The Australian domestic debt market has long promised more than it has delivered. Not any more. In recent months, the pace of activity in the primary market has surprised even the most bullish participants.
Corporate issuance is growing fast, while the Kangaroo market for foreign issuers has also come back to life as borrowers try to fill the gap in investor portfolios caused by declining government bond supply and the investment requirements of the fast-growing Australian fund management industry.
Some still say it is all a flash in the pan. But many others believe that the market has now developed critical mass and a level of diversity - of maturity, credit and yield - that has been lacking in the past. Who is right? Mark B Johnson reports.
The explosion of activity in the domestic Australian bond market in the first months of 1999 has taken even the most optimistic of the market's protagonists by surprise. Corporate issuance has come thick and fast, moving down the credit scale and along the maturity curve, and the Kangaroo market for foreign issuers has come alive again after a long pause.
The year started modestly with just three issues in January, all showing tell-tale features of the traditional domestic market in recent years - fairly small deals, from highly rated bank issuers and with maturities of less than three years.
Then in early February Commonwealth Bank of Australia (CBA) broke through the yield ceiling with a 10 year subordinated issue of A$300m, rated A+. The deal was followed later that same month by a similar issue for Westpac, also with a 10 year maturity.
But better was to come in March. Leading corporate names surged into the market - the most notable deal being the dual-tranche A$530m placement for triple-A government-owned credit, Australia Post, which included a A$300m 10 year tranche.
For the first time, the domestic bond market is delivering what so many had hoped for in recent years. It is offering yield to return-hungry investors, moving down the credit curve (triple-B corporate names began to emerge in April with a well received issue by media group John Fairfax) and offering corporate borrowers an increasingly viable alternative to offshore bond issues and bank loans.
Meanwhile, amid this spate of domestic corporate activity, a pack of foreign issuers led by the Asian Development Bank - and including Nordic Investment Bank and a host of public sector German banks - are attempting to inject new life into Australia's stop-start Kangaroo market.
Hoping to extinguish memories of a controversial A$1bn debut in the Kangaroo market last year, ADB returned at the end of April with a A$500m five year offering led by Warburg Dillon Read and Westpac.
Although the Kangaroo market has been in existence for many years, it has never managed to build up any viable momentum and was dealt a blow to its credibility when a series of issues by Korean credits collapsed when Asia's crisis struck.
The ADB's deal last year had been criticised in some quarters for being too big, although others had said that poor syndicate discipline had been a factor in the issue's disappointing reception.
Ironically, it was the liquidity of this earlier issue - and its resulting outperformance in the recent market rally - that enabled the ADB to re-enter the market, which it had been keen to do since the start of the year. This time there was no disputing the deal's success.
"The first ADB issue has been one of the most actively traded issues in the market, even relative to the semi-state borrowers," says one banker. Another adds, more ambivalently: "This issue wipes the slate clean where the ADB in Australia is concerned."
One week later it was the turn of German development bank DSL, which launched an equally well received debut Kangaroo bond - the first by a German issuer - through Deutsche Bank and Warburg Dillon Read.
Strong investor demand enabled the deal, which was launched off DSL's A$3bn programme to be increased from A$500m to A$750m - with even DSL officials expressing surprise at being able to increase the deal by 50% so quickly.
Like the ADB, DSL - which is 51% owned by the German government - intends to be a regular issuer in the market. "With Australian government bond supply diminishing, there are opportunities for issuers like us," says one funding official. "We would hope to tap the market about twice a year."
Among other foreign issuers waiting to tap the market, and which have established debt programmes in anticipation, are German development agency Kreditanstsalt für Wiederaufbau, Nordic Investment Bank and Landesbank Baden-Württemberg.
In the same week in early May, the domestic corporate market saw another important development when retailer Coles Myer launched its largest single offering. The A$200m 2003 bond was upped by a further A$50m on the back of strong investor support, the deal confirmed the pulling power of the single-A rated company's brand name.
The first quarter of 1999 saw A$4.78bn in total non-government issues (including CBA's government-guaranteed issues), of which A$1.63bn (34%) was corporate and the remaining two thirds was bank issuance.
In the article that follows, Euroweek presents a roundtable discussion with five leading underwriters that have invested the time and effort to support the market's disappointingly slow development in recent years.
The key trends in the market are highlighted as well as the details and significance of the prominent deals of the first several months of this year.
However, it would be inappropriate to present these arguments without the balancing views of leading international firms that do not choose to participate in the domestic market.
While enthusiastic about developments in the domestic market, some of these firms caution against over-enthusiasm as non-bank corporate issuers still need the breadth of issuance opportunities that has been available in the Yankee sector and which are becoming more accessible in the Euromarket.
One banker at CSFB argues: "In the past, the domestic market has not been a serious alternative to offshore issuance. It has been domestic brand name oriented and has favoured only the strongest credits, including subsidiaries of US companies and certain triple-A foreign issuers. For the average Australian issuer it offers a very limited universe of investors, short maturities and relatively small deal sizes."
Gregg Johnston, managing director of JP Morgan Australia Securities, points out that "the local corporate bond market is providing competition to the bank market," but he is concerned that "it is still inherently short term". He agrees that the market "is reasonably price efficient out to three and occasionally five years," but maintains that "it does not bring much incremental value in terms of diversity to the Australian treasurer".
JP Morgan is one of the more successful of the foreign investment banks operating in Australia, but the firm has chosen not to compete in the local market. Johnston backs his views with a historical perspective.
"Investors all say that they want longer maturities, but they do not yet appear ready to reduce their pricing expectations to levels where longer dated domestic issues can compete with the offshore markets," he says.
"There is somewhat of a vicious circle. The necessary degree of pricing tension does not exist for long term assets because institutions still remain suspicious of those longer dated deals that have emerged."
He adds: "There is a strong perception over the past year or two that portfolio managers have paid for duration flexibility by taking longer dated domestic issues. They have often found out later that bid/offer spreads blow out when they try to adjust their portfolio."
CSFB has also enjoyed considerable success over the years with leading Australian issuers. But an official at the firm is genuinely concerned that the market might be pushed beyond its limits in a wave of (albeit understandable) enthusiasm.
"Lots of people have been trying desperately to kick start the market in a fashion that reminds me of the early days of the Eurosterling market as it tried to shake off the shackles of the old Bulldog market with which the local market here shows many similarities," he says.
"It is illiquid, there are not enough investors to create competitive price tension and new issue pricing is not always transparent. Often, the investors end up pricing the deals and lead managers end up owning large portions of the issues they have brought."
As far as this banker is concerned, the main driver for the growth of the corporate debt market is not so much demand from issuers or investors as banks offering an alternative to syndicated loans.
"As with other debt markets around the world, the local commercial banks are leading the market because the issuers would be their natural clients on the commercial banking side," he says.
"All the major banks here are aggressively competing for lead management roles. Banks can justify ending up with a large chunk of an issue on their books, because they have made the deal fees, they have not lost the client and they have a surrogate loan on their books. However, secondary market trading remains an issue as there is usually only one price maker in the market."
Until very recently domestic investors have been reluctant to take up any issues rated below single-A. JP Morgan's Johnston explains: "A paradox of the local market is that only recently have we seen issuers south of the single-A credit rating whereas most of corporate Australia is at or below that rating.
"For the local market to become truly viable maturities need to go out, pricing at the longer end needs to contract and institutions need to become more willing to go down the credit curve. We are not so rash as to say that these factors will never emerge or coincide, but we are not particularly confident in the near term. Accordingly we would rather focus our current efforts on taking Australian companies offshore."
Another foreign banker, who prefers to remain anonymous, believes that in the past bankers have been overzealous in their efforts to push out maturities and simultaneously obtain sufficiently tight pricing for their clients.
"What really puts investors off," he says, "is when sales people call at the launch of a new issue and ask them to buy at, say, plus 65bp and the investor says 'no'. Half an hour later the same salesman is on the phone with the same paper at plus 75bp and the investors says 'no' again. Then three days later the same salesman is trying to push the paper at plus 85bp.
"Participants don't want to admit that this is happening, but it is. Deals that are too ambitious in terms of size and pricing are still being promoted today and we believe that these issues continue to be poorly placed."
However, the same banker points out that "recent deals signal an improvement and we applaud the effort of the issuers and the intermediaries involved." Nevertheless he cautions that "it remains to be seen whether these are a mere flash in the pan".
As the 10 year National Australia Bank deal in late 1997 showed all too clearly, one bad issue can very quickly bring the market screeching to a halt. That particular deal put paid to the market for about six months.
The AA- subordinated NAB issue of November 1997 was priced at just 27bp over the swap - whereas the A+ Westpac subordinated deal launched this March was priced at a far more realistic spread of 52bp over the swap curve. Bankers say this indicates that NAB's issue should have carried a spread in the plus 40s.
Pricing and credit relativity are both improving in the local market, but there is still some way to go. "In overseas markets, a deal is led mainly by its credit relativity whereas here there is little credit investigation in terms of linkage to international comparables," says one foreign banker in Sydney.
"We believe that this leads to wilder swings in pricing and a lot more 'gaming' because there is a lack of transparent secondary market trading levels. Offshore, on the other hand, you will get far closer to the real pricing for a new issue because secondary market comparables are that much more available and comprehensible."
Banks that have made the decision not to participate in the market are also concerned about the law of diminishing returns. "We recognise that for the local commercial banks it is vital for them to take a leading role in pushing the domestic bond market," says a banker from one such firm.
"We can also understand why some foreign houses are competing fiercely. But our interest in the market, like many other leading foreign houses, dissipates when we hear stories of fees down to a mere 10bp for term issues.
"In targeting, for example, the Euromarket - where fees are closer to 30bp - we can achieve returns for our shareholders as well as offering our Australian clients access to a growing market which offers depth, liquidity, cost effectiveness and diversity of funding."
Another international banker echoes these views. "As an institution, we are not prepared to invest our time and money in the market," he says.
"If there are no fat returns at the inception of a market - and this is a relatively immature market - then why bother?
"The numbers do not stack up for us. We do not see the critical mass of issuers coming into the market and we would rather focus our efforts on taking these companies offshore where we believe there will be considerably more opportunity and activity in the months ahead."
What then of the opportunities afforded should interest withholding tax be removed and a flood of new investors pours into the local market? One banker believes he has the answer.
"If you look at the performance of the Australian market and the currency over the past decade you will see that it has massively underperformed the US and most other leading markets. Therefore you have to ask why foreign investors will suddenly emerge as big buyers of Australian debt paper when history would militate against it."
He adds: "Remember that the last time Australian dollar paper sold offshore in bucket loads, local interest rates were 15% and above. Today interest rates are under US dollar levels. This would seem to indicate that any buyer needs a very aggressive viewpoint on the upside potential of the economy and the currency to buy Australian dollar corporate debt paper as an alternative."
Other bankers are also cautious, arguing that foreign investors should be seeking incremental returns for participation in the domestic market. "We believe foreign investors will be justified in demanding a premium for the relative lack of disclosure, the lack of liquidity and the potential for excessively large bid-offer spreads," claims one.
"If you look at the major trends in the offshore markets you can see that investors continue to migrate towards the big, liquid tradable benchmarks. If they play in smaller, less liquid, more marginal markets they need a liquidity premium, especially from the smaller issuers.
"You have to wonder why the foreign investors should take a different viewpoint when coming into a small foreign market with credit, currency and interest rate exposure."
Bankers do on the whole agree that the arrival of more foreign investors, following the removal of withholding tax, will enhance liquidity. But one cautions that "some more fundamental changes will be demanded by European and US investors before they will become serious participants here".
He believes that disclosure, for example, needs to significantly improve. "Foreign investors do not simply want to look at the mechanics of disclosure," he says.
"They require an understanding of the style of management and overall transparency of a company in order to make the credit evaluation and relativity that they are used to offshore.
"The local market therefore needs to introduce standards that eventually allows the market to compete with the highest codes of practice in more developed jurisdictions."
The same is true for foreign issuers. As a vibrant Kangaroo market daily becomes more of a likelihood, Australian law firms are increasingly asked to opine on the levels of disclosure required of the issuers. Says Richard Mazzochi, partner at leading law practice Mallesons Stephen Jaques: "The content of offering documents for securities distributed in the Australian wholesale market, and the extent of due diligence undertaken in respect of such documents, continue to be contentious issues, especially now that more foreign issuers are lining up domestic MTN programmes."
As is the case with most countries with well developed capital markets, a different regulatory regime applies in Australia depending on whether securities are issued to retail or wholesale investors. A wholesale issue is one for which the minimum subscription amount is at least A$500,000.
"Because wholesale securities issues in Australia tend not to be listed, the content of related offering documents are not subject to the prescriptive provisions of listing rules to which many Eurobond offering documents are subject," says Mazzochi.
"This is because market practice and Australia's legislative regime are founded on the assumption that sophisticated investors do not need the protection of the registerable prospectus provisions."
Nevertheless, Mazzochi cautions potential Kangaroo issuers and their investment banking advisors to err on the side of over-provision, rather than under-provision, provision of information and due diligence support.
"Unfortunately, as yet, the legislators have not clarified disclosure for debt securities offerings to wholesale investors but we advise clients to follow the distinct trend toward more detailed disclosure being made in offering documents in the Australian wholesale capital markets," he says.
Mazzochi points out that the greater disclosure is driven by several key factors. "Institutional investors doing their own credit analysis rather than relying on the analysis undertaken by ratings agencies" is one factor, he says.
"Expectations developed as a result of the many recent privatisation deals, where the same very detailed information was made available to wholesale debt security investors as was given to bank debt and equity providers. Moreover, issuance is being undertaken by entities about which little information is otherwise readily available either because they are newly established, unlisted or foreign entities."
Some potential Kangaroo issuers are also keen to exploit Australian retail investors. Listing of debt securities on the Australian Stock Exchange Limited (ASX) has generally been utilised where issuers wish to tap a retail investor base.
It has not generally been market practice for wholesale issues of debt securities to be ASX-listed.
However, as a result of anticipated changes to Australia's interest withholding tax laws, listing of debt securities on the ASX (in addition or as an alternative to London or Luxembourg listing) is likely to become more prevalent. For example, Nordic Investment Bank's recent Kangaroo bond programme is ASX-listed. EW