Bond pond has shallow returns

PORTFOLIO POINT: Retail investors can still get better returns on bank deposits than on the bond market. That’s a reflection of regulatory distortion and government intervention.

There was much excitement among participants in the wholesale corporate bond market last week. BHP Billiton returned to the market for the first time in over a decade to issue $1 billion of five-year bonds.

BHP Billiton typically issues bonds in Europe and the United States, raising as much as US$5 billion at a time. Its issuance in the domestic market gave institutional investors a rare chance to gain exposure to the company.

But, perhaps even more importantly, it gave investors an equally rare chance to diversify their investment portfolios away from financial institutions. Financial institutions, of one sort or another, account for almost 90% of the bonds outstanding in the wholesale market. 

As with any investment portfolio diversification is critical, not only by borrower in a bond portfolio but also by economic sectors. Apart from the $1 billion of bonds just issued by BHP Billiton, there is only another $600 million of bonds that have been issued by two other issuers that are active in the resources sector.

As a result, investors were also delighted to be told that BHP Billiton intends to be a regular issuer in the market in future.

BHP Billiton is also a company that retail bond investors – mums and dads – would like to have the opportunity to invest in. While there are many hurdles to be overcome to establish a viable retail corporate bond market, one that doesn’t receive a lot of attention is the distorted risk and return opportunity set that confronts retail investors.

The institutional investors that were so excited to get the opportunity to buy BHP Billiton bonds will receive a yield of just 3.96% per annum on their investment. To paraphrase Naomi Campbell, most retail investors would not get out of bed for 3.96% per annum.

So what is going on?

The perspective of the institutional investors makes sense when it is considered that a five-year bond issued by the Commonwealth government yields only 2.5% per annum at the present time. A five-year bond issued by one of the major banks yields 4.25% per annum.

Admittedly, holding a bank bond appears more attractive than the BHP Billiton bond but there is the diversification opportunity, as discussed, that institutional investors are willing to pay for. Higher yields can be obtained by accepting a higher level of credit risk.

A five-year bond issued by Crown Limited is currently yielding just under 5%.

Mums and Dads reading this commentary are probably yawning by now. They know that even after the Reserve Bank cut the official cash rate last week, they can still get 4.8% per annum on a five-year term deposit from NAB and they can probably do better at one of the other banks.

What’s more, provided their term deposit does not exceed A$250,000, it will come with a guarantee from the Commonwealth government, free of charge. Thus retail investors are taking exactly the same risk as an institutional investor that buys a government bond but receives only half the yield.

The government guarantee is a free ride for the investor and, for the moment, a free ride for the bank. But why does an institutional investor receive a yield of 4.25% per annum on a five-year bank bond but a retail investor earns at least 4.8% on a five-year term deposit?

The bank regulator, APRA, and the credit rating agencies are putting considerable pressure on the banks to raise the level of their funding obtained from deposits and to decrease their reliance on wholesale bond markets. APRA is doing this ahead of the introduction of the Net Stable Funding Ratio from the beginning of 2018 and, like the credit rating agencies, it is concerned about the funding risks faced by the banks in wholesale markets that could still shut down at any time.

Thus, there is more competition among the banks (and other financial institutions) to raise deposits than there is to sell bonds to institutional investors, and the banks are paying up accordingly.

The regulatory distortion being brought about by APRA and the government intervention in the form of a free guarantee is resulting in a very good deal for retail investors, or is it? Retail investors are being sheltered from the reality of historically low yields in the developed world.

As a result, there is little appreciation of credit risk and the danger signals being flashed when very high yields are on offer. The issuers of hybrid notes are well aware of just how high the yields are that they are offering to pay.

But mums and dads, seeing offers of 8% or more, are rushing hybrid note issues with little realisation that coupons don’t have to be paid, and in some cases will be prohibited, and that their capital may not be returned for a very long time, if ever.

Unfortunately, this distorted reality is unlikely to change for some time.

Philip Bayley is a former director of Standard & Poor’s and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.