Time to take bonds seriously

"Investors have learned that to survive market shocks they should have exposure to all asset classes, including bonds." Photo: Moviestore Collection/Rex

An interim report into Australia’s financial system could open the door to the corporate bond market for retail investors.

The search for a safe harbour is drawing mainstream investors away from an overload in equities and into fixed interest securities. Now an interim report into Australia’s financial system could open the door to the corporate bond market for retail investors.

Some of Australia’s most powerful groups are at loggerheads over whether to turbocharge Australia’s bond market – a topic that has emerged as a key focus of the Australian Government’s current inquiry into the financial system.

The inquiry’s head, David Murray, has often talked about the failure of the domestic corporate bond market. A country the size of Australia should have at least A$600 billion of corporate debt on issue, he says, way more than the paltry A$233 billion it currently has.

This view has triggered debate with both the Reserve Bank of Australia (RBA) and the funds management industry. They don’t want Canberra to step in, arguing that efforts to influence financial institutions’ decisions are unnecessary since the debt market is growing by itself.

Certainly, market forces are already working.

“The corporate bond market is really starting to grow at the wholesale level and the retail level is starting to get some traction,” notes Warren Bird, who used to head global fixed interest and credit at Colonial First State Global Asset Management.

While the market may be picking up, at A$7 billion domestic corporate bonds still account for less than 1 per cent of total superannuation assets.

In Australia, instead of super funds financing the corporate sector directly through the corporate bond market, they’re financing the banks. The banks, in turn, fund corporates.

This isn’t how sophisticated markets behave. But it’s not currently a problem for companies because debt is so cheap their needs are being met by their lenders.

Or as the RBA’s deputy governor, Philip Lowe, puts it: “We shouldn’t lament the state of Australia’s corporate bond market, because it’s a sign of the health of our banking sector.”

However, this will change and companies will want to borrow directly from investors, according to Curve Securities chief, Andrew Murray, who shares the view that a vibrant corporate bond market provides competition in the financial system by ensuring that banks don’t charge too much for loans. And it offers companies a real alternative to raising money from the sharemarket or from the banks.

The bigger problem is that Australian super funds have just 14 per cent of their portfolios in bonds, compared with the US where pension funds hold 27 per cent in bonds, Canada, where pension funds hold 36 per cent, and Japan, where such funds have 56 per cent in bonds, according to actuary Towers Watson.

Having such a low proportion of funds in interest-bearing assets poses a risk. And following Australia’s woeful performance in the wake of the 2008 sharemarket meltdown, retail investors now understand the danger of putting their faith in shares rather than bonds. After 2008, Australian super funds were the second worst performers globally due to their substantial share allocations.

Leery of equities, investors are trying to find a better way to hedge equity risk. National Australia Bank’s head of debt markets, Steve Lambert, confirms that retail demand is developing in Australia for the first time. He sees the changed behaviour as the response of an ageing population keen to protect its wealth.

“Even though we are at the low point of the interest rate cycle, people feel a need to rebalance their portfolios with fixed interest products.”

People have become alive to the risks now, confirms Matthew Johnson, interest rates strategist for Australia at UBS.

“They’ve learned that to survive market shocks they should have exposure to all asset classes, including bonds.”

Tariq Holdich, ANZ’s director of equity capital markets, also observes the trend.

“Increasingly, people are looking – as they get older – at more defensive asset classes and fixed income has become popular, particularly with self-managed super funds and high net-worth investors.”

Although retail investors are now feeling more confident about the global economy, they’re still looking at a lower growth scenario. They may be ready to take on some risk, but many investors want a defensive security that produces some certainty of cash flow.

The growth of the self-managed superannuation fund (SMSF) sector is boosting the appetite for corporate bonds, as investors look for higher yielding income in their portfolio. Bird says they are particularly looking at the debt listed on the ASX, such as hybrids and unrated bonds.

“They come with particular levels of credit risk and, increasingly, it seems that more and more investors think it’s worth it, since yields on three-year investment grade bonds are much the same as for term deposits.”

There are other signs that the retail investor is changing. In March, the appetite for fixed income exchange traded funds (ETFs) among Australian investors reached a high, according to Amanda Skelly, head of SPDR ETFs, Australia. More than US$13 billion in net cash flows have been invested in fixed income ETFs over the first quarter of the year.

“That’s more than twice that of equity-based ETFs,” she says.

Johnson says a strange feature of Australian retirees is the extraordinarily large risks they take. Super funds will commonly hold equities which are the least protected part of the capital structure, yet they won’t hold bonds.

“It’s crazy to hold a stock and be the furthest person down the food chain when you can buy a hybrid or bond, take less risk, and get a better return.

“What this has highlighted is that the role of fixed income as an important ‘stabiliser’ or ‘portfolio diversifier’ is still not well understood by many Aussie investors,” says Skelly.

Yet in the US, which has a similar demographic make-up to Australia, the demand for fixed interest ETFs has outstripped the demand for equities this year – and the sharemarket has gone gangbusters. That’s the reverse of Australia – until March.

US retail investors have long put their money into interest-bearing assets. Bird says there are a lot more large companies borrowing a lot more money, so it’s economical for the US to have a big capital markets sector. Also, US companies traditionally pay lower dividend yields than those in Australia, where dividend yields of 4.5-6 per cent are common.

But the bond sellers are out in force.

“Everyone from [Australia’s] big four banks down are educating clients on the features of the various fixed interest securities and where they sit in the company capital structure,” notes ANZ’s Holdich.

“You’d have to say if you offered someone an unsecured bond it has to be safer, just by definition, than say ordinary equity, because they’re investing in a more senior part of the capital structure.”

Enter the retail investor

About 99 per cent of corporate bonds are owned by institutions because the minimum 500,000 parcel size hinders retail investor purchase. This group are stuck with listed debt securities as well as a few over-the-counter (OTC) products.

Market players are trying to do something about that – splitting wholesale bonds into smaller parcels and selling them to retail investors. ANZ prefers to offer retail investors listed securities sold under prospectus because of the transparency and liquidity provided by the ASX. Westpac and NAB are selling unlisted bonds to income-hungry investors and FIIG Securities, the country’s largest fixed-income broker, is bringing in OTC-type deals and issuing unrated unlisted bonds.

Mark Paton, chief executive of FIIG Securities, wants the rules to stop favouring wholesale investors over their retail counterparts. Currently, only big institutions can buy bonds at the point of issue. After it has been circulated for a year, then retail investors can own the bond, but waiting 12 months means they may be forced to pay a premium. One way to make things fairer is for regulators to drop the “seasoning period” from 12 months to 30 days, in line with other markets.

Allowing SMSFs and SMSF trustees to automatically qualify as wholesale investors for the purposes of investing in corporate bonds would also help.

New legislation will definitely open up the market in Australia to a broader investor base. Moves are afoot to do this with the blending of the wholesale and retail markets under the proposed new Simple Bond legislation. Corporates will be able to issue a bond using disclosure documents that work for institutional and retail investors. Banks and brokers can buy bonds on behalf of retail investors and subsequently offer a listed tranche using the same disclosure document.

“Right now, if a well-regarded corporate wanted to issue a senior listed bond they would have to put out almost as much information as if they were going to issue new equity. That needs to be fixed and we understand the current government wants to deliver a simplified corporate bond regime for vanilla bonds,” says Holdich.

In essence, this means big ASX-listed companies, such as BHP Billiton and Rio Tinto – who already comply with the continuous disclosure regime – will be allowed to issue “vanilla” (or straightforward) bonds without releasing an extra prospectus for retail investors.

But it’s not as clear-cut as saying let’s make it so much easier. The last thing you want is to dilute the amount of helpful information given to investors.

"It’s crazy to hold a stock and be the furthest person down the food chain when you can buy a hybrid or bond, take less risk, and get a better return." – Matthew Johnson, UBS

“If Australian companies want retail investors to lend them money by purchasing their debt securities, then they have to be prepared to provide relevant information to the market so they can make an informed decision on the company’s credit risk,” Bird argues.

While listed companies shouldn’t have to issue a full-blown prospectus for every new bond issue, he says, the information they provide the stock exchange isn’t the ideal data set either.

“Equity and bond investors need different things. I’d prefer a regime of regular full prospectus updates (say once every two years) with short-form prospectuses each time a new bond is issued that would outline key credit metrics.”

Unsurprisingly, issuers want less red tape; investors want a tax incentive.

At the moment, dividends get better treatment tax-wise through franking credits, yet interest on bonds is 100 per cent taxable. That’s because companies haven’t paid tax on the interest earned by investors and often it is claimed as a tax deduction. Sorting such issues will be top of the agenda for the current inquiry into Australia’s financial system.

Retail unfriendly

Mark Paton, chief executive of FIIG Securities, Australia’s largest fixed-income broker, believes the corporate bond market will only grow when non-institutional wholesale investors and retail investors become more engaged.

“Market forces work fine if you’re an institutional investor; market forces work fine if you have a credit rating and want to issue a corporate bond,” Paton says.

But it is the smaller companies and retail investors who are not well served. The growth of the Australian corporate bond market depends on making life easier for the smaller unrated borrowers to tap into it, he believes.

Until recently, says Paton, Australia’s capital markets have lacked the depth for debt funding for mid-market businesses and mid-cap listed corporates. He talks of competing forces in the broader financial services sector, explaining that for many the expansion of the corporate bond market doesn’t necessarily suit. Regulators seem fixated on the importance of listed fixed-interest securities as the way for retail investors to enter the corporate bond market.

Australia’s over-the-counter bond market has more than A$1 trillion dollars on issuance, making it as liquid as, if not more so, than the ASX.

“Most bonds globally are traded on the OTC market, yet no one talks about it in Australia,” says Paton.

Some experts believe the real obstacle to a domestic bond market is weak demand at the retail level.

“To make a market you need buyers and sellers, investors and borrowers. And if the investors aren’t going to be there – even if the cost to the borrower issuer is cheap – then the market won’t develop,” points out Warren Bird, a veteran fund manager and financial commentator.

Ross Bolton, senior fixed income portfolio manager, State Street Global Advisors (SSgA), agrees. In the past, he says, either there hasn’t been enough demand or the demand has been at the wrong price.

'Time to take bonds seriously, Moneypenny.'Photo: Moviestore Collection/Rex

'Time to take bonds seriously, Moneypenny.'

Photo: Moviestore Collection/Rex

With bond yields at historical lows and unlikely to rise over the next few years, it’s difficult to see how corporate bonds can be as attractive as high-yielding bank stocks. As well, investors may incur a capital loss if they sell out before a bond reaches maturity. That said, consumer demand is mostly for “floating notes” for just that reason. Rates are reset each quarter so if rates go up, interest rate risk is alleviated to some extent.

For some, the answer might be to switch money into absolute return bond funds, which use a wider range of tools and techniques to boost returns.

Paton says current legislation works against retail investors – locking them out of opportunities. Matthew Johnson, interest rates strategist at UBS, also reckons the rules make it easy to buy equities and hard to buy bonds.

“Indeed, regulation makes it easy for a person to become the least protected person in the corporate capital structure,” he says.

“Anything that deregulates the superannuation market will make it more competitive and lower fees, and that’s the beginning of a reasonable inclusion of bonds in a portfolio.”

Examining high fees will certainly be a priority for David Murray’s inquiry into Australia’s financial systems, which is due to deliver an interim report in the middle of this year, and a final report in November.

Indeed, in April, the Grattan Institute found that Australia’s super funds were charging fees that were triple the median rate of other OECD nations.

This article is from the July 2014 issue of INTHEBLACK.

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