they’ll dwindle on the vine, posing longer term threats to hybrid funds and ETFs.   Tier 2 spreads in secondary markets are a smidge wider on the news, a basis point at worst, with minimal traded flows.  The orderly transition process ensures there is plenty of time for banks to replace AT1 with Tier 2 without causing any undue stress on the market’s digestive capabilities. ADI’s have ramped up from just 2.0% Tier 2 to 6.5% as part of APRA’s ALAC requirements over the past five-plus years with spreads currently trading towards the tight end of historical ranges.  Accordingly, I don't expect an additional 1.25% of Tier 2 by 2032 will materially weigh on spreads in the medium term.  In dollar terms the volume of Tier 2 required by 2032 is estimated to be somewhere between $24bn and $26bn, which would see the Tier 2 market grow 20% by the completion of the phase out   APRA did raise the risk of a downgrade to Tier 2 securities from the rating agencies as the loss buffer normally provided by AT1 will disappear, and only been partially replaced by higher CET1. No word yet from the agencies, but this process will be a slow bleed, so I actually doubt any downgrade will be forthcoming. Having said that, if a downgrade eventuated, ratings would be back to where they were six-months ago.   Looking further afield, the move from APRA is positive for Mutual’s funds. More Tier 2 issuance increases the depth of our investment pool, and we would expect to capture some flows out of hybrid ETF’s as the investment universe disappears.  Mutual’s fund invest extensively in bank debt securities, including senior bonds and Tier 2 paper. Following the announcement from APRA, some hybrid investors have talked up the prospect of listed Tier 2 issuance as an alternative for them, but I find this a naïve hope.  APRA’s decision around AT1 is because they don’t want loss absorbing capital in the hands of retail investors.  APRA has alluded to this by saying… “ converting AT1 would impose losses on investors who may not be prepared to absorb those losses, potentially leading to contagion in the broader financial system, further undermining confidence in a crisis.  This is heightened in Australia where retail investors, who are less equipped to absorb losses compared to wholesale investors, participate in the AT1 market. ”  While that references AT1, it’s hard to see how it’s not relevant for Tier 2 also. Source: https://www.apra.gov.au/a-more-effective-capital-framework-for-a-crisis

Earlier today Chris Joye (CIO, Coolabah and AFR journalist) and Andrew Lockhart (MD, Metrics Credit Partners) went head-to-head in a debate on the virtues of public credit vs private credit. Joye has been a vocal and aggressive critic of private credit (because they don’t do it), while Lockhart has built Metrics up as a big player in the private credit space. A transcript of the debate can be found here .    As Joye does, he has already written about the debate and the underlying matter in the AFR ( here ). In said article he claims exit polling had him winning the debate, 69% vs 31%, a poll he ran on his LinkedIn page. A poll conducted by ‘Livewire’, a more impartial pollster had Lockhart win with 55%. You should know my views on private credit by now, but if not, I’ll refresh your memories. I’ve done private credit in the past, didn’t enjoy it. It’s labour intensive and requires specialist skill sets. My main issue with the asset class – here and now – is when it is blended in funds with public credit. Investors need to be mindful of the risks here, specifically around transparency and liquidity. If an investor wants private credit, go to a full private credit fund run by a reputable shop – such as Metrics, they have a strong track record. Don’t invest in a blended fund. And by private credit here, I mean direct lending to businesses that typically are considered too risky for the banks in the post GFC world – in the Australian context, tends to include a lot of property developers. Does this mean I agree with Joye? In some regards, yes – as it relates to the private credit I referenced in the previous paragraph. In others, less so. He’s throwing – at least that’s my interpretation – non-bank originated mortgages into the mix of private credit, which is flawed. Recall, mortgages are used as collateral in RMBS structures. His comments here are twisted. Specifically….   “Looking at all securitised loans (adjusted for biases), we find that non-banks have default rates that are 2.5 times higher than banks . Even if we cherry-pick the very best “prime” non-bank loans, their default rates are 1.5 times worse than the banks . That’s not surprising and reflects the variances in risk preferences between the regulated and unregulated worlds.”  My emphasis. Sound terrible, doesn’t it. But what he doesn’t say is that loss rate on mortgages within banks through time has been 0.02% or 2 bps ($20 for every $100,000 lent). For the non-bank originators, the cumulative loss rate has been anywhere between 0.04% and 0.10% ($40 - $100 per $100,000 lent). Yes, loss rates are higher, but at a base level they’re also very low and have remained so for 30 – 40 plus years.

Market pricing for the end of year cash rate was largely unchanged through May, with no rate cuts priced in until well into 2025, likely around mid-year at this stage. The recent inflation data has further cemented the growing belief that rate cuts are not imminent. While markets are not pricing in rate cuts for 2024, median consensus expectations are for one cut by year end, either at the November or December meeting. Click below for monthly reports: Mutual Cash Fund Mutual Income Fund Mutual Credit Mutual High Yield

Macro growth and inflation trajectories, combined with the path of monetary policy settings remain the core dominating themes for markets, with geopolitical risk re-emerging as a factor through the month. While geopolitical risk escalated, the market impact was brief, and largely limited to French securities – bonds, stocks and credit, a result of the snap election called by Macron that risks the far right taking a majority control of the government. Click below for monthly reports: Mutual Cash Fund Mutual Income Fund Mutual Credit Mutual High Yield

Post the CPI outcome consensus estimates quickly moved to rates remaining on hold for 2024, although there is a reasonable number of forecasters (8/30) predicting at least one cut by year end. Market pricing also indicates the possibility of a cut, but no full rate cut is priced in until February 2025. CBA make a strong argument for the first rate cut to come in November. Their forecasts have a material fall in the annual rate of headline inflation in Q3 2024 to sit within the RBAs target band, paving the way for a 25bps cut at the November meeting. The RBA has since announced that they contemplated a rate rise at their August meeting and while they left them on hold at 4.35% they also said “no cuts expected in the next six months.." Click below for monthly reports: Mutual Cash Fund Mutual Income Fund Mutual Credit Mutual High Yield

Private credit has attracted a lot of attention in local markets over recent months. One could say it’s the new ‘black’ of the investment world. In this piece, I’ll provide my thoughts and opinions on the sector, specifically some of the risks and pitfalls investors should be wary of if considering an allocation. In doing this I’ll also articulate why we don’t participate in this part of the market. A few recent publications linked below also shed some light on the asset class and the risks that come with it. Private credit is generally defined as non-bank lending where the debt is not issued or traded on public markets. It is also known as ‘direct lending’ or ‘private lending’, where the loan is directly negotiated between the lender and borrower. The private credit market is roughly half the size of the public credit market, but is growing. I’d caveat that by saying private credit numbers are somewhat rubbery.   Why the growth in private credit? To some extent growth has been a function of banks stepping away from lending to riskier parts of the economy, which has been driven by post financial crisis regulatory developments (higher risk weights and resulting cost of capital). Commercial property lending is a good example referenced in one of the above articles. Super funds and other fund managers have stepped into the void. Investor appetite for private credit has also risen as investors look to diversify their portfolios beyond stocks, bonds and traditional credit investments (public). Private credit investments can offer diversification benefits and may also help investors enhance risk-adjusted returns by adding an alternative asset class to their portfolios. Private credit also offers flexibility and customization. Deals can be tailored to meet specific needs of borrowers, offering flexibility in terms of loan structure, covenants and term or tenor. Private credit can be attractive in a low interest rate environment, where investors might seek high-yielding investment opportunities. Private credit can offer yield premium over traditional fixed income securities, which is enticing at face value. That’s the sales pitch, but there are no free lunches, so here are some risks…. Before I go into the risks of private credit investments, let me say I am not entirely adverse to these investments. I have invested in them in past lives, which opened my eyes to the required skill, diligence and expertise, as well as resources needed to take on the risks safely. Private credit investing is labour intensive – or should be, if it’s done right. And, while private credit offers a higher premium than public credit, generally, this premium reflects higher risks, mainly liquidity and default risk. What’s the difference between private credit and public credit? One of the most obvious differences between private credit and public credit is tradability and valuation transparency. Public credit is, as the name suggests, publicly traded. It has an observable price at which it can trade, it is transparent. Private credit on the other hand is a negotiated loan outside of the public market, with no trading functionality – other than bilateral negotiation, which is time consuming, complex and often not viable. Private credit is typically valued at par in a fund, which is the face value of the outstanding amount. Once a fund is invested in a loan, it’s generally a buy and hold investment, in it to the bitter end. Private credit transparency…what’s under the hood?   Some firms specialize in managing private credit portfolios, it’s all they do and it’s all they put in their funds. Investors would go into these funds knowing underlying liquidity is limited. Other managers dabble in both public and private credit, often blending exposures to both credit classes in the one fund. Investors need to be mindful of this when investing in such funds. If a blended fund has meaningful redemptions (withdrawal), remaining investors may be left with a greater exposure to private credit than perhaps they’re comfortable with. Blended funds can also have misleading portfolio metrics. Let’s say a blended fund has 40% of the fund in private credit, which is typically valued at par. During periods of market dysfunction or heightened risk off trends such as the covid outbreak, spreads would typically widen on public credit, which would see valuations decline. Private credit investments on the other hand can be left at par, which is not a true or fair reflection of risk. Using our own experience as a proxy, the Mutual Income Fund lost -2.11% in March 2020, the onset of COVID, while the Mutual High Yield Fund lost -2.50% over the same month. Modest moves in the context of movements in other asset classes, recall the ASX 200 lost almost -34.00%. A fund with private credit would fall less, if at all given the underlying loans are likely not marked to market. On the surface that’s great, no loss of wealth. Unless you need your capital back. That’s liquidity, what about credit risks?   Generally public credit is of ‘better’ credit quality in that the public credit market is largely rated, and predominantly investment grade. Private credit on the other hand is typically unrated more often than not. Investors in funds populated with private loans put faith in the fund manager to do the necessary due diligence to ensure an appropriate risk vs return dynamic is maintained. And, to take necessary action to protect their capital if an underlying loan is materially deteriorating. The recent articles linked below touched on examples where fund managers failed to do so. And recently, ASIC Chairman, Joe Longo, singled out the sector for some attention, “ we don’t know what’s really going on there because of lack of transparency and data, and we could end up with some unexpected or unintended consequences of this activity .” And… “ I think that’s a serious subject. I think we’re doing a lot of work with market participants, which I’ll have a little bit more to say about, trying to figure out what’s going on in that space. ” (AFR) So, is private credit a bad investment? No, of course not. But, caveat emptor, make sure an exposure to helps meet your investment goals while remaining true to your risk tolerance and risk capacity. Mutual has the capacity and required skill set to add private loans to a couple of our funds, but elect not to. A core philosophy of the business and focus for all funds we manage is to provide investors with steady and predictable income streams with minimal capital downside, all the while ensuring ready access to their funds as and when required. Private credit does not meet our investment goals or risk tolerances, nor is it required to meet fund investment targets. Further reading: A couple of good AFR articles, linked below, have also shed some light on the asset class and the risks that come with it: ‘Marking their own homework’: Inside Australia’s $200b unregulated private credit boom Perpetual’s $100m private debt pitch shies away from real estate

With APRA on the case for whether hybrid securities should remain accessible to retail investors, Mutual Limited CIO Scott Rundell offers his take on why hybrids have been popular, are they still fit for purpose and what is an alternative should the hybrid pin be pulled?

Retail investors have proven their affection for bank issued hybrid securities. And why not? They have historically paid a stable income, greater-than-term-deposit rates and with less variability than bank dividends. However, with the bank regulator, APRA, reviewing whether hybrid securities are fit for purposes, there is risk retail investors will be prohibited from investing directly in hybrids. With an announcement on this matter expected shortly, we look at a likely income generating alternative. Namely, Residential Mortgage-Backed Securities or RMBS. Bank Capital: Back to basics A bank’s capital is the “cornerstone of its financial strength. It provides the financial resources to enable a bank to withstand periods of stress, and protects depositors in the event the entity needs to be resolved” (APRA). There are three types of regulatory capital, which I touch on below, but with specific reference to AT1. Within the capital hierarchy of banks, AT1 ranks in between common equity (or ‘CET1’) and subordinated debt (or ‘Tier 2’). CET1 is the most subordinated layer of capital in a bank’s capital stack, and well-known by retail investors via the equity market. CET1 is permanent capital, with no legal maturity and management has full discretion on whether dividends are paid or not. It is intended CET1 be immediately available to absorb bank losses as and when they occur. CET1 or common equity is both a retail and wholesale market. Tier 2 capital is debt in form, with a legal maturity date and there is no discretion around payment of distributions (coupons), they are contractual obligations. Failure to pay would trigger default of the issuing bank. Tier 2 is intended to be available during resolution of a bank, that is when it is at the ‘point of non-viability’. Under such circumstances, CET1 and AT1 capital is assumed to have been burned through, or written off because of losses. Tier 2 is used to facilitate recapitalization of the bank to allow it to continue operating as a going concern. The Tier 2 market is an over-the-counter market, which lends itself to being a wholesale market only. Minimum parcel size of $500,000 also making it prohibitive to retail investors. AT1 capital ranks between CET1 and Tier 2. While it has no legal maturity date, giving it some semblance of permanency, it does have a call date – typically 5 – 7 years after issuance. AT1 distributions are discretionary, meaning payment can be missed with no legal ramifications. AT1 is traded on the ASX and has proven popular with retail investors, which is at the core of APRA’s concerns. AT1 is designed to absorb losses as part of early crisis intervention to restore a bank’s capital position, and can be used as part of resolution if needed. Credit Suisse situation and subsequent APRA review… For reasons I won’t go into here, Credit Suisse – a global systemically bank – was on the cusp of collapsing in the early months of 2023. To prevent failure, and to avoid potential contagion risks (remember Lehman Brothers), the Swiss banking regulator arranged a shot-gun marriage with cross-town rival, UBS, who was coerced down the aisle, acquiring Credit Suisse for $3.5bn. When the dust settled, Credit Suisse’s AT1 bondholders had been wiped out, their securities worth zero. Strangely, shareholders remained whole, violating the ‘absolute priority rule’ touched on above. In light of these events, and given more than half of AT1 paper in Australia is in the hand of smaller, retail investors, APRA launched a review to determine whether AT1 capital remained fit for purpose. APRA is concerned banks may be reluctant to cancel AT1 distributions to conserve capital given the market signaling effect and contagion risk. Further complicating things, Australian banks rely more on AT1 (relative) than international peers (~14.0% of tier 1 capital vs 11.6% - 12.4% globally), likely because it is a cheap form of Tier 1 capital. APRA has flagged three potential options to ensure AT1 remains fit for purpose. One is to improve the design of key features to ensure AT1 does what it’s supposed to do – minimal impact on retail investors. The next is to reduce the reliance of AT1 for regulatory capital purposes – potentially reduces issuance and availability of AT1 securities. And last, and this has most potential impact on retail investors, is to restrict their access to AT1 securities, which is what we’ve seen in US and UK markets in the past. APRA requested market feedback by 15 November, 2023. Six months on, there has been no formal announcement, but we would assume we’re approaching some resolution. With the risk that retail investors will be prohibited from investing in AT1 going forward, what’s an alternative with similar risk-return dynamics? Read on… Alternatives... AT1’s are tradable on the ASX, so they provide some perception of liquidity (daily traded volumes are actually quite small as a % of total outstanding), and they have historically provided investors with an enhanced income stream relative to say term deposits. They have also provided less capital volatility than bank equity, although they are not completely devoid of risk in this regard. During COVID AT1 securities fell as much as 20% vs bank stocks that fell 35%. For comparison, Tier 2 securities fell perhaps 3% around the same time. Like Tier 2 securities, AT1 securities pay a floating rate distribution, which is determined by a fixed margin (set at issuance) over the bank bill swap rate, which is reset every 90 days. Unlike Tier 2 securities, the distribution on AT1 securities is discretionary. If we look at the underlying fundamental risks of AT1, an alternative is Residential Mortgage-Backed Securities (RMBS), specifically the mezzanine tranches. Roughly speaking, 70% - 80% of bank lending assets are residential mortgages vs 100% for RMBS structures. Like bank capital stacks, RMBS have different tranches or layers of risk, from the first loss equity piece all the way up to the AAA rated tranche. Put a bank capital stack next to an RMBS structure, and the similarities are clear. One could say that a bank is just one big RMBS. The AAA tranche of an RMBS is akin to bank deposits, while the AA tranche is akin to senior debt and so on. Continuing the analogy, the BB tranche is akin to AT1. However there are significant differences. RMBS is a secured investment, backed by a pool of mortgages. Hybrids on the other hand are unsecured. Further, RMBS begin to amortise 18-24 months post issuance, which effectively reduces risk for investors. RMBS are generally shorter dated, with weighted averages lives of around 3.5 years vs 5 – 7 years for AT1. Where AT1 out-trumps RMBS, at least optically and for now, is access and liquidity. Retail investors can invest themselves in AT1 via the ASX and can trade in and out as they please. RMBS on the other hand is the domain of wholesale investors, such as Mutual Limited. To gain access to RMBS, a retail investor would need to choose a fund that invests in RMBS, such as the Mutual Credit and Mutual High Yield Funds. A comparison of RMBS vs AT1 is tabled below. The most like for like comparison is the ‘BB’ RMBS tranche vs the AT1. The average coupon on the BB tranche is around BBSW+550 bps, but has been lower and has been higher, but this is the average. Given prevailing BBSW rates, this provides a coupon of 9.80%. Compare this to the last AT1 deal, from ANZ, the distribution on this security is 7.51%. The table also compares capital price volatility, which in this instance is the standard deviation of daily price movement, from which we see RMBS has been marginally less volatile than AT1. One point to highlight also, the RMBS market is over $150bn in size, whereas the AT1 market is less than $50bn. Investors might raise housing market risk as a reason for avoiding RMBS over AT1, but we’d point out if there was in fact a marked sell off in house prices, which precipitate credit loss issues, AT1 securities are more exposed than RMBS. Lastly, we would point out that no rated RMBS tranche in Australia has ever defaulted. Even through the Global Financial Crisis, the RMBS market held firm.

Dear unitholders, In accordance with ASIC Regulatory Guide 26, we wish to advise that Grant Thornton Audit Pty Ltd has been appointed auditor of the Schemes effective 4 March 2024. Our previous auditors, KPMG, were appointed our auditor in 2010 and have acted in the role for 13 years.  In considering the length of KPMG’s tenure, the Board decided to investigate other available alternatives.  A detailed external auditor selection and interview process was conducted, culminating with a recommendation that Grant Thornton be appointed as auditors of the both the Company and Schemes. Throughout its period of appointment, KPMG provided valuable and professional external audit services to the Company, adhering to best practice standards of governance.  We are grateful to them for the services that they provided.  The board looks forward to Grant Thornton continuing to meet the external audit needs of Mutual Limited.

For fixed income investors, trying to predict the interest rate cycle and bond prices is like catching a falling knife, which in the end may have costly consequences. Fixed income investors don’t need to try their luck at catching. In the world of investing, reducing risk without significant sacrifice is a rare opportunity. However, within the fixed income space, there’s a chance to reduce risk in investor portfolios. While reducing risk is typically associated with lower returns, the opportunity to reduce interest rate risk, by switching some exposure from fixed rate to floating rate assets, may actually lead to improved returns, depending on the market environment and other factors such as bond market volatility. This is particularly relevant in today’s fixed income landscape, where there’s extensive speculation about whether bond yields and interest rates have peaked. There’s no question that the direction of interest rates significantly affects the performance of bonds on the “fixed rate” side of fixed income investments. But what may often be overlooked is that changing interest rates have a far less direct impact on the price of assets on the “floating rate” side of the fixed income universe. That’s because floating rate notes reset their coupon rates generally every 90 days, while fixed rate bonds price do not reset their coupons. It’s as if floating rate notes can “change their clothing” to suit the weather and are therefore less exposed to extreme conditions. This can be a meaningful consideration for investors seeking defensive assets in their portfolio. There are two important points to note when comparing fixed versus floating rate notes: Despite the naming convention of “fixed income”, the asset class can often include both fixed rate and floating rate choices from the same debt issuer. While the relationship between interest rates and fixed income returns can be beneficial when rates decline, it can also introduce significant volatility, especially with traditional bond funds as they often tend to have meaningful interest rate exposure. Allocating to a fixed income strategy with floating rate assets rather than fixed rate assets can mitigate this risk. Although both floating and fixed rate bonds fall under the “fixed income” category, they can yield vastly different results when interest rates and bond yields fluctuate, even if they share the same issuer. This can matter to the investor seeking defensive assets because timing the precise peak in interest rates is a challenging task and even experts can make errors in their predictions. To illustrate the importance of making the right fixed income allocations between fixed and floating, consider the example of two bonds issued by ANZ, one fixed and one floating. ANZ example: Fixed and floating bond In August 2019, ANZ issued a fixed rate five-year senior bond with a $450 million face value and a coupon of 1.55 per cent. In the same period, they issued a floating rate security with a face value of $1.35 billion, which was identical to the fixed rate bond in every aspect except for its floating rate coupon. The floating rate bond’s coupon was initially set at 1.74 per cent (3M BBSW+77 bps) and adjusted every 90 days, reaching 4.91 per cent at its last reset. Both securities were issued at par, priced at $100.00. The difference in performance between these two bonds becomes evident when you consider the inverse relationship between yields and fixed rate bond prices. As yields rise, fixed rate bond prices fall, and vice versa. With inflation on the rise, the RBA increased rates by 400 basis points between May 2022 and June 2023 to 4.10 per cent. While they’ve paused rate hikes since June, the risk of further increases remains due to persistent inflation. Bond yields have generally followed cash rates upward. The fixed rate ANZ security pays a constant coupon, which is relatively low. As interest rates have been on the rise, the bond’s capital price has fallen. Since the end of 2019, the fixed rate bond has traded in a range of $93.3 to $104.4, with an average price of $99.4. It has traded at a discount to par 51 per cent of the time. In contrast, the floating rate note’s coupon resets every 90 days, allowing it to rise with increasing interest rates. Consequently, the capital price has traded in a narrower range, fluctuating between $97.9 and $102.1, spending only 5 per cent of the time at a discount to par and averaging $100.7. The trading ranges between the fixed and floating versions of the same bond can be illustrated in the charts below. The blue area highlights when the bond is trading at a premium to face value ($100) while the red shows when the bond is trading at a discount. The floating rate note in this period has experienced more time in the premium zone. Of course, this can change when interest rates are falling, but the point here is the volatility can be reduced with floating rate exposure. The upshot is to be wary of increasing allocations to duration risk (fixed rate bonds) as there is doubts around the end of the cycle, and the cost of being wrong hurts. Floating rate notes can be an alternative, providing capital stability and sustainable and relatively low risk income flow.

With inflation still above the RBA’s comfort level, interest rates likely to peak and ongoing geopolitical tensions, what is the outlook in 2024 for the Australian fixed income investor?