Bond perennial not so bad

The FSI did not spend a lot of time examining the corporate bond market in its interim report, released yesterday. The report devotes no more than six well-spaced pages to the subject.
 
The overall conclusion of the FSI is that "Australia has an established domestic bond market, although a range of regulatory and tax factors have limited its development".

This conclusion seems contrary to the angst expressed about the undeveloped nature of the market in previous reviews and in commentary from numerous market bodies and participants.

However, the conclusion is consistent with that expressed by Sam Wylie in his report on 'Financing the Australian Business Centre', published by the Australia Centre for Financial Studies (ACFS) last week.

Wylie says that, "Australia has a bond market that matches its position as a small, open economy with large commodity and service sectors, a dominant domestic banking sector and a substantial and persistent current account deficit".

He also says, "No major policy initiative is needed to support the domestic corporate bond market. But is (sic) important the policy makers avoid providing additional support for the banking channel at the expense of the bond channel."

The FSI's thoughts on the range of regulatory and tax factors that have inhibited the development of the domestic bond market may also be drawn from Dr Wylie's report.

In the report, it is argued that the Federal Government has favoured banks over other channels of capital distribution, especially the corporate bond and securitisation channels.

This favouritism may damage the future financing of Australian business by inhibiting the natural development of non-bank channels.

Nevertheless, the FSI says: "the proportion of debt funding for Australian corporates that is intermediated by banks is broadly consistent with that of other advanced economies with the exception of the United States, which has an unusually large corporate bond market."

This is broadly true, although it ignores the existence of the Eurobond market which, while not as large as US bond markets, serves issuers and investors globally.

The size of US bond markets is the product of the Glass-Steagall Act 1933, which greatly restrained the activities of US banks (along with prohibitions on interstate banking), and more recent legislation that opened up US bond markets to international issuers and investors, when the competitive threat of the Euromarket was realised.

The Euromarket developed to provide a means of recycling petro-dollars and was greatly boosted by the introduction of the euro.

Large Australian companies, and especially the major banks, favour both the Euromarket and US bond markets over the domestic market.

Wylie observes that growth in the use of the domestic market has stalled since the end of 2006, while issuance in international bond markets has nearly doubled over the intervening period.

However, in another report recently released by the ACFS, 'International Linkages: Financial Markets and Technology ', the authors argue that the heavy reliance of Australian companies on international bond markets for debt funding is unhealthy and would leave Australia very exposed in the event of another GFC.

Consequently, there is a need to develop a liquid and resilient domestic corporate bond market.

The authors of this second report, Ralston and Jenkinson, also note that 90 per cent of bonds issued by non-financial Australian companies are held by foreign investors.

This reflects not only the proportion of bonds issued in international markets, but also the fact that international investors are the largest participants as a group, in the domestic market, accounting for around 30 per cent of the bonds on issue, according to ABS data. 

This point is picked-up by the FSI, noting that Australian investors' appetite for fixed income securities is apparently lower than in some other advanced economies.

Australia has a lack of investors because the tax treatment of fixed income securities is unfavourable compared with other savings products, the dominance of defined contribution superannuation discriminates against holding bonds, whereas defined benefit superannuation typically favours bonds, and the lack of superannuation funds in the retirement phase also discriminates against holding bonds, with equities preferred while accumulating capital.

The FSI also points out that the domestic market is relatively illiquid compared with other markets for financial assets, and a lack of issuers makes it difficult for investors to establish well-diversified bond portfolios.

There is a lack of issuers in the domestic market because institutional investors generally require bonds to be rated but issuers balk at the cost, and rating agencies are generally reluctant to provide ratings for use by retail investors, due to licencing requirements.

And there are the costs and liabilities associated with prospectus production that confront companies contemplating issuing bonds to retail investors.

While this latter issue is dealt with in legislation currently before Parliament, it is one reason behind Ralston and Jenkinson's observation that less than 0.5 per cent of Australian of Australian fixed income securities are listed on the ASX. Moreover, only one per cent of bonds issued in Australia are held by households.

The FSI is seeking further consultation to address these perennial issues.