The great corporate bond debate seems to be gathering steam and moving up the agenda of Australia’s treasurer and shadow treasurer, both of whom spoke out last week in favour of legislative changes to boost the domestic corporate market.
The Liberal-National coalition said that it would consider offering bond guarantees to private sector infrastructure companies in order to allow them to raise funds more cheaply by leveraging Australia’s ‘AAA’ rating, though commentators doubted the practicality of such an idea.
A spokesperson for shadow treasurer Joe Hockey said the sovereign would also consider issuing 30-year bonds in order to provide a benchmark for the guaranteed private sector debt.
Then last Wednesday, March 20, treasurer Wayne Swan announced that reforms to make it quicker and cheaper for Australian companies to issue bonds to retail investors had come into effect.
Far from coming from nowhere, these reforms are part of an ongoing conversation about how best to deepen Australia’s corporate bond market. But for the most part, this conversation finds little practical outlet.
Those holding the dialogue are right to do so. Australia’s uninspiring corporate bond market is dominated by financial issuers. This could lead to problems if Basel III regulations restrict the lending capacity of the nation’s banks, leaving corporations strapped for cash.
If this happens, as many doomsayers suggest it will, refinancing could become somewhat sticky for certain names if the onshore market remains small and illiquid and high swap costs prohibit many companies from issuing offshore.
However, despite an unremitting stream of predictions to the contrary, bank lending in Australia has not fallen. According to the Reserve Bank of Australia (RBA), total credit provided to the private sector by financial intermediaries rose by 3.6% year-on-year at the end of January 2013.
Business credit was unchanged in January, after increasing by 0.7% in December and increased by 2.8% year-on-year.
Furthermore, a majority of corporations are already extremely well cashed up and many have easy access to the equity markets for funding.
A vicious circle
No country wants an illiquid domestic bond market. A small market leads to a lack of transparency and increased funding costs, which discourages both buyers and sellers. But until more buyers and sellers come to the market, it will remain illiquid. So far so good.
Institutional investors in Australia have strict investment mandates and so government rhetoric has primarily targeted the retail sector as the buyer to boost the fledgling corporate bond market.
But perhaps now is the wrong time to match retail investors with first-time issuers of corporate bonds, when the bond market is looking super expensive and, by many accounts, returns have become detached from the underlying fundamentals.
In addition, many potential retail investors are content to place their capital in banks which pay between 4% and 4.25% on government-guaranteed deposits. This risk-free return is higher than the sovereign bond yield which for the 10-year Commonwealth Government Securities [CGS] was 3.56% at the time of going to press.
This unnaturally high risk-free rate skews asset prices across the entire risk spectrum, meaning that highly-rated corporates will have to pay up if they want to attract retail attention. This effect is magnified for corporates lower down the rating scale.
This is the problem that lies at the heart of Australia’s stumbling corporate bond market. It is a simple issue. The gap is too large between the risk premium demanded by investors and the level that companies see fit to borrow at.
To add insult to injury, the way that interest income is taxed in Australia discourages people from buying bonds and the tax system favours saving via deposits. To be fair, this is being discussed by market participants, as are ways to make pricing more transparent.
The sovereign issued a 16.5-year bond last October, the longest to date, which has set a benchmark to develop a longer dated debt market. The AUD3.25 billion (US$3.39 billion) deal priced with a yield to maturity of 3.595%. This is a positive for the market as without a benchmark rate it’s difficult for companies to get in and drive out the curve.
Another positive is the plan to implement infrastructure that will allow retail trading in CGS, which will bring wholesale and retail investors together for the first time, resulting in more clarity on pricing and a merging of the two pools of liquidity.
But while these changes don’t cause any harm, the bond market is an arena driven almost entirely by price, and changing legislation to make it easier for companies to issue and investors to buy bonds will only get you so far.
If an investment grade corporate bond was offered at 20%, investors would take on all the legislation in the world and jump through hoops to get at it. Likewise, streamlined documentation is not much use if the underlying security is deemed to be expensive.
This means that if the government is serious about kick starting the corporate bond market, it should take one of two routes. The first is reducing the risk-free rate for bank deposits. This would force depositors to look elsewhere to generate returns, redefine the risk spectrum and allow issuers to come to market at a lower rate – by extension it would reduce the bid/ask spread.
Another way of arriving at the same end point would be to offer tax breaks to investors. This would increase total returns for buyers and would lower the cost of issuance for companies.
If neither of these is put into action, it looks likely that Australia’s corporate bond market will remain small until bank lending really does contract and corporates are forced to raise funds through bonds.
If issuers have no other option, the bid/ask spread will tighten in favour of investors, who will probably buy the bonds, particularly if legislators have spent the interim years smoothing out the investment process. And if they don’t, Australia could find itself in trouble.