Whatever the arguments, it appears clear that - for the moment at least - bank and corporate treasurers have, in the domestic debt market, a real alternative to offshore issuance and bank loans. And foreign issuers are increasingly attracted by the potential.
For those who believe that Australia could establish a role as a financial centre in the Asia-Pacific region, the growth of the domestic debt market is a highly encouraging development. Euroweek asked senior executives at ABN Amro, Commonwealth Bank of Australia, Deutsche Bank, Merrill Lynch and Westpac for their opinions on the market's evolution and prospects in the months and years ahead.
* Graham Metcalfe, director, debt capital markets, ABN Amro
* Wayne Hoy, chief manager, financial markets division, CBA
* Paul Umbrazanas, director, capital markets, Deutsche Bank
* Stephen Duchesne, head of debt capital markets, Merrill Lynch
* David Hurford and Julie Hunter, respectively director and associate director of capital markets, Westpac
Q: Corporate bond issuance in the first three months of this year was almost A$5bn against A$7bn for the whole of 1998. And the pace is still picking up. What reasons would you ascribe to the issuance boom by both corporate and bank names?
ABN: There is one compelling reason - the fundamental
imbalance between the supply of traditional securities and demand
from institutional investors. Institutional investors have ever
increasing funds under management as Australia embraces
professional management of its savings and the Australian
government forces an ageing Australian
population to fund its retirement through compulsory superannuation levies.
Reduced public sector borrowing requirements due to privatisation and a new era of fiscal restraint have left the way open for non-government borrowers to meet the shortfall in government and semi-government new issuance.
CBA: The real driver for change here is the growth of institutional retirement funds since the early 1990s. With individual contributions at 7% of gross personal income, and with rising asset prices in the property, equity and debt markets, the growth in the available pool of investible savings is now becoming almost exponential.
Around A$65bn of new money is invested each year and, if one adds earnings on existing retirement savings, recent statistics - for December 1998 - indicated that new funds of close to A$120bn came into circulation last year.
We are also witnessing a rise in asset allocation to fixed
income from about 12% of institutional portfolios in the last
quarter of 1998, to the current levels of around 18%. While this
reallocation has been largely at the expense of cash holdings, it
is not only a function of the view on interest rates but also on
valuation of equity markets.
DEUTSCHE: Australian fund managers have a very real need to increase the proportion of corporate bonds in their portfolios evidenced by the high level of issuance absorbed by the market.
This is driven in part by the redemption of federal and state government bonds whose outstandings declined by approximately A$3bn in the first two and a half months of the year.
Secondly, fund managers are searching for yield in a low interest rate environment. Meanwhile, corporate Australia has become perceptively less risky as economic growth has improved and as the equity market has grown in value and liquidity allowing the potential for major corporates to refinance balance sheets if they should require.
The result is that there is a dramatic realignment of corporate bonds within the Warburg Dillon Read Australian Composite Bond Index (ACBI). In February, federal government bonds accounted for 54.1% and state bonds for 36.5% of the ABCI and 9.4% was allocated to corporate bonds.
This was already reweighted by early April to bring corporate issues to 11.5% of outstandings held by institutions. Total non-government debt in the market is now valued at around A$45bn, whereas government and semis are worth A$90bn.
You can therefore see that non-government issues are gaining a critical mass. Of the non-government debt, it is split roughly equally between securitised paper and corporate and bank paper.
The clear message is that portfolio managers need to reweight their portfolios in line with the index. If they do not, they will be effectively betting against the index. In the next six months alone there will be some A$7.3bn of government redemptions. This will push the corporate component of the index up again to around 14%.
MERRILL LYNCH: With the decline in government and semi-government debt, funds are moving into new asset classes. They are buying more bank paper, straight corporate issues and they are increasingly looking at offshore corporate bonds.
Investors here need yield-enhancing products on the fixed income side because interest rates have plummeted. We are therefore also seeing that they are moving further down the credit spectrum to single-A, A- and more recently to triple-B and below in the domestic market.
For the moment, they feel most comfortable with lower rated bank names but there will certainly be more lower rated corporate issuers coming through the market.
The success of the recent Fairfax issue is a very encouraging sign that the domestic market is developing an appetite for new credits rated lower than A-, particularly corporate credits.
Q:Is the growth of the market sustainable or is it more of a flash in the pan?
CBA: When people looked at the reasons for the debt market faltering in recent years they assumed that the negative factors they saw would continue in the future. However, we believe that they were not viewing the market's development, or lack of it, from a clear perspective.
The mistake too many people made was to assume that the market's poor growth pattern was a demand side problem when in fact it was a supply side problem and it is still is.
The next three years will see a reduction of around A$50bn in government and state bonds in the market with A$23bn maturing this year alone. Then you can also factor in the potential at least A$18bn from the sale of the next tranche of Telstra - the government does not need the money as it is strongly in surplus so it is possible that more federal debt will be paid off.
So, not only do we have vast amounts of additional funds available, but the traditional debt instruments those funds would chase are no longer available. This is a real dilemma for the pension funds as they need to take a balanced approach to their portfolios.
So we would argue that the real question to be asked now is just how big is the demand and how large can it grow? The debate as to whether there actually is demand is truly old hat.
We believe the supply gap is already huge and it is increasing rapidly relative to the funds available. For example, on long term historical fixed income asset allocations the Australian market is generating around $25bn per annum of new investible funds for the bond market.
And the funds available could grow further if asset allocations are further slanted to the debt market and if foreign investors are permitted to invest without withholding tax. The pace of disintermediation - personal savings going into pension funds rather than deposits - will likely continue. In the year 2002, for the first time in Australian history, the assets of the managed funds industry are projected to surpass the assets of the banking industry.
WESTPAC: Questioning the viability of the market is yesterday's story. You only have to pick up a corporate rate sheet to see the diversity of issuance across ratings, industry types and maturities.
To date in 1999 we have had two BBB+ issues and three subordinated issues. There have been nine deals so far this year where the volume has been in excess of A$300m. And whereas in the early days of the market there were only two or three real price makers, there are now six or seven intermediaries providing real liquidity in the secondary market.
The reopening and development of the market in the first few months of this year has followed what we would have anticipated as a normal pattern reflective of a period where investors are emerging from a bout of uncertainty and nervousness.
The well rated banks were the first to issue, placing out senior debt. Then investors diversified credit risk by taking on structural risk in subordinated issues from the higher rated banks such as Westpac and CBA.
As the subordinated paper is A+ and both banks are AA-, this gave investors a yield enhancement on lower rated paper without buying further down the issuer credit spectrum. Then we have seen lower-rated banks such as the BBB+ Colonial State Bank and we will soon see more triple-B corporates emerge, following the example of Fairfax.
DEUTSCHE: It is fair to say there is a certain amount of euphoria at the moment. However, to determine whether the domestic bond market is really working you only need to look at the statistics - these speak for themselves.
In the first quarter of 1999 there was approximately A$4.5bn in new issuance by corporates and financial institutions. That compares with the first quarter of 1998 when there was only A$1.5bn in new issuance, at a time when global debt market conditions were relatively favourable.
This means the new issue market has tripled in size. There are sufficient underlying forces to drive the continuation of the first quarter trend. The full calendar year 1998 saw total issuance of A$7.7bn and we believe the market will far exceed this figure this year. At the same time, there has been significant improvement in the variety of issuers as well as the size and maturity of issues.
Q:Has the enthusiasm of issuers to enter the market this year taken you by surprise? If not, why do you think that the supply side of the equation will continue to rise?
ABN: Yes and no. On the one hand, we have been predicting this level of supply since 1996. On the other hand, after A$7.7bn of supply in the whole of 1998, to achieve A$5bn in the first quarter of 1999 certainly exceeded our more optimistic expectations.
Many corporate borrowers have recently been convinced that the market is a viable alternative to the US capital markets and to their bank facilities, at least for medium term funding.
The relatively low outright interest rate levels may attract some of the corporate borrowers to fixed rate A$ funding. This market is working for the banks as an alternative to Europe and may come to work for overseas borrowers seeking to diversify their funding sources.
The market is self-perpetuating now to some extent for index reasons. We don't expect to see more than A$20bn in total for 1999 but there is no longer a risk of the market stopping dead in its tracks.
The capital market is now cost competitive with bank financing. For your average A- type corporate borrower, right now we estimate that pricing is quite comparable. Spreads in the bank market have certainly widened to more realistic levels over the past 12-18 months, largely due to the withdrawal of several banks from lending activity and the increasing focus of the remaining banks on returns on solvency.
The corporate bond market should not be seen as a substitute for the bank market, rather as complementary to the bank market. Corporate Australia will still require the flexibility in drawings and repayments permitted in the bank market but not in the bond market.
We also feel that by issuing core debt into the capital markets, corporate borrowers are able to preserve their bank lines for when they really need them, for example in making acquisitions.
CBA: We are not at all surprised. We have been betting on this happening for some time now. The market would have had a very good fourth quarter last year had it not been for the collapse of the debt market in the US.
Interestingly, that collapse sucked the confidence out of the debt market here even though the domestic market was not involved in the turmoil and suffered no damage. However, the funds were happy to sit on the sidelines and watch developments.
If you look at reasons for the explosion in supply, we believe the biggest single cause is that commercial banks here had been forced to compete aggressively for some years for scarce corporate and banking assets against the cut-throat pricing of the Japanese banks.
This pushed down loan spreads for corporates and banks to very attractive levels, actually to prices at which the capital market could not have competed.
When the Japanese banks withdrew, the fever went out of the lending market and this has caused loan spreads to move out significantly, actually just at the same time as institutional funds began to compete for assets - thereby drawing issuers to the fixed income securities market.
Furthermore, the Australian banks are faced with falling retail deposits, their cheapest source of funds, and are therefore increasingly focused on return on their risk adjusted equity.
Actually, they have enormous capacity to lend but not necessarily the will unless their hurdle rates can be met. The result is that banks are looking more at acquisition finance, especially in the infrastructure and privatisation arena.
DEUTSCHE: Corporate bonds are the ideal asset category to provide fund managers with yield enhancement over triple-A securitisation deals or government issues. Up to now the predominant issuance has been by the double-A banks such as Westpac, NAB, CBA or ANZ, with some triple-A foreign names such as the ADB in the Kangaroo market.
Given this, we would maintain that portfolio investors ought to be looking more broadly at credits of single-A and below. By doing this they can enhance yield and build a balanced portfolio along the lines of international portfolio managers in more mature markets.
We certainly see that this is taking place. The investors we talk to are increasingly receptive to corporate credits, as has been seen with the issues from Schroders Property Fund (A-), Colonial State Bank (BBB+) and the triple-B issue of A$75m for Newcourt Financial (Australia) Limited. That last deal, led by Deutsche, was oversubscribed by 50% and was solidly placed with a dozen institutions.
WESTPAC: As little as 1218 months ago, we were still having explain the market to potential issuers and justify to them that it was a viable funding source. These days they are more interested in discussing the detail: terms, mechanics, dealer panel structure and so forth.
What this highlights is that issuers are now confident that the market is viable in the long term. The changing nature of banking relationships and last year's repricing of margins in the bilateral and syndicated loan markets has also focused issuer attention on the need for funding diversity.
MERRILL LYNCH: In general, issuers are tending to diversify funding from bilateral lending and the new investor base is not correlated with the bank lenders, meaning that the capital market has become price competitive with the bank market.
However, the bank market has responded by targeting the better credits aggressively and still offers those names funds at between marginally and materially lower cost than the local market can currently offer.
What has been surprising is the increase in the responsiveness of investors. This year we have seen a contraction in the time between launch and pricing of deals - at the extreme this has narrowed to 45 minutes!
While there is reluctance for investors to welcome decision making in 45 minutes, the average launch time has contracted from three days to one day and this is encouraging.
Q: Will the local debt market really achieve the five vital elements of any viable debt market: extension of maturities, tightening prices further out along the yield curve, increased access to investors by credits rated below single-A, larger deal size and greater secondary market liquidity?
ABN: Yes. Extension of maturities will come provided we retain long term pricing benchmarks (either Australian federal and state government bonds or perhaps triple-A borrowers from offshore), a deep 10 year futures contract and a reasonably liquid swap market.
Tighter prices will come as large Australian institutional investors with long term liabilities buy more assets to match these maturities, and particularly if they end up competing with offshore investors who have longer duration portfolios.
We have placed 33 year indexed annuity bonds with these local investors, but we need a more viable market for 10 year nominal corporate bonds before we start thinking about competing with the US market.
We recently undertook a credit survey of Australian institutional investors which revealed that 71% of these investors can buy A- paper.
Corporate Australia is really an A-/BBB+ proposition, so if investors want to make debt investments in the companies in which they already have equity investments, they will need to move down the curve. Although the trend in this regard is positive, it does not yet seem to be moving fast enough.
Deal sizes are respectable now, although it would be nice to aim a bit higher for the corporates, for example A$250m instead of A$150m for a BBB+ name. Investors are focused on liquidity which suggests deal sizes may increase, but there has also been major consolidation in the funds management sector which is a concern as it could make new issues too dependent for size on a few investors.
Promoting liquidity in this market is a high priority and, like the investors, we are sometimes disappointed at the level of liquidity in some issues. In saying this, there is a real danger of us being overly paranoid about liquidity in our market.
After all, liquidity was an illusory concept for investors in European and US markets for much of the second half of 1998 and the Australian market did not in our view suffer greatly in comparison.
There also needs to be a greater recognition that liquidity means the ability to enter or exit a position at a fair market level, not the ability to exit an investment at entry price in a declining credit market.
CBA: We admit that historically this has been a short term market so, in order to develop a longer term market we are first of all concentrating on the quality of issues.
By doing so this engenders a sense of confidence among the fund managers. In particular, the funds like to see the intermediaries offering full underwriting support for public offerings. They prefer liquid deal sizes which we would regard as A$200m-plus. And they like syndication through quality management groups and widespread distribution.
Secondary market liquidity is developing but our market is still at a relatively early stage of development. However, we do not like sceptics pointing out that the market should become like the US market.
Actually, one should bear in mind that liquidity in the US bond market, the largest domestic debt market in the world, is in fact still thin, to say the least. We would also caution against those who argue that bid-offer spreads here are too wide and again point to the US market.
You will also see that the bid-offer spread in the US market is wide, around 5bp. We are already tighter than this as the bid-offer spread is currently between 3bp and 4bp. What the US has is immense depth at the primary issuance level and that is what we should be striving to emulate.
If you look at the Australian debt market you can see that it has historically been an actively traded market as funds could deal in size in the government and state issues, often in lots of A$50m and more.
Now, however, the situation is rather different because the investible funds are growing so rapidly that they have to fill up their books and are therefore net buyers rather than net sellers.
Therefore, we would argue that secondary market liquidity will develop over time provided large, quality issues are brought to the market.
As credit research develops and as there is a far greater volume and diversity of paper in the market, then institutions will gradually seek to enhance returns through additional trading activity.
MERRILL LYNCH: The yield curve in the domestic market has certainly lengthened this year. We have already seen the maturity spectrum extend in 1999 with the 10 year deal for Australia Post which went very well. Last year this market was clearly a two to four year market and this year it is a two to seven year market for most borrowers.
The Australia Post issue really opened up the longer end, and we expect to see more highly rated issuers completing deals in the seven to 10 year sector this year. Issue size has also improved this year. The A$530m Australia Post and A$400m Sydney Airport issues were well received by investors, partly because of the larger volumes.
The average deal size this year is A$300m and A$100m is almost considered a private placement. Last year the market was reluctant to absorb more than A$150m-A$200m for non-bank borrowers.
Similarly, the credit spectrum has also broadened as more investors have been willing to move down to triple-B, such as the recent Colonial State Bank issue rated Baa2/BBB+. The fact that longer dated issues have emerged is because the price tension further along the yield curve is improving fast for the quality names.
As deal sizes become larger, so the potential for liquidity is enhanced.
A factor to bear in mind for the year ahead is the development of a private placement market to supplement the rise in public issues. Private placements will pave the way for the evolution of the public market for non-investment grade credits.
For example, we expect to see more longer dated deals and deals by triple-B and potentially non-rated borrowers, and many of these will emerge in the nascent private placement market that is developing here.
This is similar to the US private placement market whereby an intermediary is appointed more as an agent, essentially on a best efforts basis for non-rated borrowers to execute an issue at the clearing price for that particular credit.
Q: As there as still relatively few issues in the market and maturities have only recently been extending, how are deals priced and what is happening to pricing in general?
CBA: What we are all trying to do now is to build a new benchmark yield curve for new issues. For example, the Sydney Airport deal was priced at 97bp over CGLs and then tightened significantly to the low 80s when it began trading. Was it mispriced? No, not against market conditions at that time. Could it have been more accurately priced? Yes, but not until there are more benchmarks available to price it off.
Sydney Airport is an A+ credit but is a new name in the market. Moreover, the issue became the largest single offering for an A+ credit to date. Further, the company is not yet pure private sector; it has been corporatised but it is still a government entity and is not likely to be listed until 2001, after the Olympics. There was also a call provision that prevented the re-offer spread being tightened significantly below 97bp.
The issuer and lead managers wanted to be absolutely certain that the issue performed well and was widely distributed.
In a relatively new market with few benchmarks, it is dangerous to take risks by pricing issues too tight.
The deal was in fact significantly oversubscribed, we estimate in the region of two times, and the price has tightened significantly as a consequence.
But does this represent an expression of relative value by investors? Probably not. We think it is more related to scarcity value. However, it would have been a dangerous ploy for the lead managers to price on scarcity.
WESTPAC: There was some conjecture on the Sydney Airport transaction as to whether it should be priced higher or lower than the CBA and Westpac subordinated deals of the same rating.
This highlighted an idiosyncrasy of the Australian market as bank paper has traditionally traded tighter than pure corporate paper of the same rating. This is because many institutions are permitted to hold more bank paper than corporate under the Reserve Bank of Australia rules.
The theory at the time of the Sydney Airport issue was that senior bank paper would be tighter than corporate debt but there was uncertainty as to how to price senior corporate deals against bank subordinated. In the end Sydney Airport was priced tighter than the subordinated bank issues and emerged at 52bp over the BBSW.
Pricing the Sydney Airport deal involved an active dialogue with the institutions. The feedback we obtained was that they were looking at two comparables. One was BOC Gases, rated A+, although there was no paper at the same maturity. The second was Telstra, although it is far further down the privatisation road and, at AA+, has a higher rating.
The deal was well priced in the end. Institutions had been hoping for the magical 100bp spread to CGLs but we managed to price at 97bp. By early April the issue had tightened, along with most of the market, and stood at 82bp over the September 2004 CGL, equivalent to around 47bp over the BBSW.
The issue was well structured to tackle certain key concerns surrounding the company. For example, institutions correctly asked what would happen if the company was sold by the government before the maturity of the bonds.
This was addressed with a provision that the government can instruct the issuer to call the bonds at what would be a rather investor-friendly price. Moreover, if there is a downward ratings change, and the bonds are not called, the coupon would be adjusted accordingly.
The Sydney Airport transaction testifies clearly to the growing sophistication of the domestic market that is now far more proactive in trying to accommodate the peculiarities of a transaction. As this happens, new benchmarks are established and new comparables emerge off which to price and structure future issues.
The deal is also firmly part of the common theme of good transactions this year which have demonstrated a more disciplined marketing process than before with smaller and more efficient dealer panels.
Last year it tended to be the case that intermediaries drove the deals, leading investors too often dictated pricing and the deals were consequently narrowly distributed. Now, however, it is evident that the deals are in response to real demand and are often structured to meet that specific demand.
This has led to wide distribution of the issues which in turn has pleased the issuers and made them increasingly receptive to more regular issuance.
ABN: The ability to price deals on the basis of relative value to others is rapidly improving. We have 70 non-government stocks on our revaluation sheets. With the bank issuers pricing has become very fine and deals live or die by a single basis point; with the corporates we still have some way to go to achieve this. The Australian issuers have generally acted responsibly, issuing into investor demand at fair levels.
The actual pricing process is becoming more refined after a couple of controversial interest rate sets. There is still some improvement required in terms of how pre-marketing of deals and the syndication process is conducted.
DEUTSCHE: Most of the public deals coming to the market are increasingly price talked with investors following a roadshow, particularly where a new issuer is concerned to establish the appropriate re-offer margin ensuring transactions are fully cleared at fair value.
Few transactions are driven by a lead order. Examples include John Fairfax Group Finance, Schroder Property Fund and Caltex Australia - all of which had strong roadshows, extensive price talk and wide distribution clearing levels.
In addition, the A$200m Key Start Bond Ltd (AAA) placement, which we led in March, was widely distributed into strong hands - our book of A$75m was distributed to eight local buyers.
Q: Will the domestic market be able to compete with the international debt markets?
MERRILL LYNCH: Larger deal sizes and greater liquidity will mean the domestic market will provide ever greater price and size competition to the foreign markets, especially at the top of the credit spectrum.
Lower down the credit spectrum the foreign market will remain far more competitive because investors, especially from the US, are more familiar with lower grade credits, particularly for term debt.
Therefore, until the local market becomes more price competitive for these credits, the lower rated issues will continue to go offshore for long dated funding.
Australian issuers who are eyeing the domestic bond market increasingly request real-time advice on options in any of the debt markets across the globe. International names wanting to tap the local market will only do so when the cost of funds after swap is sufficiently attractive to match any price they could achieve in any other market at any given time.
All of this fits our strategy as we are replicating in Australia our approach to other significant capital markets around the world, namely to provide a global credit perspective to local and foreign investors as well as to provide global access to local issuers across the debt product spectrum.
A factor to bear in mind is the impact of the Kangaroo market on the basis swap. The heavy volumes of offshore issuance by Australian banks early this year pushed out the BBSW/US$ Libor basis swap to a cumulative 6bp.
Many market participants now anticipate that the arrival of more Kangaroo issuance will compress the swap cost. This should have facilitating effect on offshore issuance by Australian borrowers.
CBA: If we project forward, we certainly anticipate that the domestic market will continue to develop in such a way that will allow top rated issuers to tap funds as cheaply here as in any market around the world.
The market has almost broken the nexus between corporates and their bank lenders as bond pricing is coming down, as you would expect with the weight of institutional money.
Spreads have not quite contracted to the level of the US market and nor has it been possible to get the tenor of funding available in the US, but we believe it is only a matter of time.
Issuers and intermediaries are deliberately striving for larger transactions and pushing the envelope in terms of maturity. The positive shape of the yield curve gives investors an excellent opportunity to pick up high quality stocks at yields significantly above cash rates
DEUTSCHE: Given the relatively lower costs of implementation and in some cases the lack of need to swap, the all-in cost of A$ funds can be quite competitive. The question then reverts to one of volume and maturity. In the case of the former, for many corporates, a refinancing risk of more than, say, A$300A$400m will not suit their balance sheet so the local market can provide appropriate accounts.
ABN: It already is for the banks and the establishment of many new corporate debt programmes clearly suggests that many of the local treasurers are confident it will. A better way to view it may be that the domestic market will complement the offshore markets rather than compete with them.
The domestic market offers competitive pricing, ease of execution and - importantly for Australian borrowers - local currency funding without crossing spreads on currency and basis swaps.
Q:Are domestic institutions becoming more sophisticated with regard to fundamental credit research?
MERRILL LYNCH: Sell side credit research is a relative new phenomenon in Australia where deals have traditionally been sold only with the aid of in-house sales memoranda, not detailed credit research papers.
We are seeing the emergence of the US style and credibility of credit research in the local market. A key element of this will be to set the relatively small universe of Australian issuers against regional and global comparables and standards.
International investors are beginning to look seriously at investing in the local market if and when the interest withholding tax is removed. These investors need to assess such purchases on a relative value basis and need access to the credit research and market information tools to allow them to make these decisions on an informed basis.
Although new foreign investors are not likely to flood into the market, their arrival have a significant impact on domestic investors' perceptions. Local investors will be driven to assess issues in the primary and secondary markets increasingly on a credit arbitrage basis as a more international approach to pricing and market making evolves.
ABN: Undoubtedly yes, although this process takes time. The institutions have not exactly been tested by looking largely at bank deposit deals. However, the ongoing capital market financings of infrastructure assets and the prospect of unfamiliar Kangaroo issuers means that the larger institutions are conscious of the need for credit research.
Leading intermediaries now employ dedicated debt research specialists specifically to enable differentiation between two assets that the rating agencies consider to be of the same credit quality. If you are a credit analyst working overseas and want to come home, now could be the time!
WESTPAC: There is a strong trend for fund managers to build up their own credit analysis capability. This demonstrates real commitment to the market that already has a great forward momentum. If you add this to the increase in weightings of corporate bonds in all the major indices, then you can see that a major change has come about in the domestic bond market.
Q: Are deals underwritten these days or on a 'best endeavours' basis? What is happening to fees? Are they high enough to make it viable for non-commercial bank intermediaries to compete?
ABN: New issues are generally underwritten but not forward underwritten. That is, the intermediaries are on the hook for the stock but only once a price is agreed after a period of marketing the issue to investors.
It is closer to the US Rule 144A process than the Eurobond process in this respect. This 'soft' underwriting process has meant that fees have tended to be placement fees rather than underwriting fees and therefore as low as three yield points per annum.
If anything the recognition now is that Eurobond type fees are appropriate compensation for the services provided by the intermediaries.
The expectation has been that the market would be profitable for intermediaries as a low margin, high turnover business line. Until 1999 it has been low margin, low turnover for everyone.
As a commercial and investment bank we have absolutely no doubt that the domestic bond business will be profitable, viable and a very important component of our effort to provide a full service to Australian clients.
WESTPAC: We are heartened when we hear that some of the major global intermediaries do not want to compete in the local market. We certainly concede that in the past there has been a 'gold rush' for deals which helped to compress fees to unattractive levels, around 3bp per annum payable as net present value on virtually all deals.
What happened was that the banks were not offering the issuers underwritten transactions and therefore the fees were very low. The deals were on a 'best endeavours' basis - in effect the issues were underwritten by default as the banks told the issuers they would not back out.
However, the market turmoil of the last quarter of 1998 meant that intermediaries did in fact begin to pull out of deals. This has led to the market moving away from best endeavours and more to an underwritten or bought deal structure.
Moreover, this trend has been supported by the gravitation of issuers to employ banks that have demonstrated their ability to deliver the deals, even in somewhat inclement market conditions.
The net result of all this is that fees are now moving up towards 5bp per annum and a more flat fee structure. What this means is that a five year issue may now pay fees of 25bp whereas the net present value of fees on similar deals in the past might have been just 12bp.
MERRILL LYNCH: The fee structure is certainly lower than the Euromarket where there is no fixed fee structure, and significantly lower than the US market. The rule here seems to be that fees of between 3bp and 5bp per annum are paid depending on whether a deal is underwritten or not.
Depending on the size of the deal and allocations amongst firms, there is money to be made with these fees. The expansion of the market through the growth of Kangaroo issues, the inflow of foreign issuers and investors, and the growth of private placements are all factors that will increase the overall return that firms can anticipate from the market.
Q: What prospects do you see for the Kangaroo market?
CBA: The lag between the ADB issue last year and new Kangaroo issues blind-sided people into assuming, erroneously, that the market could not take off. Controversy over the ADB issue was also overplayed. As such, events this year are already proving the Kangaroo sceptics seriously wrong.
The ADB deal has in fact been positive for the market although there were concerns about the size of the issue and the execution of the issue at the time it was done.
However, we need to step back and look at the positive side - ADB as an issuer in the market is good for its development because we need top name issuers.
If there were errors in the execution of the deal, so be it. That is all part of the growing pains of a new market but certainly not a reason to criticise its potential.
Recent developments and research demonstrate that asset allocation of Euromarket investors will gravitate increasingly towards currencies such as the Australian dollar. This is already being witnesses as the Euro-A$ market gravitates towards institutional buying rather than remaining a purely retail market.
Withholding tax reform, if it emerges, will certainly encourage these investors to buy into the Kangaroo market. For example, if asset allocation of Euromarket investors in the Australian dollar rises from the current 2% to 5% and more, this means that the Kangaroo market will have additional impetus for strong growth in the future.
WESTPAC: The Kangaroo market will continue to develop as investor appetite is strong, although initially only for the highest rated names. There will be demand for double-A credits but only those with familiar brand names.
Pricing for the top credits will be close to parity with the offshore markets after swap costs although there will be exceptions as some issuers might be prepared to pay a small premium to enter a new market.
What foreign investors are saying to us is that they see the single European currency as a fairly compelling driver to diversify into other currencies. There is already a strong overseas holding of Australian dollar credits as around 50% of government bonds are held offshore.
Such investors will be interested in picking up supranational issues at a yield premium to CGLs. Moreover, as CGLs are gradually repaid in the years ahead, foreign demand for Kangaroo and top rated domestic issues might really blossom simply in order for foreign institutions to maintain their weightings in Australian dollar paper.
MERRILL LYNCH: The Kangaroo market has so far focused on the supranationals and now we are seeing highly rated agencies and international banks, all of which are driven to issue here for funding diversification, and the competitive funding costs available.
We have already seen the phenomenal interest in the Australian market from sovereign and supranational issuers in 1998. This year the interest has come from the German public sector banks.
The next logical development in interest from offshore borrowers is for the non triple-A issuers. Once we see a number of the triple-A borrowers complete successful deals here, we expect that there will be a move towards issuers further down the credit spectrum.
A great attraction of the local market is the very low start up costs as the market is purely institutional under domestic regulations. It costs less than A$30,000 in legal fees for a program, regardless of the size and issuers only need one rating here.
Frequent large volume issuers are increasingly looking to establish domestic programmes as they diversify their sources of funding. There is definitely demand from local investors and the market has the capacity to grow significantly.
However, we do not imagine at this stage that the Kangaroo market will provide the opportunity for credits rated below single-A.
ABN: We see the Kangaroo market as a great opportunity for the Australian financial markets as a whole. In theory we have a great deal to offer foreign issuers as a cost competitive alternative to their traditional markets.
Our expectation is that over time, the Australian market will receive not just triple-A supranational borrowers but also foreign banks and well known multinationals. We view this market as an excellent prospect for our European and US clients and have backed this view by making the necessary investment in the Australian non-government bond business.
Australian investors are increasingly looking at a global
investment picture and we are
confident they will embrace the opportunity for them to invest in foreign credits in A$ in their home market.
Q: What is hindering the issue of Kangaroo bonds under the various programmes being established? When do you envisage that issuance will become active?
ABN: In a word, pricing. The borrowers who have established programmes for the issuance of Kangaroo bonds are triple-A borrowers. For these borrowers we need a viable sub-BBSW funding market.
At present we have a strong, established sub-BBSW market for Australian government and semi-government bonds but the only other liquid stocks that trade a substantial margin under BBSW are the CBA Deposits (which are federal government guaranteed).
There are some positive signs for issuers who are looking for high single digits under BBSW (for example, ADB's Kangaroo issues, Australia Post and Rabobank are all trading in this region to the swap).
For triple-A supranational issuers looking at high teens or better under US$ Libor, the market still has some way to go as investors prefer the more familiar, semi-government stocks with associated market-making.
It seems a widely held view that the CBA deposit issues will rally by 8bp or 10bp against BBSW once the federal government guarantee of any new issues ceases in July. We have our doubts about this but if it were to happen then opportunities for triple-A issuance at closer to 20bp under BBSW than 10bp under could arise.
A more liquid A$ swap market would also be helpful in lining up the ducks, since the issuers' concern is their all-in level to US$ Libor or Euribor than their level to the Australian government curve.
However, by the time these remarks are published, the Kangaroo market will probably be fully underway!
MERRILL LYNCH: Many of the programmes have only recently announced the arranger - meaning that the documentation has only just started. They are therefore still a few weeks away from being in a position to issue anyway.
The three Kangaroo borrowers who have completed their documentation - NIB, Rabobank and KfW - are monitoring the market. Rabobank issued recently for the Australian branch - a domestic issue, but they have not yet completed a Kangaroo bond.
There is much speculation that Kangaroo issuance will pick up
when CBA loses its guarantee in July. We believe that deals will be
completed before this, although the removal of CBA as a triple-A
borrower here will certainly leave a gap in the triple-A market.
The obvious replacements are the triple-A Kangaroo
WESTPAC: Firstly, let's not forget that there is a legal and administrative process to finalise before an issuer is ready to come to the market. In some cases, the issuers have only just completed this process.
Secondly, there has been a key structural impediment in the market working against issuance by some of the supranationals. The CBA's own bonds form a pricing benchmark that offer an arguably generous premium for liquidity.
With the CBA's guarantee lapsing shortly, investors are re-assessing what constitutes fair value in the triple-A part of the curve. We have already seen this with the Rabobank deal and expect that we will see a number of Kangaroo issues this year.
Q:What proportion of domestic issues are now purchased by foreign investors, such as the Asian central banks? Are they exempt from interest withholding tax (IWT) and, if so, on which issues? What do they buy and why?
ABN: The latest Australian Bureau of Statistics figures show that just under 42% of all bonds issued by the federal and state governments is held by offshore investors, but this includes debt issued offshore as well as in Australia.
It is difficult to get a precise handle on how much domestically issued debt ends up offshore at any given point in time. Foreign investors have been buyers of domestically issued government and semi-government bonds in years gone by, although the need to buy through a local nominee and the withholding tax situation have been a deterrent even if they fundamentally like the Australian market.
Bonds issued in Australia by an Australian government, semi-government or corporate borrower are generally speaking subject to interest withholding tax, unless the buyer itself is exempt (as with the central banks).
The non-government issues launched in this market in the first quarter of 1999 are subject to withholding tax and generally there is a restriction on distribution of the Information Memorandum outside Australia.
Accordingly the offshore scope for offshore sale of these issues is limited.
The situation is different for borrowers who are not Australian residents. For example, the ADB Kangaroo issues are not subject to Australian withholding tax, which from one perspective gives this issuer an unfair advantage over the Australian semi-government issuers.
Offshore investors have been made aware by intermediaries such as ourselves of the 'coupon washing' legislation and are not so enticed by the A$ market as to run the gauntlet of this deliberately imprecise legislation.
The proposed amendments to the application of withholding tax on domestically issued corporate bonds should facilitate offshore interest in the Australian market, however the delay in enacting this change is rather unsatisfactory. If we are serious about promoting Australia as a regional financial centre, removing withholding tax entirely would be a good start.
We would not expect much effect on pricing if IWT is lifted. In theory, the benchmark for the pricing discrepancy are the NSWTC and QTC withholding tax free programmes which trade 6bp-7bp inside their domestically issued bonds.
If the IWT exemption is, as expected, only for corporate issues it is hard to see that the participation of offshore investors could drag pricing in tighter than that currently available.
It may well increase the volumes that corporates are able to issue on each transaction and on an annual basis. This may increase liquidity and consequently may confer a pricing benefit, but it is not likely to be very significant.
WESTPAC: Local issues are not yet technically exempt from IWT, even if they were issued post July 1998 and otherwise comply, because the amending legislation has not yet been passed.
Some offshore investors have been willing to take a view on the timing of the legislation, as have some of the Asian central banks who have IWT exemptions. However, most prefer to buy those issues that don't carry IWT, such as the Kangaroos and A$ globals.
MERRILL LYNCH: It is worth noting that domestic programmes usually have a restriction on the distribution of the Information Memorandum outside Australia, so international participation is usually in the secondary market. The bonds that are IWT free are the ADB deals and the global bonds issued by the semi-state authorities.
Q: How has the link between Austraclear and Euroclear/Cedel affected the market, especially in regard to eligible RTGS (real time gross settlement) funds in Australia?
MERRILL LYNCH: The link has only been proposed and our understanding is that it will not be available until mid-year. Even then it is only one-way, for local investors to buy international bonds.
We would like to see the bridge going both ways, to facilitate international participation in domestic issues.
Foreign buyers are limited in their participation of Kangaroo issues, since they settle through the Austraclear system. If the proposed Austraclear/Euroclear bridge were to be two-way to allow foreign buyers access to Austraclear, then the foreign participation in domestic deals would increase.
ABN: The recently established links are beneficial to Australian investors looking to invest in A$ Eurobonds issued offshore and settled through Euroclear/Cedel.
Being able to trade these securities and using this new Austraclear facility for collateral management will make life easier for the major local investors.
Of course what we would really like to see is Euroclear/Cedel signing up to Austraclear so that offshore buyers do not need to use Australian nominees to buy Australian domestic bonds. It seems that every effort is being made to bring this about but without success so far.
WESTPAC: It is too early to comment, as the Austraclear bridges to Euroclear/Cedel are not yet operational in a practical sense. However, we see the development as being positive for the market.