Foundational Concepts

The May Federal Budget has thrown a significant spanner in the works for wealth creation and property investment in the name of intergenerational equity.  The jury will be out for quite some time on whether this objective is achieved – the younger members of our team here at Corval Avenue actually feel the rug has been pulled out from underneath them.

For those who have saved, invested and built wealth responsibly over decades, a pivot towards income investing may suit both the new tax paradigm and their life stage, where they are looking to replace income from work with income from investments.

How do you make your wealth work for you in retirement – without taking excessive risks that could erode what you’ve built?

Our team has put together a series of articles with the aim of demystifying fixed income investing generally and highlighting the attractiveness of senior secured real estate credit as a complement to a traditional bond-focused fixed-income portfolio.

In this first article, we will explain three concepts that are essential to understanding any fixed income or credit investment: Duration, Yield and Liquidity.  We will also make a quick comment on how they apply to real estate credit.

Duration

Duration is probably the most important and the most misunderstood concept in fixed income and an example aids understanding more than the dictionary definition.

Imagine you lend someone money for 10 years at a fixed interest rate of 4 per cent per annum. Halfway through the loan, interest rates in the market rise to 6 per cent. You’re now locked into receiving 4 per cent when the going rate is 6 per cent. If you were to try and sell your loan, it is worth less to anyone who might want to buy it from you because it is paying sub-market interest rates.  The price of your investment has fallen. The longer the remaining term of the loan, the bigger the price fall for any given increase in rates.

For the purists, the dictionary definition is “the sensitivity or relationship between a change in interest rates and the change in the value of a fixed-income investment.”

A bond with a duration of 7 years will lose approximately 7 per cent of its value if interest rates rise by 1 per cent. The longer Australian government bond portfolio carries duration in the range of 7 to 10 years. In 2022, when rates rose by roughly 3 percentage points, investors in long-dated bonds experienced capital losses of 20 to 30 per cent.

Duration is relevant to real estate credit, but much less so than for other fixed income instruments.  Commercial real estate loans are typically short-term, mostly 12 months with some stretching to 3 years.  This means the interest rate on the loans is repriced regularly so they have comparatively low duration.

Yield

Yield is the income return on your investment expressed as a percentage per annum. 

Gross yield is the return before fees and costs. Net yield is what you actually receive after the manager takes their fees. 

In real estate credit, as with all fixed income or credit products, the yield is essentially the total return.  There is no capital appreciation.  If you lend a dollar, you are expected to receive interest over the life of the loan and get that dollar back at the end.  By contrast, shares pay a dividend (the yield) and also may have capital gain (or loss) as part of their total return.

Liquidity & Liquidity Premium

Liquidity refers to how quickly and easily an asset or security can be converted into cash without affecting its market price. It measures the ease of exchange and access to cash to meet short-term financial obligations, with cash being the most liquid.

A liquidity premium is the additional return or higher yield investors demand for holding assets that cannot be easily or quickly converted into cash at fair market value.

Liquidity is where real estate credit is meaningfully different from listed investments, equities or credit.  Mortgage loans cannot be sold on an exchange. The underlying loans have fixed terms — typically one to three years — and can’t be liquidated on demand.

For investors who can accommodate illiquidity, the question is whether the premium is adequate.  That’s a judgment each investor and their adviser need to make in the context of their overall financial position.

Disclaimer:

This article is general in nature and is prepared by Corval Avenue for discussion and educational purposes only. It does not take into account your personal financial situation, objectives or needs. Nothing in this presentation constitutes personal financial advice. Any decision to invest should be made in consultation with your financial adviser and after reading the relevant product disclosure statement.