After false starts, Australian domestic corporate bonds have finally come of age this year. Although the market is not yet fully mature, in the past half year or so there has been a significant increase in the number and size of corporate issues. So far there is no sign of a slackening of this trend.
In the three months to the end of February, more than A$2.3 billion (US$1.8 billion) was added to domestic debt by corporate bond issues, according to a study by Westpac Bank. February was lively, with more than A$1 billion in fresh non-government issues. Westpac predicts that by December this year corporate issues will have exceeded A$4 billion, with no noticeable widening of spreads.
The market is exhibiting satisfactory liquidity, with secondary trades being negotiated more or less readily. Some of the underwriters and investment banks now take principal positions for short periods in order to facilitate transfers.
Increased corporate bond issuance has been matched by robust demand from investment institutions. This has held back any tendency for spreads to blow out, as happened in earlier, eventually unsuccessful periods of market growth.
Kangaroos kick off
The Australian domestic market has also attracted foreign issuers and investors, which have shown considerable interest in kangaroo bonds, devised by the Commonwealth Bank of Australia to enable overseas investors to participate in the market without having to deal with withholding tax.
In February one offshore issuer, UK utility National Power, marketed a A$250 million, 10-year issue to refinance its equity in the Hazelwood power station in Victoria and raise new capital. Investment bank BZW, which arranged the issue, describes it as the largest and longest to appear on the Australian market. The bonds were priced at 69 to 73 basis points above the October 2007 Commonwealth government bonds and an interposed bond and were rated A by Standard and Poor’s and A2 at Moody’s.
The major domestic banks, among them Westpac and Commonwealth Bank of Australia, as well as some investment banks, have committed considerable resources to the corporate bond market and all express confidence in its new-found vigour and permanence. Some have appointed dedicated corporate bond traders and specialist sales staff to place bonds with investors. These traders are backed by researchers to generate supporting analysis and technical specialists to create issuance programmes and documentation.
Such confidence is not shared by all potential issuers. So far, the bluest of blue-chip companies, with the notable exception of the largest banks themselves, have stood aside from the market. But Wayne Hoy, Commonwealth Bank’s chief manager, financial markets, believes the cost advantages of using the domestic market will eventually overcome the reluctance of the biggest and best-rated companies.
Glenn McDowell, head of debt origination at Deutsche Morgan Grenfell Australia, points to potential cost savings from issuing domestically. These include diversification of funding away from banks to institutions, lower legal costs, lower dealer fees, less onerous reporting requirements than are required in some foreign markets, and the need for only one rating compared with the two that are required overseas.
A failure to recognize cost savings is not the only reason blue-chip issuers are thin on the ground. Many of them suspect that the corporate bond market is no real market at all but rather a de facto system of private placement, in which much of the paper stays with the underwriting banks and other investment institutions. Corporate sceptics apparently believe they can do better for themselves by dealing directly with institutions or by relying on the larger markets in Europe, Japan and the US.
But big corporates in the second rank are beginning to come to market. Cathryn Carver, head of debt securities in Westpac’s institutions and international banking group, cites the issue by Southcorp Holdings of A$100 million of medium-term notes as part of its A$250 million domestic programme. Although its BBB+ rating means Southcorp is not a blue chip, it is a substantial conglomerate, predominantly involved in wine production, packaging and water heating in Australia and the US. It is ranked 34th among companies listed on the Australian Stock Exchange with a market capitalization of A$2.56 billion and its credit rating makes it investment grade according to Reserve Bank of Australia guidelines.
With biggish companies such as Southcorp participating, it might well be claimed that corporate bonds have become a permanent fixture in Australian capital markets trading. In support of this view, Westpac’s February/March Debt Security Monitor listed the following recent transactions:
more than A$600 million of private placements for banks, building societies and finance companies;
issues worth more than A$800 million from foreign companies such as Korean banks, National Power, Merrill Lynch, and GE (HK);
issues from unrated issuers such as Futuris, Crown Casino and building societies;
Eurobond-style (swap-driven) fixed-rate issues for BankWest, Bank of Melbourne, National Australia Bank, Banque Nationale de Paris and BOS International (Australia);
Medium-term note issues for newspaper publisher John Fairfax, GMAC Australia, Southcorp, BTR Nylex and Burns Philp;
more than A$4 billion in mortgage-backed securities.
The figures are impressive, but cynics still point to the way in which the market shrivelled in the 1987 crash and again during the recession of early 1990-91. Bullish observers note, though, that circumstances are now different. Commonwealth Bank’s Hoy, for example, argues that in 1987 the market was plagued by structural weaknesses, such as low institutional savings, excessive borrowings by state governments and an obsession with high liquidity (the ability to buy and sell large amounts of stock at fine bid-offer spreads). Eventually institutional investors shunned corporate offerings concentrating instead on state government issues, spreads collapsed, and blue-chip corporations turned to other markets, such as the US.
Demise of the public borrower
Hoy; Westpac’s Carver and her colleague Jason Cavanagh, senior manager debt securities; and DMG Australia’s McDowell identify four fundamental changes. First, government and semi-government borrowers are rapidly vacating the market. Second, vast sums are flowing into investment institutions from compulsory retirement pension funds. These have to be bedded down in a variety of investments and – of special importance for corporate bonds – a range of maturities. Third, specialist repackagers have securitized domestic debt and some of this has been sold on as bonds to offshore investors, notably in Japan. Finally, the emergence of specialist underwriters in banks has made the market much less hazardous for issuers and given it greater liquidity.
The change in the balance of private and public funds available for investment is particularly significant for the bond markets. While compulsory retirement superannuation is boosting the volume of domestic savings by about $42 billion a year, of which $13 billion could well find its way into corporate bonds, government borrowers at all levels – federal, state and territory – have been bitten by the fiscal rectitude bug and are targeting balanced budgets. State government paper in issue, for example, has declined by $7 billion in the past 18 months and is set to reduce further.
Sales of assets such as water, gas and electricity utilities have enabled some states to reduce outstanding debts and have lowered their need for further borrowing. The Commonwealth (federal-level) government is also seeking to reduce debt by diverting funds from the forthcoming sale of its telecommunications enterprise, Telstra, into debt retirement and is seeking to balance its budget next year.
Less public borrowing and more cash both point to an impending shortage of supply and a narrowing of spreads. Commonwealth Bank’s Hoy says that over the past two years spreads on investment-grade corporate debt have tightened to levels that are now below minimum rates of return on equity set by many commercial banks.
Both borrowers and financial intermediaries have been surprised by the pace of spread narrowing over recent months. For many years, long-term debt ratings of single A were considered the minimum investment grade threshold in Australia. As in the fully developed US markets, that threshold is shifting down to embrace BBB risk, giving more corporates the opportunity to issue bonds rather than rely on bank finance.
Westpac’s Carver and Cavanagh argue that a similar demand/supply imbalance in the 1980s was insufficient to develop a fully fledged corporate bond market – the market lost impetus despite a spate of activity similar to that of the past nine months.
A blow-out in spreads in the 1980s meant that corporates could not fund themselves domestically and sought more rational pricing in offshore markets, although the relatively closed nature of Australian markets meant that spreads could be sustained at what Westpac describes as ridiculously high levels.
In the 1980s building societies had a growing share in the domestic housing market and fund managers were monopoly funders to the societies. Building societies gave fund managers better returns than they deserved for the underlying risk and the risk/return matrix of corporate paper was relatively unattractive in terms of running yield.
A more disciplined market
In the deregulated 1990s, the cosy low risk/high yield relationship some fund managers had with the housing market is no longer possible. The development of securitized mortgage-backed paper has made the provision of housing finance more competitive and this has helped bring down interest rates for consumers. Investors must now allocate funds within a more efficient risk/return framework, say the Westpac analysts, a framework in which corporate assets can compete effectively.
Although the market has become more mature and efficient in its handling of risks, including securitized risks, one severe disciplinary force has emerged in recent years: the global market. Global arbitrage of spreads means that no domestic spread can stay out of line for very long. Spread movements tend to derive largely from international leads.
So disciplines are in place, costs are competitive, investment funds are well supplied, yet the corporate bond market falls short of what participants would like it to be and some issuing companies prefer to look elsewhere.
“The effects of the change in Australia’s bond markets have still not worked their way fully through the system,” says Commonwealth Bank’s Hoy.
“As investors search for yield, lesser-rated investment grade credits have been the first beneficiaries, both in terms of improved credit spreads and a lengthening of maturities which are now acceptable to investors. AAA-rated entities have yet to experience the effects, but as the supply of risk-free assets continues to diminish, the Australian market will finally recognize appropriate credit spreads for highest-quality risk.”
The picture that emerges from such comments is one of an evolving market in which some intermediaries and fund managers are insufficiently involved. As an example, any number of intermediaries are willing to be involved in a broking role but too few are willing to run a book by holding some of the risk for a period. Westpac’s view is that more bookrunning is needed to smooth the timing mismatches between buyers and sellers and to enhance liquidity. This requires the establishment by market intermediaries of corporate bond books supported by specialist corporate traders. There is already an adequate number of brokers but there is not yet a diversity of principal traders.
Westpac, along with other Australian banks, has put up the money to back its opinion. The February/March issue of its Debt Securities Monitor indicated that it maintained a secondary trading book of US$500 million, which is turned over on average every 30 days.
Another deficiency readily detected in the Australian market is inadequate debt research. Only the rating agencies provide research of real depth but their focus is not necessarily just on debt, and they are seen as a little slow to move. For a debt market to function effectively, regular monitoring of the credit health of issuers is vital.
Obviously debt monitoring requires issuing companies to disclose detailed financial information. The market will never achieve its potential if corporate borrowers regard the market as a less rigorous way of raising funds than borrowing from banks.
The industry would like to see the establishment by investment managers of separate corporate bond funds and asset-backed securitized funds. At the moment, corporate bonds are mostly held in general fixed-interest funds, which do not allow the product differentiation seen as desirable in an increasingly well-informed market, which requires different products for different clients.
Under fire
Australian superannuation funds have come under fire recently for their perceived failure to invest in Australian industry. If they were able to show that they were increasing their holdings of corporate bonds, the superannuation funds would have a perfect riposte to charges that they are not investing Australian savings in industries that provide Australians with jobs.
Another argument for specialist corporate bonds funds is that this would ensure that relative value analysis in the corporate bond sector was carried out by credit specialists rather than by managers seeking specific maturity dates. The effect of this would be to reduce the element of risk in transactions.
Banks that arrange corporate bond issues for clients probably experience lower gross revenue from the deal than they would if they were to provide bilateral or syndicated loans. The drop in gross revenue could be offset in part by fees earned and the lower cost of not having to take deposits on to their balance sheets to finance the loans.
From December this year, the Reserve Bank of Australia will allow banks to risk-weight securitized assets at 20% provided the assets are rated as investment grade and meet other technical requirements. This means that for capital adequacy purposes there will be a strong incentive for certain banks to own their assets in securitized form, as the return on regulatory capital for the 20% weighted assets is better than for a bilateral or syndicated loan. With such advantages, the banks are bound to play a crucial role in the development of the corporate bond market.
As important as the banks are in the market, the real power in fostering or hindering corporate bond development must always rest with the investment fund managers. With funds under management for retirement superannuation alone growing at an estimated A$42 billion a year, the allocation decisions of funds will determine the growth or otherwise of the market.
