Jonathan Rochford, portfolio manager at Narrow Road Capital, answers SCI's questions

Q: How is Narrow Road Capital involved in structured credit in Australia?
A: Narrow Road Capital is an Australian high yield and distressed debt asset management business, targeting investments primarily in loans, bonds, structured credit and listed notes. Structured credit is a key part of what we invest in, with the deal flow more regular and often having better risk/return characteristics than the deal flow from the bond, loan and listed note markets.

Narrow Road invests in both primary and secondary transactions in the Australian structured credit space, with particular interest in RMBS and CDOs. The Australian RMBS market has been gradually improving over the last few years, with larger deals and lower pricing, and is regularly finding a solid buyer base at triple-A levels.

Narrow Road typically targets investments paying at least 5% over the base rate, which means that we are looking at assets with ratings of triple-B and below. We will also look at CMBS and ABS transactions; issuance in these asset classes is, however, much more sporadic.

For CDOs, there is a rump of outstanding transactions that were issued in 2005-2007, which are now either defaulting and seeing their principal wiped out or are approaching their maturities with capital to be returned in the next 2-3 years. The buyer base for these transactions was not a typical institutional buyer base, so from time to time there are opportunities from sellers who have a particular reason for needing liquidity.

Q: How do you differentiate yourself from your competitors?
A: Narrow Road differentiates itself from our main competitors in three key ways. First, we are on the ground in Sydney and that allows us to see a much greater Australian deal flow than our primarily Hong Kong- and Singapore-based peers.

It also allows us to have a much broader understanding of the people and processes involved when we are considering investments. While we are well connected into the broker community here, we are not reliant upon the brokers for deal flow and source most of our transactions independently.

The second differentiator is that we target ticket sizes of up to US$20m, which limits the number of competitors in our key investment areas. We target mid-market and large cap deals, so as an example we are happy to invest US$5m into a US$300m transaction. In targeting the smaller ticket sizes, we find that we are much more helpful to the originators and the brokers, and also get better pricing relative to the same risk for a larger ticket size.

Finally, we have a track record of making and managing investments in Australia in our target asset classes over the last eight years that stands above the vast majority of our peers. For instance, in my capacity at Lehman Brothers I managed a structured credit portfolio (primarily CDOs and RMBS) from 2005-2008.

The portfolio was closed in the final days of Lehman Brothers and, since then, over 90% of the principal has so far matured or amortised, with the small number of remaining securities rapidly amortising and all are now stronger than at the time the portfolio was closed in 2008. In addition to the expected full recovery of principal, none of the 37 securities has ever missed an interest payment.

While it is common to see US and European asset managers who cover the broad range of high yield and distressed asset classes in their home markets, that model has yet to take off in Australia. The few overseas asset managers who have set up an office here have typically either set it up for marketing purposes (Australia is often named as having the fourth largest pension fund market) or to target investments in one particular asset class, such as large cap distressed and turnaround investments. Probably the only exception is Fortress, which I believe has the most diversified business model of the overseas credit specialists operating in Australia.

Q: What are your key areas of focus today?
A: At the moment, we are working on a range of investment opportunities across structured credit, loans and listed notes, as well as continuing to build our relationships with capital partners. Given the broad scope of our potential investments, the focus on just Australian opportunities and the relative newness of high yield and distressed investing in Australia, we are developing a mandate-oriented business model rather than focusing on fund raising for one particular close-ended fund.

We'd prefer to have a small number of really good mandates than a large number of investors in one fund. With a fund, realistically it is only possible to meet each investor once every three to six months and it is somewhat of a shallow relationship; many investors would like more than that. The relative immaturity of the market also means that it's better to work individually with investors.

On the investment side, there is always more potential deal flow than we can realistically cover, so we of course gravitate to the most developed and best risk/ return opportunities. If we had more time, we'd love to talk to the Australian banks about the potential to provide mezzanine financing on property and leveraged finance transactions, and to assist them with loan pools that they haven't been able to term out.

On the client relationship side, we have a lot of conversations with high net-worth and institutional investors who are coming up the curve on high yield and distressed debt as an asset class for their portfolio. While there is a definite demand for yield-oriented investments and lower volatility ideas compared to equity, the technical nature and lack of familiarity with structured credit is a significant hurdle for some. I always find it strange that many people will happily invest in preference shares and equity of a bank with few questions, but are very concerned about the risks of RMBS when it is arguably a simpler, more transparent and more stable version of a bank.

The credit markets reward three key variables: perceived risk, perceived complexity and actual illiquidity. The RMBS market in Australia is an example of perceived high risk, when - if proper due diligence is done - the actual risk uncovered is often much lower than the perception.

In order to really understand what's in a portfolio, it is necessary to talk to a lender's collections staff, go through the individual loan paperwork and tick off the relevant boxes in an audit fashion. These basic practises allow the good assets to be uncovered. Due diligence allows us to differentiate between perceived risk and actual risk, which is based on pool, structure and manager.

Particularly when it comes to due diligence, we only look at a limited pool of originators. Once we've done the initial due diligence, three-quarters of the work has already been done the second time we visit.

Q: What is your strategy going forward?
A: The expectation of a general shift towards debt investment in Australia - particularly higher yielding debt investment - is the reason Narrow Road Capital exists. The withdrawal of many of the European banks, Basel 3 requirements and increased cost of funding for banks all mean that great value in the institutional debt investment classes is likely to be a long-term feature of the Australian markets.

As investors start to allocate more to the asset class, the latent supply of higher yielding debt investments will become more apparent to the broader investment community. At this stage, many potential investors believe that the market is too small to devote time to or that listed retail notes are all that there is to consider.

For instance, there's no logical reason why one of the originators we're talking to at the moment is struggling to find other investors to look at their deal. It's a straightforward, high-quality transaction, but the yield isn't enough for distressed investors, the size isn't big enough for the typical institutional investors and the credit is a little bit tricky for some others. There are a small handful of houses in Australia that are in the sub-investment grade space, but they typically target larger opportunities and are often only focused on one sector, such as mezzanine debt for infrastructure.

A big part of what we do at Narrow Road Capital is simply to tell people what the broad range of opportunities are and how we can help them access those opportunities. In a sense, our strategy is to explain to whoever will listen that the markets here will develop to be more like the US and European markets and that we'd like to help them get an early mover advantage.

Q: What major development do you need/expect from the market in the future?
A: In 10 years' time I'd like to see high yield and distressed debt as an accepted and regular part of the institutional investment landscape in Australia, just as it is in the US and Europe. There is currently a lot of public debate in Australia about the relative over-allocation to equities by Australian pension managers, and the debate is likely to grow as the population ages and people demand greater capital stability from their retirement savings. Higher yielding debt is ideally placed to fill the gap as equity allocations are reduced.

To make the change happen, a lot of education will need to be undertaken. The largest Australian pension funds are just starting to wrap their minds around the fact that they can invest in Australian loans directly and are beginning to make some allocations to the asset class.

The understanding of structured credit investing also needs to improve; the view of a sometimes vocal minority that all structured credit is as dangerous as 2006 US subprime needs to be continually challenged. Not only has Australian RMBS and ABS performed exceptionally well through the credit crisis, but primary issuance today also comes with greater subordination for the same rating and is paying much wider margins than it was in 2007. I hope that in 10 years' time what we are doing today will have been a small part of bringing into existence this change.