In capital markets, different sectors traditionally have different risk profiles. In general, more volatile assets provide a higher return in times of economic expansion, but perform worse in times of deflation. This is applicable in both the equity and fixed income markets.
It is for this reason that certain sectors have traditionally been classified as “defensive” sectors, as they provide investors with safer and better relative returns in times of economic downturn. Typical examples of defensive asset classes are gold bullion, pharmaceutical companies, food companies, certain infrastructure assets, utility companies and quasi government / sub sovereign entities. These sectors tend to be more removed from the economic cycle.
Within these sectors, certain sectors are considered at the lower end of the risk spectrum. Specifically these sectors include:
- Regulated Utilities
- Public Private Partnerships
- Sub Sovereign Entities, such as provinces, cities and US municipal bonds
- Governments & Supra-nationals.
Being at the lower end of the risk spectrum effectively makes them the least risky of all market segments and debt default history in all sectors has illustrated this. It is within these four sectors where Broad Peak Finance has focused its attention i.e. the Public Sector debt finance market.
(i) Regulated Utilities
Certain utilities, namely electricity, gas and water, often operate in a highly regulated industry. This is primarily for two reasons – the monopolistic nature of the business, and the essential nature of the service provided.
The UK has the most developed regulated market in the world, and as such debt regulated by UK utilities has an excellent track record with no defaults recorded.
Utilities are also considered a good defensive sector because the demand for the service provided has little elasticity of demand, being fundamental to the operation of an economy and for day-to-day living.
[ Top of Page ]
(ii) Public Private Partnerships (PPP)
A PPP is an arrangement between the public and private sectors with clear agreement on shared objectives for the delivery of public infrastructure and/or public services by the private sector that would otherwise have been provided through traditional public sector procurement. The structure can be used for providing services such as schools, roads, hospital and other assets traditionally provided by the public sector.
The sector is considered defensive because of the essential nature and low elasticity of demand of the service provided by PPP transactions. Furthermore, there is often heavy regulation or supervision and cash flows in the transaction which are used for paying interest and principal on the debt come from public sector entities.
Broad Peak Finance focuses on the lowest risk European PPP transactions with significant government support and little market or volume risk on the asset.
[ Top of Page ]
(iii) Sub Sovereign Entities
The sub sovereign debt market is a specialist market which provides arguably the strongest recessionary defensive play in international capital markets.
Although credit quality of a sub sovereign borrower may deteriorate due to reduced revenues from tax collection, unlike corporate borrowers, sub sovereign borrowers have the unique ability to increase “turnover” by raising taxes. They may also benefit from state support or institutional lenders of last resort, and there are often very strong central government controls.
Defaults for publicly rated local government borrowers have been extremely rare and in most cases recovery rates have been close to 100%. Moody’s has recorded no OECD (ex US) sub-sovereign defaults since it started its sub sovereign rating scale in 1983.
[ Top of Page ]
(iv) Governments and Supranational
The highest authoritative level in any country is the governing body, which is also generally the lowest risk borrower in any jurisdiction. The largest global borrowers are also governments, with the US having a larger amount of debt outstanding than any other single entity. However, because of the ability of governments to change laws and statutes, the huge revenue base available to them and its mandate to control the national monetary system, they remain the lowest risk borrowers in the world.
Supranational Agencies (such as World Bank and the Inter-American Development Bank) are normally guaranteed on a jointly and severally basis by the member state, or by the percentage shareholding a state has in the agency. Therefore, depending on the agency, they are often comparable to government bonds from a risk perspective, but because of structural issues may provide even more attractive returns.
[ Top of Page ]