Partner James Darcy, Managing Associate Paul Cerché, Senior Associate Simun Soljo, and Associate Mizu Ardra
It has been recognised for some time that the domestic corporate bond market constitutes a weak spot in the otherwise robust and deep Australian capital markets. The less developed domestic bond market is a distinguishing feature among the leading financial systems and capital markets. This was no more evident than through the GFC, when corporate Australia recapitalised through the equity markets rather than turning to investors in the domestic wholesale or retail bond markets.
Corporate Australia's reliance on the equity markets has historically been coupled with a reliance on offshore funding. This offshore funding has been effected by raising funds directly from the US or Eurobond capital markets, but also through intermediary banks that source capital from those offshore markets. Those sources of capital have, historically, offered greater depth and, as a consequence, lower execution risk for corporate treasurers than the Australian corporate bond market.
The trend in recent years has been for Australian corporates to diversify their funding sources to reduce dependence on bank debt. Largely, this has been through offshore capital markets, but to some degree the domestic corporate bond market has also benefited from this. In the past 12 months, there has been an uptick in issuances at the wholesale level in Australia, particularly by infrastructure companies looking for tenor. At the other end of the bond market, we have also seen the start of a mid-cap market for unrated borrowers aimed at high net wealth investors, with 10 such deals being completed in the past nine months. So, we are seeing some signs of development in the domestic bond market.
We are, however, a considerable way from being able to say that we have the vibrant domestic bond market that participants and economic observers acknowledge is a missing link in the Australian financial system.
The further development of a domestic bond market has been on the radar of policy-makers for a number of years, with various regulators looking at levers and legislative intervention to facilitate easier and more efficient access to the bond market.
Public discourse will continue on the subject as part of the Financial System Inquiry (the FSI), with its terms of reference including to recommend policy options to 'promote the efficient allocation of capital and cost efficient access and services for users'. In doing so, the FSI is expected to take account of the regulation and taxation of entities to the extent these 'impinge on the efficient and effective allocation of capital by the financial system'.
The opportunity to tackle the issues confronting the further development of the corporate bond market through the FSI has been embraced by market participants and observers, with a number of submissions made on the topic.
As a number of those submissions have noted, there are impediments to the development of the corporate bond market in Australian which has a detrimental effect on the ability of Australian companies to access capital and so should be of concern to the FSI.
In this article, we consider some of these impediments and the changes which might be required to assist the development of the market in Australia.
There are many factors that contribute to the state of the domestic corporate bond market, but the public debate on how to further develop the market will, to a degree, focus on how to mobilise the deep pools of investment funds in Australia towards fixed income products offered through the corporate bond market.
Superannuation funds are natural participants in the corporate bond market. All other things being equal, corporate bonds should be attractive to superannuation funds looking to make long term investments providing fixed returns to match, in particular, the liabilities of superannuation funds providing defined benefits and pensions to members.
As identified in number of submissions to the FSI, however, there is a relatively low allocation by superannuation funds to fixed income assets generally, and in particular to Australian corporate bonds. The lack of depth and relatively low liquidity of the domestic market is a factor. This poses a dilemma – a lack of depth in the market will of itself be a limiting factor in its development.
This dynamic could shift if there is a change in policy by the Federal Government to encourage or mandate an increased take-up by retirees of products such as lifetime pensions and lifetime annuities, which provide a guaranteed income for life but do not otherwise permit access to the capital supporting the income stream. There is currently a relatively low allocation of superannuation savings to these products, but they are seen as a possible solution to the risk that increasing longevity of retirees will result in many of them running out of superannuation savings during their retirement and having to fall back on government-provided pensions.
An increased take-up of lifetime pensions and annuities, whether because of Federal Government compulsion or incentive, may result in increased investment in corporate bonds by life companies and superannuation funds which provide these income streams. The providers will have greater scope to invest the assets supporting these income streams in less liquid asset classes, such as domestic corporate bonds, on the basis that investors are only entitled to a long-term income stream and cannot call for the immediate transfer to them of the capital supporting the income stream. This is in contrast to the ability of retirees to generally call for the immediate payment of their lump sum superannuation benefit.
If the allocation of superannuation assets towards annuities and other longevity products increases, the willingness of funds and life companies to invest in Australian corporate bonds may therefore grow, and the increased investment may be a catalyst for the deepening of the market and increasing liquidity.
In the pre-retirement phase, while members do not have access to their superannuation savings, they generally have the ability to switch investment options within their fund and to transfer their benefits between funds. This also contributes to a preference by trustees for liquid investments. Whether the Federal Government would be prepared to curtail these member rights through changes to the legal framework governing superannuation is doubtful (and would likely be contentious).
While the superannuation industry may be supportive of the development of the corporate bond market, it is resistant to any suggestion that the currently low allocation to corporate bonds reflects any failing on the part of the industry. Superannuation trustees are under an obligation to act in the best interests of members, and would argue that they invest based on the expected risk and return characteristics of the available investments. Any proposal to prescribe minimum investment levels in particular sectors, such as infrastructure or corporate debt, may impose on trustees an obligation to select potentially sub-optimal investments, and so may pose a risk to the best interests of members. Previous criticism of the industry's lack of participation in the corporate bond market (perceived or otherwise) has noted that the funds do not appear to sufficiently value the risk benefit of the enhanced position of where corporate bonds sit vis-à-vis equity in the capital structure of a company.
Another possible source of funding are retail investors, including self-managed superannuation funds, which also arguably are relatively under-invested in corporate bonds. A significant proportion of corporate bonds offered in Australia are offered only to wholesale investors.
There are a number of actual and perceived limitations on the development of a retail bond market. In part, the lack of a retail bond market for corporate issuers can be explained by the higher initial and ongoing costs and demands associated with a retail bond issuance by comparison to those associated with wholesale debt raisings.
Unlike offers to institutional investors in Australia, an offer of bonds to retail investors requires a formal prospectus. The due diligence process associated with disclosure, particularly for a single offer of retail bonds, is regarded by some issuers as prohibitively costly and time consuming by comparison with wholesale debt issuances.
Various regulatory changes to simplify the offer of bonds to retail investors have been considered over the years, and a number of submissions to the FSI have called for changes in particular to the prospectus regime, which is considered to be overly burdensome for retail offers and which increases the costs of an issue, the time required to get an issue to the market and the execution risk.
Recently, the Federal Government re-introduced a Bill into Parliament to allow for simplified offerings of corporate bonds to retail investors. If passed, the legislation would allow companies to issue what the Bill terms 'simple corporate bonds' using a shorter prospectus regime, rather than the current one. This shorter prospectus regime would involve a two-part prospectus – a base prospectus containing general information which would have a life of three years, and an offer specific prospectus containing more detailed information about the specific issuer of bonds being promoted. The content requirements for the shorter prospectus regime is yet to be determined and will be contained in regulations.
The proposed legislation would also make changes to the liability regime to reduce directors' liability and provide greater certainty around the due diligence steps required. Under current legislation, certain directors are liable for misleading and deceptive statements in a prospectus prepared in connection with a retail bond issuance, whether or not they are involved in a contravention. While there is a due diligence defence, this highlights the level of attention required to be given by management and advisers to the preparation of a disclosure document for retail bond issuances. Under the proposed legislation, directors will only be liable where they are involved in the misleading and deceptive statement or the omission of required information.
While the simplification of the prospectus regime could assist in the development of the market, there is also an element of doubt among some participants as to the real effect this would have in increasing participation. Overseas experience indicates that retail investors will remain a small component of the overall corporate bond market. We anticipate that increased institutional participation will therefore remain a significant objective of regulators.
Some market participants argued that the definition of retail client itself should be amended. In our view, there is certainly scope to clarify some existing uncertainty, especially in relation to the treatment of self-managed superannuation funds. However, this is likely to assist only at the margins, and would be unlikely to significantly affect overall demand for corporate bonds.
As noted above, there has been a recent emergence of a market for unrated bonds issued by mid-cap corporate issuers. These bonds have been targeted at high net-wealth individuals who satisfy the 'sophisticated investor' test under the Corporations Act, thereby avoiding the need for a formal prospectus. This is an interesting development in the market, and perhaps highlights the untapped demand from individual investors for fixed income products.
Even if the disclosure in relation to corporate bond issues to retail investors is simplified, issuers may face another impediment in the behavioural preference of Australian investors for equity. One possible response to this may be greater education of investors as to the pricing, characteristics and benefits of corporate bonds. This may go some way towards changing these preferences. To this end, credit ratings agencies have argued for a review of Australia's licensing requirements for their businesses to improve retail investors' access to the credit ratings of corporate bonds.
Several submissions to the FSI also suggested that the taxation settings in relation to corporate bonds should be adjusted to reduce the perceived incentives for investors to prefer equity ownership. While superannuation entities are able to obtain a refund of any excess franking credits attached to dividends, the yield on bonds by definition is paid out as a fully assessable coupon.
The development of the corporate bond market in Australia is seen as important by a number of Australian corporates and by other market participants. This has been acknowledged by successive Federal Governments, and is reflected in the submissions that have been made to the FSI.
There is no quick solution to the lack of depth in the market which is currently inhibiting its growth. Some of the proposals put to the FSI could assist with fostering that depth, particularly an increased participation by the superannuation industry and easier access to the retail market. Market participants are guarded about the short term impact of the proposals, given some of the broader competitive challenges the market is facing, but see these moves as having the potential to enhance the long-term infrastructure of Australia's corporate bond market.