Building government bond markets or, more specifically, sovereign bond markets, is always the first step that enables other financial markets to be developed. The existence of longer dated government bonds will allow the extension of interest rate swaps beyond ten years, and this will allow cross-currency or basis swaps to be similarly extended.
With these essential requirements in place, long dated sovereign, supranational and agency (SSA) issuance in the corporate bond market can be expected to quickly follow. SSA issuance has already reached the 10-year boundary but is constrained from going any further.
SSA issuance will go beyond 10 years if the opportunity is provided. From there the next step is introduction of longer dated credit risk.
The corporate bond market has struggled in recent years to attract corporate issuers. What was on offer? Three- to five-year debt - the market was competing directly against the banks and the banks happily undercut the market most of the time.
As a result of this and the increase in government bond issuance now under way, fixed income investors are aware of the growing sectoral concentration in the market's benchmark index - the UBS Composite Bond Index. It was reported last week that UBS expects the composition of the index to move towards 41 per cent government bonds by 2011, from 23 per cent now, and corporate bonds will fall to 9 per cent, from 21 per cent now.
If this eventuates what will happen to diversity, and perhaps more importantly, how will fund managers outperform the index? They may simply have to go back to being duration players.
An alternative is to revitalise the corporate bond market and entice the corporate issuers back into the market. The lengthening of the government bond yield curve can provide the corporate bond market with a sustainable competitive advantage over the banks.
With more longer dated government and SSA bonds entering the UBS Composite Bond Index, the duration of the index will also lengthen and typically, in a stable interest rate environment, fixed-income bond managers will seek to maintain the duration of their portfolios close to that of the index. Outperformance is sought from yield pick-up and this comes from taking on credit risk.
With fund managers looking for longer term yield pick-up, the corporate bond market will be able to consistently offer something that the banks cannot - debt maturities beyond five years. Australia will be better off for it.