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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?

Scott Rundell, CIO of Mutual Limited, provides a hot take on the latest November rate rise. The RBA is focusing on two key variables, and Scott also discusses why the 0.25% rise will have a greater impact on a third of households.

June 2023 was a milestone month for Mutual’s High Yield Fund (‘MHYF’) with its running yield breaking through 10% per annum, aided by the inflationary backdrop and RBA rate hike cycle. A ‘running yield’ is an important feature of fixed income investments. It is like a real time barometer of how the investment is expected to perform, by measuring the weighted average coupon rate of the portfolio of bonds held by the fund. For example, a $100,000 investment in the Mutual High Yield Fund with a 10% running yield would be expected to return over $10,000 (gross) over the coming year (paid quarterly), all other things being equal. While the actual one-year performance of the Fund may be higher or lower than the running yield at any given time, it still demonstrates an attractive return proposition for investors. For the one year ending September 2023, the Fund returned 9.4% net of fees. This is lower than the prevailing rate because running yields have been rising with underlying interest rates. The one year number captures a period where the running yield was lower. For broader context, the Fund returned 6.5% versus the ASX 200 Index return of 5.3% over the past three years per annum. Bonds have a lower risk profile than equities A key consideration here is the difference in risk associated with equities versus bonds and the impact on investor portfolios. Bonds, unlike stocks, generally have a more predictable return profile, and exhibit less return volatility – both from an income and capital perspective. Bond holders have priority over equity holders The other key difference is the income generated by bonds are contractual and legally must be paid before any other distributions can be made, including dividends. Stocks on the other hand, which pay income via dividends are purely discretionary. Payment is at the discretion of company management and can only be made once all contractual payment obligations have been met. Accordingly, stocks returns are typically 3 – 5 times more volatile than bond returns. Bonds can be fixed rate or floating rate Expanding on the risk profile of bonds, it is important to make the distinction between fixed rate bonds and floating rate bonds, more commonly called floating rate notes. Add to this the term fixed income is used generically for the asset class and can encompass both fixed rate bonds and floating rate bonds. A fixed rate bond pays a constant coupon from issuance to maturity. In a rising interest rate environment, such bonds are exposed to duration risk, which means when interest rates are rising, the attractiveness of a fixed coupon stream reduces. In a rising interest rate environment, duration risk exposes a fixed rate bond investor to capital losses. This works in the opposite way when interest rates are falling. How coupon payments are set The coupon payable on a floating rate note is set as a margin above a reference rate, typically the Bank Bill Swap Rate, or BBSW. The reset period is every 30 or 90 days depending on the security in question. The BBSW rate in turn is strongly correlated with the RBA cash rate. Accordingly, as the RBA has hiked rates over the past year and a half, BBSW has risen, and in turn floating rate note coupons have increased. For example, a year ago the 1-month BBSW rate was approximately 2.70%. The coupon available on say a ‘BBB’ rated Residential-Mortgage-Backed Security (‘RMBS’) was around +450 bps, so the coupon was set at 7.20% (2.70% + 4.50%). At the last reset, at the end of September 2023, the 1-month BBSW rate was 4.05%, so the coupon is now 8.55%. Floating rate notes have minimal duration risk and as such capital variability is much less than for fixed rate bonds. Credit risk is mitigated by portfolio diversification Another key risk for bonds, with fixed and floating rate bonds impacted equally, is credit risk. This is the risk that a bond issuer (the borrower) is unable to pay the promised coupon due to financial difficulties. Within a managed fund however this risk is mitigated by holding a diversified portfolio of bonds across multiple issuers. Can the Fund’s high running yield be maintained? As a consequence of the COVID pandemic and measures taken by governments and central banks globally to negate the pandemic on their respective economies, inflation has reared its head – after being largely dormant for many years. The traditional tool used to combat inflation is monetary policy, which has seen interest-rates rise sharply over the past year and a half thanks to the RBA increasing its cash-rate target. In turn, BBSW has risen, which has supported higher coupon rates on the underlying securities – floating rate notes – in the Fund’s investment universe. The Fund is made up of approximately 80% Residential Mortgage-Backed Securities (RMBS) and Asset-Backed Securities (ABS). Each of these bonds are generally made up of close to thousands of collateralised loans that can range from Australian mortgages to auto loans. The Fund holds approximately 50% - 60% of funds under management in RMBS and 15% - 20% in ABS. At Mutual we diligently review and monitor each ABS/RMBS bond we hold on a loan-by-loan basis. While rising interest rates place pressure on mortgage serviceability, and in turn mortgage arrears, RMBS structures are designed to withstand materially worse conditions than those expected for even the most severe worst-case scenario. In this regard, we point out no rated RMBS note has ever defaulted in Australia. Outlook for interest rates Inflation, as measured by the Consumer Price Index (CPI) is still running well ahead of the RBA’s target range, 6.0% vs 2.0% - 3.0% target, with CPI not expected to be back within target ranges until late 2025 (RBA forecast). As a consequence of these expectations, interest rate markets are not pricing any meaningful drop in the RBA cash rate or BBSW until well into 2025. Accordingly, for the year ahead floating rate note coupons will continue to be reset at margins above a cash rate of at least 4.10% for the foreseeable future. DISCLAIMER This information has been prepared by Copia Investment Partners Limited (AFSL 229316 , ABN 22 092 872 056) and Mutual Limited (“Mutual”) ABN 42 010 338 324, AFSL 230347), the Responsible Entity and issuer of the Mutual High Yield Fund. This document provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully and seek advice from qualified professionals where necessary. The information in this document does not constitute personal advice and does not take into account your personal objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to in this document, you determine whether the relevant investment is suitable for your objectives, financial situation or needs. You should also consider seeking independent advice, particularly on taxation, retirement planning and investment risk tolerance from a suitably qualified professional before making an investment decision. Neither Copia Investment Partners Limited, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the payment of particular rates of return on investments or the repayment of capital. Copia Investment Partners Limited publishes information in this document that is, to the best of its knowledge, current at the time and Copia is not liable for any direct or indirect losses attributable to omissions from the document, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions. © 2023 Copia Investment Partners Ltd.

After repeated scandals and questionable strategic decisions, in March 2023, the 170-year-old Credit Suisse, a pillar of the much-vaunted Switzerland’s banking system, was on the cusp of failure. To avert financial crisis, the Swiss National Bank intervened. Credit Suisse was ushered into the reluctant arms of UBS in a shotgun wedding. Through this process, AT1 investors controversially suffered loss of capital while lower ranked common shareholders where left whole (the precipitous fall in Credit Suisse’s share price notwithstanding). Following these events and some internal regulatory soul-searching, APRA has released a discussion paper titled “Enhancing Bank Resilience: Additional Tier 1 Capital in Australia”. The bank regulator is reassessing whether AT1 in its current form is fit for purpose, which is to absorb bank losses in stress scenarios and provide capital to support bank resolution at the point of failure. AT1 securities are a form of “contingent-convertible" bonds created after the global financial crisis to prevent the need for government-funded bail-outs of precarious banks. AT1 bonds are designed to convert into equity when a lender runs into trouble. In reviewing AT1 in the context of its intended purpose – i.e. “to avoid the use of public money and safeguard depositor funds”, the regulator recognised that in its current form “certain design features and market practices that would create significant challenges, or potentially undermine, the effectiveness of AT1 in Australia,” (APRA). On the table for review is the design, role and investor base of AT1. As AT1 securities are popular with retail investors, the outcome of this review has potential implications for the structure of such securities, and importantly their ongoing access to AT1. At this juncture, it is worth highlighting that in most jurisdictions, only sophisticated investors are allowed to invest directly in AT1. Australia is an outlier by allowing retail access. Key Considerations The tone of APRA’s discussion paper signals several potential changes are on the table. On the design side, two core areas stand out. Namely the coupon and when they can be paid and when they should be cancelled, and then beyond that conversion triggers, that is when AT1 should be converted or written off. I’ll touch on these in turn below: Unlike tier 2 coupons, which are contractual and non-discretionary, AT1 coupons are discretionary. Nevertheless, there is an expectation by investors (and issuers to some degree) that coupons will always be paid. Accordingly, APRA fear banks won’t be willing to cancel coupons as required for fear of contagion risk. Consequently, APRA will look to implement constraints around distributions, with likely more prescriptive and granular conditions around when a coupon can be paid, to ensure banks are willing and able to halt coupons when necessary. If this goes ahead, it should increase the risk premium investors demand as the risk of non-payment of coupon has risen. Obviously, the cost to banks will also rise. Next, we look at conversion triggers. Under the current AT1 framework, conversion (into equity) or write off of AT1 capital in a stress situation would be triggered when CET1 falls to 5.125%. This level was set when CET1 regulatory requirements were around 7.5% - 8.5% for the major banks vs now where the requirement is much higher, around 11.0% - 11.5%. Accordingly, in a bid to have AT1 loss absorption triggered sooner in a rising stress scenario, APRA have signalled that perhaps a more appropriate conversion trigger is 7.00%. Again, investors should demand a higher risk premium with such a change. Another consideration for AT1, what is its role and is there an alternative capital that can fulfil that role more effectively? At present, the minimum level of tier 1 capital a bank must hold is 6.0% (excluding capital buffers and additional loss absorbing capacity requirements), of which 4.5% must be met with CET1, or common equity. The balance of 1.5% is generally met with AT1. Australian banks hold more AT1 capital compared to international peers despite the 1.5% being on par with global standards. APRA suggest this is likely the result of AT1 being listed and the high proportion of retail investors – that is, it tends to be cheaper for banks than common equity. In some research released recently, WBC calculated the four majors held $9.4bn of excess AT1 (vs regulatory requirements). A possible solution is to cap the level of AT1 that qualifies as capital. Result is less issuance of AT1. Lastly, who is the investor base for Australian bank AT1, and are they appropriate holders given the intended purpose of AT1 capital. Of the A$40bn or so of outstanding AT1 capital on issuance by Australian banks, 53% is held by ‘retail’ or ‘smaller’ investors. Per APRA’s discussion paper…”Australia is an outlier internationally with a large proportion of AT1 held by domestic retail investors. This would make it particularly challenging to use AT1 to facilitate the recapitalisation of a bank in resolution, as APRA would be concerned that imposing losses on these investors would bring complexity, contagion risk and undermine confidence in the system in a crisis.” This concern is amplified by Australia’s relatively concentrated banking system. In a former life, as Head of Credit Strategy at CBA, I often travelled to the US and Europe to provide views and analysis on Australian companies issuing into offshore markets. Being the biggest cohort here, the banks took up the bulk of my time. And within these discussions with offshore investors, a common theme was their utter surprise that Australian AT1 was predominantly a retail market. Long story short, APRA might restrict direct retail access to AT1 securities. Other Considerations There are various other considerations, but an important one that wasn’t really touched on in APRA’s discussion paper is deductibility. And here I’ll borrow some words from WBC, who commented on the matter recently…”one approach APRA may consider is changing the tax treatment of AT1 securities to be debt rather than equity capital as is the case in offshore jurisdictions. From an investor perspective, this would make AT1 similar to Tier 2 (APRA appear content with T2). Market access outside the listed space, particularly offshore, would improve providing added diversification to the investor base and seeing a natural down weighting of AUD AT1 supply. From a bank perspective the distribution impact is largely neutral (deductible interest vs non-deductible interest, but franked distribution), however pricing will clearly be impacted by market pricing differentials.” Impact on Mutual Limited Mutual Credit Fund (‘MCF’) and Mutual High Yield Fund (‘MHYF’) both have capacity to hold AT1 securities, however, here and now the two funds don’t. The risk-vs-return dynamics of the asset class in its current state is not attractive. Notwithstanding, as a firm we are experienced with AT1 as we have private clients who are active holders. Applications for submissions close in November 15th. They’ll then take time to digest it all. Likely a 2024 story.

We are pleased to announce the Mutual Cash Fund (MCTDF) received a Recommended rating from Lonsec in its first review of the strategy. In its Product Review dated 25 September 2023, Lonsec describes the Mutual Cash Fund as a "low volatility fund that provides investors with security and minimal risk in generating regular income, with a focus on liquidity management”. The Fund is managed by Mutual Limited and is an actively managed portfolio of deposits offered by the four major Australian banks only. The Fund prioritises capital security for investors and targets a net return of 0.5% pa above the Bloomberg AusBond Bank Bill Index over a rolling 12-month period. The Fund also targets greater income over the Benchmark after fees, on a quarterly basis. Key features of the Mutual Cash Fund Gross running yield of 4.66% As at 30 September 2023, the Fund had a Gross Running Yield of 4.66%* Diversified across the Big 4 only The Fund is invested across numerous deposits offered by the Big 4 major Australian banks - ANZ, CBA, NAB and Westpac. Fund investors are not exposed to any singer borrower or investment term. Daily liquidity The key advantage of the Fund is that it provides investors with a term deposit-like return without the lock up. Daily unit pricing allows daily access to funds and there is no need to wait for deposit maturity to access funds. Reliable track record The Fund (established Sept 2011) is managed by Mutual Limited, an Australian-based fixed income fund manager. The Fund has never had a negative daily return and has never been unable to fund redemptions. This record reflects its low risk profile. A more responsive return profile With a wide spread of deposits across a range of maturity dates, the Fund is designed to provide incremental changes to the Running Yield reflecting changes to the RBA rate. The helps investors avoid being left behind if the RBA increases rates while they may otherwise be locked in a long term deposit. Platform availability The Fund is listed on a range of platforms including: Asgard, BT Panorama, CFS FirstWrap, Expand, HUB24, Macquarie, MyNorth, Netwealth, Powerwrap, Praemium and Mason Stevens. Find out more about the Mutual Cash Fund here: https://www.mutualltd.com.au/mutual-cash-fund * The Gross Running Yield is the percentage of income earned by the Fund divided by the Market value of the Fund assets. Past performance is not a reliable indicator of future performance. The rating issued September 2023 is published by Lonsec Research Pty Ltd ABN 11 151 658 561 AFSL 421 445 (Lonsec). Ratings are general advice only, and have been prepared without taking account of your objectives, financial situation or needs. Consider your personal circumstances, read the product disclosure statement and seek independent financial advice before investing. The rating is not a recommendation to purchase, sell or hold any product. Past performance information is not indicative of future performance. Ratings are subject to change without notice and Lonsec assumes no obligation to update. Lonsec uses objective criteria and receives a fee from the Fund Manager. Visit lonsec.com.au for ratings information and to access the full report. © 2023 Lonsec. All rights reserved.

Scott Rundell, Chief Investment Officer | August 2023 Introduction Mortgage arrears have been attracting a fair amount of press lately given the aggressive rise in interest rates and some early signs of ‘mortgage stress’. We believe most of the commentary fails to provide insights on where the risks are, how to avoid them, or what the opportunities might be. While Residential Mortgage Back Securities (RMBS) arrears have risen, we consider this is entirely normal and nothing to be alarmed about vis a vis RMBS investments. Arrears do not equal losses. Two questions. First, is RMBS arrears a good indicator of mortgage stress, and second, what does increasing arrears mean for RMBS performance? Arrears here and now To ensure full transparency, we’ll stick to public data, specifically Standard and Poor’s (S&P) SPIN data. We have also corroborated this with our own data. SPIN data details the proportion of mortgages held within RMBS structures that are behind on their scheduled mortgage payments for 30 days or more. We’ll focus on ‘non-conforming’ mortgages here, mortgages typically written by non-bank originators, such as RedZed, Peppers, Liberty and Resimac. Non-conforming mortgages are to borrowers who do not satisfy the standard lending criteria of mainstream lenders, including banks, for example self-employed borrowers. Non-conforming mortgage arrears are sitting at 3.47% as at the end of June, up from 2.18% a year ago. While arrears have risen vs this time last year, the recent trend has been lower, falling -0.52% in recent months as borrowers adjust to the higher interest rate environment. For some historical context, the long-run average SPIN rate is 8.28% (2000 - now), while the post GFC average is 5.66%. The worst SPIN rate on record was 23.25% in July 2000, while the peak through the ‘GFC’ was 17.09% in January 2009. Even though arrears reached such extreme levels, no rated RMBS tranche incurred an uncured capital charge off. Is arrears data a good measure of mortgage stress? There are no doubt households struggling with their mortgage payments given higher interest rates rising cost of living pressures. But, from the perspective of investing in RMBS, arrears measures are a poor measure of mortgage stress? SPIN only looks at delinquencies within the RMBS universe, which is a small sub-set of the broader mortgage market. In total there are roughly $2.3 trillion of mortgages outstanding nationally – predominantly written by banks. RMBS outstanding on the other hand is down around $90 billion, or less than 5% of total mortgages. Although RMBS is not the worst sample size it is however an incredibly biased and inconsistent one. Loans within an RMBS pool experience a high degree of churn as loans are prepaid at rates of 20% - 30% per annum, moving them out of the RMBS universe and into other funding vehicles, often refinanced by banks. To further complicate matters, outstanding RMBS loans are heavily skewed toward new loans, which are in their early stages (lightly seasoned). This means new RMBS issuances disproportionately influence SPIN, leading to downward pressure on SPIN during periods of high RMBS issuance. Naturally, new loans are less likely to fall behind on payments, with some pools having a weighted-average seasoning as short as six months. Another consideration is the nature of RMBS structures with call factors on RMBS trusts at around 10% - 25% of the original pool balance. In laymen’s terms, each RMBS trust will be brought back by the issuer at some stage, repurchasing the loans and taking them out of the RMBS universe. The call date is set at a certain date generally within 3 - 5 years of issuance, with an additional call-option if the original pool balance reaches 10% - 25% of its original amount. This means as RMBS loan pools season over a 3–5-year period, most loans are refinanced or paid-off prematurely and the remaining loans are subsequently called back by the issuer and vanish from the RMBS universe. Again, another reason why RMBS and SPIN are poor proxies for mortgage stress. Does arrears impact RMBS performance? SPIN is not only a poor proxy of mortgage stress but also a poor measure of RMBS fundamental performance. During the ‘Global Financial Crisis’ or ‘GFC’ (2007 – 2009), RMBS SPIN for non-conforming loans more than tripled, yet no uncured charge-backs were recorded on any rated tranche or note. There was a marked to market impact, given heavy selling on US contagion fears, but actual charge-backs or losses at the time, on rated tranches was zero. Mortgage defaults are relatively uncommon within RMBS pools since they represent unfavorable outcomes for all parties involved, yet they do obviously occur. Lenders are typically cautious about repossessing properties and handle each delinquent loan individually, utilising various measures to rectify the situation. Furthermore, when a loan does default, it is unlikely to result in a loss because the majority of loans in the RMBS universe have loan-to-value ratios (‘LTV’) below 80%. Typically, the weighted-average LTV within an RMBS pool is around ~67% or even lower. In simple terms, this means that if the collateral property is sold, the proceeds from the sale exceed the loan amount, ensuring that the lender is repaid in full. This is the principal advantage of securitised lending. However, even if the collateral does not fully cover the loan, there are additional measures in place to protect RMBS investors from losses. The most significant among these is the presence of ‘excess spread’ within RMBS vehicles. Each month, the RMBS pool collects principal and interest on its loan portfolio, which usually surpasses the principal and interest owed to RMBS note holders. The surplus amount is captured in the structure and can be used to offset any losses incurred by the pool. RMBS trusts often incorporate provisions for accumulating this excess spread in a designated account to prepare for any future losses should they occur. These lock ups / balances can average somewhere between 0.5% and 1.0% of the original pool value. Lastly, RMBS trusts are structured with different tranches, which constitutes senior and mezzanine financing. If losses occur, the charge-back is assigned to the lowest-ranking tranche, typically the unrated note – usually equity, which holds the lowest rank in the waterfall. Tranches can range from AAA rated (the ‘A’ tranche) down to unrated (the ‘G’ tranche). The excess spread from each period can be utilised to address these charge-backs during any subsequent payment month. It is worth noting again that no rated Australian RMBS note has ever experienced an uncured charge-back. There is long run historical data to support the strength of RMBS, or more specifically the economics of mortgage underwriting. Within the banking system, the long run average loss rate on mortgages has averaged 0.02%, since at least 1990. Banks tend to lend to prime borrowers only. Within the non-bank originator space, who cater to the non-conforming borrows, the long run average loss rate is less than 0.10% (originators with 20+ years track record). Now, within your standard RMBS structure, credit enhancements protecting the lowest rated tranche – the ‘F’ note, typically rated single B – total 1.00% - 2.00% on average, sometimes more. Again, no rated note has ever incurred an uncured capital charge back. Why RMBS and Why Now? While the interest rate cycle is likely maturing, there remains a fair degree of uncertainty around where interest rates will go from here. They may linger around prevailing levels (base case) or they could move higher of inflation lingers. This uncertainty underpins fragility in equity market valuations, which despite earnings headwinds remain within throwing distance of their all-time highs. Accordingly, for the more prudent investor, seeking income stability rather than risking capital loss, RMBS funds represent a worthwhile consideration. RMBS structures use floating-rate notes to fund mortgages, meaning they offer a coupon determined as a fixed spread or margin determined at issuance over the one-month bank bill swap rate (1MBBSW). Such structures shield investors from interest duration risk and allows them to benefit from a rising interest rate environment, or a steady income stream during periods of interest rate stability. In the past six months, the credit spread (over the BBSW 1M rate) on RMBS has significantly widened, with notes rated single B, or the ‘F’ tranche, pricing as high as +850 bps. This implies am initial coupon of c.12.5% for note holders. For more risk averse investors, the BBB rated notes, or the D tranches, the spread available is around +450 bps, which provides a coupon of c.8.50%. Mutual Limited is an active investor in the space, with the investment team having over 30 years-experience doing so. Our Mutual High Yield Fund (‘MHYF’) invests down to the B and BB rated tranches generally, with the fund delivering a current gross running yield of over 9.8%, or yield to maturity if 10.2%. Recent cash inflows to the fund have temporarily diluted the running yield. The fund targets a net return over the bank bill index of +4.5%. For 12-month period ending July 31st the fund returned +9.0% vs +3.2% the bank bill index, exceeding its target by +5.9%. Further up the capital stack, we have the Mutual Credit Fund (‘MCF’), which has up to 30% of assets under management in RMBS and ABS. This fund typically targets BBB and BB rated tranches in the RMBS / ABS space and currently is providing a running yield of 7.5%. The fund targets a net return over the bank bill index of 2.2%. Before any RMBS is added to these two funds, and our private mandated clients who appreciate this space, all deals undergo rigorous structural and cash flow stress testing. With regard to the latter, each deal is subject to a doomsday scenario whereby house prices are assumed to fall over 40% in the coming three years, unemployment doubles, the economy contracts by -4.0%, and all defaulting mortgages experience an immediate 15% valuation haircut…among other things. Typically, such an extreme-results in the equity tranche being wiped out, but not the rated tranches, although in some instances there is some very minor charge backs. This is because RMBS pools are structured in such a way to ensure they can survive such extreme downside scenarios. As a sign of Mutual’s analytical rigor, the firm invests in just 17% of the RMBS deals it is presented with. This note is for information purposes only, it does not constitute investment advice. Readers should consider their own personal circumstances before making any investment decisions. Disclosure This information has been prepared by Mutual Limited (“Mutual”) ABN 42 010 338 324, AFSL 230347).This document provides information to help investors and their advisers assess the merits of investing in financial products. We strongly advise investors and their advisers to read information memoranda and product disclosure statements carefully and seek advice from qualified professionals where necessary. The information in this document does not constitute personal advice and does not take into account your personal objectives, financial situation or needs. It is therefore important that if you are considering investing in any financial products and services referred to in this document, you determine whether the relevant investment is suitable for your objectives, financial situation or needs. You should also consider seeking independent advice, particularly on taxation, retirement planning and investment risk tolerance from a suitably qualified professional before making an investment decision. Neither Copia Investment Partners Limited, nor any of our associates, guarantee or underwrite the success of any investments, the achievement of investment objectives, the payment of particular rates of return on investments or the repayment of capital. Copia Investment Partners Limited publishes information in this document that is, to the best of its knowledge, current at the time and Copia is not liable for any direct or indirect losses attributable to omissions from the document, information being out of date, inaccurate, incomplete or deficient in any other way. Investors and their advisers should make their own enquiries before making investment decisions.

On the latest Talk Ya Book, Chris Judd welcomes back Scott Rundell from Mutual Limited. Scott shares his thoughts on interest rates and property, US inflation data, and the nuances of how inflation is measured in different markets.