Australia - Corporate bond market takes off

Yasuhiro Takama

"This country changed the destination of its exports very quickly from Asia to Europe," says Yasuhiro Takama, managing director of Nomura Australia and a long-time promoter of Australian bonds to Japanese investors. Takama's pitch to Japanese buyers has changed over the years, as the country's economic performance has improved. In the early 1990s, Australian government bonds yielded at least 200 basis points over US Treasuries. That spread has shrunk to 20bp to 50bp. Australia looks more like a developed modern economy than a banana republic. But Takama still thinks its bonds are a sound relative value buy. "This country's economic fundamentals are very good."

Indeed they are. Official estimates suggest that the country's economy will grow at an annual rate of 3.5% for the next 10 years. Australia has been producing sustainable budget surpluses, reducing its government debt. Inflation is low and continuing privatization of the power and water industries should help to curtail rising prices of key in-puts. Infrastructure is being upgraded. The government has tackled head-on the thorny problem of retirement savings by requiring high compulsory contributions by employers into superannuation schemes. Huge sums are flowing into the fund management industry. The economy is restructuring.

"Ten years ago, in an inflationary environment, you could buy assets and watch their value go up," says Rohan Hedley, head of equities at BT Funds Management. "Now we are skewed towards companies with intangible assets, with an emphasis on EVA. We look for companies that are well run, particularly in terms of capital management. And while we do own some pick-and-shovel type companies, our major domestic overweights have been media and services." Agriculture now comprises just 3% of the Australian economy.

It is against this bright macroeconomic background that Australian financial markets are now undergoing profound structural change. The bond markets in particular are being transformed. For many years the mainstays of the Australian fixed-income market have been Commonwealth (federal) government bonds and those of state governments, the so-called semi-government bonds. Budget surpluses and privatization proceeds at the state and federal level have seen new issues of Commonwealth and semi-government bonds reduce and some outstanding debt being paid back. As in the US, the Australian risk-free debt market is shrinking, to the point where federal and state treasury officials are keenly debating the merits of two options: eliminate public sector debt entirely, or maintain certain gross outstandings to maintain market access, as a precaution against unforeseen future funding needs.

Aiming to wipe out debt

Michael Egan, treasurer of New South Wales favours the first option. He says: "This is our ninth year of economic growth. In three of the last four years, New South Wales has had budget surpluses and all our forecasts suggest we will be in surplus for the next three years. We have a fiscal goal of eliminating government debt by 2020." He concedes: "There could be times when it's necessary for governments to go into deficit. And we are borrowing A$3 billion [$1.86 billion] to convert the superannuation for public servants from a defined benefit scheme to an accumulation scheme. But I would hate ever to go back to the early 1990s, when debt was rising, interest rates were going through the roof and 10% of the budget went on servicing the debt. We are slowly getting rid of the debt and funding superannuation liabilities."

Egan has little sympathy with the idea that state governments should issue bonds and invest the proceeds in other high-quality assets, just to maintain a presence in the markets. "I wouldn't like to see governments trying to be investment banks."

Rohan Hedley

The bond market, though, is growing fast from a low base. Last year there were breakthrough deals from several well-known Australian corporates, such as natural resources giant BHP, Lend Lease, power company Austran Holdings, retailer Coles Myer, Western Mining and Boral. In all there were some A$20 billion of domestic corporate bond deals last year, including large bank issues and a growing market in kangaroo bonds - domestic Australian issues by well-rated overseas issuers.

Those with longer memories will recall several earlier false starts for the Australian corporate bond markets, such as in the early 1990s when a handful of initial deals emerged to great fanfare, only for the sector to be crowded out by profligate government borrowing. "But this time the market has reached critical mass," says Paul Umbrazunas, a director of global markets at Deutsche Bank in Sydney. "It's been established in investors minds that they have to look to credit markets for outperformance. And the indices against which they are measured are being re-weighted towards credit."

Though these structural changes in the domestic capital markets have been quite easy to trace and even to predict, that stark reality has still presented challenges to investors. "What happened last year exceeded most people's expectations," says Robert da Silva, executive vice-president and head of corporate securities at BT Funds Management. "Fund managers were largely still geared to interest-rate risk and duration risk, rather than credit risk. Now all of a sudden they've got no choice because 19% of the market benchmark is credit."

This year, da Silva expects the corporate market to continue to develop with issues of more diverse credit ratings, longer maturities and greater size. The typical deal last year was around A$200 million for an A-rated corporate at three to five years maturity. This year, da Silva suggests: "Issuers will test whether the market can do 10 years for an A minus name or seven years for a triple B plus name. It would be very interesting to see a high-yield sector, although it's unlikely there will be much activity in the short term. I'm expecting to see diversification, with more plain-vanilla deals from solid Australian companies."

As for issuers, Umbrazunas says: "Corporates have been undergeared generally and have been too dependent on bank lines. Now, as the economy grows, they need to raise finance, but many companies want to free up bank lines for acquisition finance. They are very sensitive to maintaining short-term funding flexibility. And you have new managements at companies like BHP concluding that they have been far too reliant on bank lines."

Robert da Silva

Yet the general expectation is that Australian companies will continue to turn to the bond markets for mainstream funding.

Michael Dontschuk, executive general manager at Treasury Corporation of Victoria and a highly experienced issuer in the Australian bond markets, has his own advice for corporate borrowers on how to position themselves against superannuation funds growing at A$50 billion a year, with 20% or A$10 billion a year of that new money likely to be invested in debt. "Corporates should be doing A$200 million to A$300 million deals and reopening them rather like government benchmarks." It's an approach some Australian companies are coming round to.

Retailer Coles Myer set out to build itself a yield curve in the domestic bond market in 1999, concentrating total outstandings of A$600 million in separate bonds maturing in 2001, 2003 and 2005. "It's a response to changes in the bank and commercial paper market where we used to obtain a significant proportion of our funding," says treasurer Ken Latchford. "The banks are not as willing to write standby credits as they used to be a few years ago. And we saw the commercial paper market become quite disturbed in late 1998 with margins rising. Even though that may have only meant paying 10bp to 12bp over bill rates instead of 5bp, we took it as a warning signal and we have decided to reduce both commercial paper and bank standbys."

Coles Myer is something of an icon in Australia but is operating in a rapidly globalizing industry. With market capitalization of A$24 billion, it is large by Australian standards but not by world standards where it must compete for capital with the likes of Wal-Mart and Carrefour. In recent years it has fine-tuned its asset portfolio, exiting property and concentrating on the higher returns of retailing. But its domestic margins, 3.5% to 4%, compare unfavourably with the 6% to 7% at, for example, Tesco in the UK. Just under 25% of Coles Myer shares are now held offshore, mainly in the US. Offshore and domestic investors are pressing the company, for example over a possible share buy-back that would require increased gearing.

Tighter deals with banks

In such circumstances the company has to manage relations with its banks carefully. Latchford says: "There have been some changes in our bank groups as a result of mergers and we understand that some banks may want to reprice standbys because they are coming under the same pressures as us over return on capital. It comes down to negotiation and a concentration of your banking groups. There are no easy standbys from banks that don't do much other business with you." As for the new bond yield curve, Latchford says: "The investor reaction has been quite positive. We were very careful in targeting the 05 offering which was at the time one of the largest by an A-rated Australian company. Now we think this curve will be useful for pricing other securities."

Trevor O'Hoy

The company began refinancing its bank debt through a mixture of US and domestic CP and a domestic MTN programme from which it quickly placed A$400 million in two public bonds and a private placement. "We have taken out A$500 million of one-year bank debt with Australian CP and two-thirds of our A$720 million three-year bank debt with MTNs," says Lamborn. "That still leaves us with a lot to do this year as we seek to build our yield curve."

Privatization continues somewhat piecemeal from state to state in Australia. It is continuing rapidly in Victoria, South Australia and Western Australia, while being blocked in New South Wales. Based on his experiences, Lamborn suggests that debts of privatized companies could be very quickly transferred to the securities markets. "The rating agencies can assess a privatization process in four weeks. With advising banks providing bridge loan and underwriting, these deals could be structured with direct take-out in the capital markets."

Mixed fortunes for kangaroos

As in all new financial markets, there have been setbacks in the Australian corporate bond market. Some of the earlier and larger deals, such as those for BHP and Lend Lease, were well received, but others have struggled, especially during the second half of 1999, when Australian corporate spreads widened in step with credit spreads in the US. And the fortunes of several of the kangaroo deals have been decidedly mixed. It has probably not helped that these have come in clusters of issuer types. First came a group of Landesbanks, kicked off by an issue for DSL that unfortunately coincided with a Moody's report that raised questions in investors' minds about the long-term ratings outlook for German public sector banks. Then a bunch of US life insurers descended on the Australian bond market. Again one of the earlier deals, for John Hancock, struggled as its launch coincided with stories of potential liabilities arising from a US class action suit.

Fund managers in Australia have tended to suspect that international issuers with strong ratings and easy access to the eurodollar and US markets only launch kangaroo deals when there is an arbitrage advantage. Investors aren't keen to buy expensive bonds and some have used such kangaroo issues as a signal to look at buying a foreign issuer's US dollar paper and swapping back into Australian dollars.

"Some of the kangaroo deals were not well-placed by the lead managers," says Umbrazunas. "And in general in the corporate debt market, lead managers have not then supported poorer deals. So when swap spreads widened last year, spreads on the better deals also widened by a similar margin but the weaker deals underperformed." He adds: "This year, it would help to see better book-building by lead managers. Leads who up to now have only been concerned about placing their own portion of a deal should ensure the book is in a position to generate sufficient orders for the entire issue." A banker at an American firm adds: "I suspect that a lot of the big four Australian banks still own large chunks of the bond deals they have led."

Liquidity is another concern. Only Australian bank issuers have so far produced large deals in the A$500 million range. National Australia Bank has increased one outstanding issue to A$830 million. The big four banks are all eager to fund asset growth, especially in the booming residential mortgage market, at a time when retail deposits are being withdrawn and placed in more adventurous investments. With the economy growing at 4% and retail deposits at a rate slightly below that, large Australian banks are growing assets at 10% a year, mainly in loans to young people taking advantage of low interest rates and strong labour demand among employers to buy new homes.

The big Australian banks are seeking to bridge their funding gap in the wholesale markets at home and abroad. But liquidity in Australian bond deals remains thin, for all the bold claims of certain intermediaries to make tight bid-offer spreads in large size. According to da Silva: "Dealers might display 2bp to 3bp spreads and you can hit them for a limited amount, usually A$5 million. While this is welcome I would be expecting to see a broader commitment in the form of more dealers doing this and for larger amounts." Ron Erdos, head of global debt markets at National Australia Bank, agrees: "We've been trying to build our trading portfolios to facilitate client interest but it has been difficult to pick up paper in the secondary market. Liquidity at times is still not adequate." Dealers are unlikely ever to short corporate bonds unless they are absolutely certain they can obtain them for delivery.

Aside from the small size of corporate issues, another reason for their lack of liquidity is the concentration in funds under management in Australia within a few hands. Twenty or twenty-five large fund managers dominate the Australian primary and secondary bond market and these have bought and held corporate bonds so far. Smaller investors within Australia are not collectively powerful enough to provide price tension on new issues. That raises a further question over the future development of the Australian capital market: to what extent and in what ways will it be integrated with the international market?

Internationalizing the aussie dollar

Erdos at National Australia Bank is keen to use the bank's comparatively large international network to distribute Australian dollar bonds abroad. "We led Boral and and placed a lot of that paper in Europe and Asia," says Erdos. "We placed approximately half of the A$300 million Boral issue offshore on day one." The Boral deal later became highly controversial when the company announced a restructuring that reduced its credit rating. A damaging setback to the young corporate bond market seemed likely, until Boral agreed to repurchase its bonds at par.

Other issuers would love to benefit from competing demand between international and domestic bond investors. The semi-government issuers have struggled to achieve this for some time, despite the handicap of withholding tax putting off international investors from buying their domestic Australian dollar paper. "We're hoping to generate price tension from offshore accounts," says Umbrazunas, "for example through our London and New York desks which currently sell largely governments and semis."

For now, most large Australian borrowers content themselves with careful comparisons of the cost of funding domestically versus the cost of issuing in Europe and the US. The Australian banks are highly experienced international issuers. Now, as they seek to write more assets, the pressure is mounting on their funding departments. ANZ for example has announced its intention to grow its share of the already-fast growing mortgage market from 11.9% to 13% as part of an effort to rebalance the bank's business away from the corporate lending which investors in the bank's shares fear produces volatile earnings. Last year, according to Bruce Mathrick, executive treasurer group funding, it raised A$5 billion in wholesale term funding of one to five year maturity. This year's target is A$6 billion to A$7 billion.

Mathrick says: "We expect to do 60% of that in Europe, 30% domestically and 10% in the US. Obviously the domestic market is cheapest because there is no swap, but it depends on capacity. We're asking our underwriters how much we can put out domestically without hurting our pricing. We watch our spreads relative to our peers very carefully." Mathrick concludes that A$2.5 billion of domestic outstandings is a sustainable number. "It would help if we could issue domestic paper to offshore accounts on a withholding tax exempt basis, even if the offshore bid only accounted for 10% of an issue. Ultimately it will lead to improved liquidity in the secondary market" But for the moment technicalities prevent this. If ANZ bonds fall into the hands of ANZ nominees offshore, this falls foul of legislation designed to prevent offshore parent companies funding local Australian subsidiaries on a withholding tax exempt basis.

The bank is very sensitive to costs. Last year it did a $350 million three-year dollar floating rate note which it swapped back into Australian dollars at a cost of 1bp. But the cost of that swap has since drifted as wide as 10bp and recently narrowed to 7bp. Last month it sold a e750 million fixed-rate five-year deal to investors across Europe, finding first-time buyers for its bonds especially in southern Europe diversifying beyond traditional European FRN buyers.

Among Australian corporates, Kerry Packer's PBL did a successful e300 million deal in 1999, but no other Australian corporates followed up. Coles Myer roadshowed a euro-denominated bond last year but abandoned the idea when the basis swap back to Australian dollars moved out too far. "We'll pay a little for diversification and we are keen to do a euro offering to diversify ours sources when the market and our needs coincide. But we hedge all our liabilities back into Australian dollars and we won't overpay," says Coles Myer's Latchford.

Foster's, one of Australia's best-known brand-name companies, takes a different approach. It tends to borrow where it is investing and the company has long seen its best growth potential outside Australia. It established an E-MTN programme to fund its European assets and it has mandated Deutsche Bank and Salomon Smith Barney as joint leads for an e200 million inaugural euro deal this month.

"Theoretically we could use euro funding to finance domestic assets if the swap worked," says Trevor O'Hoy, chief financial officer of Foster's. "The domestic market has been very good to a lot of corporates. We have a domestic programme in place but it's been dormant because we have locked in bank funding at margins well below what the market would offer now, and that bank funding still has three to four years to run. We're not going to give that up."

Foster's has moved far beyond its origins in brewing into pure distribution and brand management in premium brands in beer and increasingly wine. It expects a big growth in wine sales and believes that the state-of-the-art technology in selling wine is to go directly to the customer through wine clubs, rather than through third-party distributors and retailers. In Australia, wine-clubs account for 11% of the wine market. In Europe, they account for just 0.5%.

So as part of the arrangement to lead the bond deal, Deutsche Bank has agreed to pilot a wine-club scheme for Foster's among Deutsche Bank customers in Belgium. It probably beats being cross-sold life insurance and its wonderful to see finance and business work hand in hand.

One of the clearest signs of the fundamental changes under way in the Australian bond markets is the number of banks openly, or sometimes discreetly, giving up market-making in Commonwealth and semi-government bonds, as that sector shrinks.

Some state treasurers are keen to promise their voters' complete debt elimination as surpluses are projected to persist. Other states are resorting to artificial life support to keep a pulse in their bond markets. Michael Dontschuk, executive general manager at Treasury Corporation of Victoria, suggests: "Some 30% of turnover in semi-government paper is generated by state governments themselves trying to keep their programmes alive." Dontschuk well understands how politicians enjoy telling voters that they will free them from the evil of public-sector debt, but he still thinks it's a bad idea. "If a government takes debt down to zero, it has lost an efficiency in its balance sheet, especially at a time when they are building infrastructure. If you walk away from the markets, it will take investors a very long time to get used to buying your bonds again if you do need to issue them." He recalls how Commonwealth bond new issuance shrank in the late 1980s. When the government did begin to issue again, it had to pay hefty margins above the secondary market trading levels of its outstanding bonds.

There is much hope in Australian financial markets that the Commonwealth government will not repeat this mistake and instead will decide to maintain a set level of gross debt, with the excess liquidity invested in liquid bonds of other high-quality issuers. Later this year the Commonwealth government will unveil its third privatization sale of stock in telecoms company Telstra, which will bring in tens of billions of Australian dollar. "That will compel the Treasury to become an investor," says one banker. Some bankers have suggested to the Australian government that it should be investing in reviving Asian bond markets.

Victoria's strategy to date has been to reduce and restructure debt, but not eliminate it. TCV acts as a bank for state-owned companies, such as water authorities, lending to them while funding these loan assets in the capital markets. The guiding principle is that it is inefficient for state-owned companies to operate with zero debt. Dontschuk has a trader's impatience with those who advocate using privatization proceeds for debt elimination, especially when equity markets in Australia and around the world are performing strongly. "So we should be selling equity and buying back debt? Is that such a great trade? Maybe not."

Surpluses and privatization proceeds have allowed Victoria to reduce debt to levels commensurate with a AAA rating and prompted a restructuring of TCV's market liabilities to concentrate on benchmark issues. "Out of A$33 billion [$20.4 billion] to A$34 billion total of debt we used to have one-third in domestic benchmarks, one third in international benchmarks, one third in other arbitrage deals," recalls Dontschuk. This last group of deals included a raft of yen loans, inflation-linked debt and other structured transactions and it is on this group of liabilities that debt reduction has concentrated. TCV has also selectively bought back international deals including Eurobonds and yankees, many of which had become illiquid. It has instructed its dealers to focus on the domestic cost of funds as its primary benchmark. It is now concentrating its market liabilities among five to six mainly domestic benchmarks issues together amounting to A$14 billion.

This will keep changing. "We have A$10 billion of loans to local government agencies," says Dontschuk. "Ideally we would like to have A$9 billion in benchmarks and A$1 billion in the other category." Today, with A$14 billion of liabilities as against A$10 billion of assets, TCV has excess liquidity that it invests mainly in Commonwealth and semi-government bonds, taking duration positions rather than credit risk. It has been a selective buyer of some recent kangaroo bond issues - domestic Australian issues by well-rated overseas issuers.

State treasury officials must prepare to grapple with new and potentially conflicting political priorities. Though politicians may be tempted to proclaim that they intend to pay off public debt, the same politicians also want to fund infrastructure development, unfunded superannuation liabilities and modestly to increase public spending. Dontschuk says: "In Victoria we have A$14 billion of unfunded superannuation liabilities. Other states have borrowed to plug those gaps, diverting money into superannaution schemes whose fund managers then invest in equity. There is a question over how rating agencies will regard the mix of outstanding debt and unfunded superannuation liabilities."

Another goal for TCV has been to make Australian dollar bonds more of a global product and Dontschuk is frustrated by the imposition of withholding tax on domestic bonds sold to offshore accounts. He doubts that it raises much revenue and looks forward to its repeal. "I suspect that overseas holders of Commonwealth bonds don't pay much withholding tax anyway, as they coupon wash or otherwise sell off bonds to avoid such tax issues. If withholding tax was removed we would look to internationalize our domestic programme. We would like investor diversity to create price tension for our issues."