How dividends and super battered corporate bonds

The structure of Australia’s banking system, and the clear bias for equities over debt brought on by 1970-80s deregulation, mean the local corporate bond market will likely never rival that of its peers.

Reserve Bank Deputy Governor Philip Lowe’s speech on market-based financing on Tuesday sparked considerable interest, as any discussion of the absence of a developed corporate bond market generally does. What Lowe didn’t canvass, however, is why that market is so underdeveloped relative to similar jurisdictions elsewhere.

As Lowe said, Australia looks like an economy that should be well placed to have a functioning corporate bond market. The legal system, the trading arrangements, the intermediaries and the savings pool are all there, and larger Australian corporates are used to issuing bonds, albeit mainly offshore.

There are also obvious gains to be made in terms of financial system security in times of stress and as a source of both domestic funding and of competition for the banks.

A missing piece of the infrastructure, until recently, was a retail market for bonds.

It wasn’t until the Australian Securities Exchange began trading Commonwealth government bonds last year that there was any reference point for pricing or liquidity for retail investors and self-managed superannuation funds to buy and sell bonds. Later this year legislative changes making it easier and cheaper for companies to issue bonds into the domestic market should help grow that retail bond market.

While those developments (which have taken far too long to be implemented) might help grow the retail market for fixed interest securities, it doesn’t explain why superannuation funds have invested, according to Lowe, less than one per cent of their assets in domestic non-bank corporate bonds.

Lowe suggested that, given that the funds’ holdings of Australian bank bonds had risen from $8 billion a decade ago to $40 billion today, it could relate to the relative risk-return and liquidity characteristic of the corporate bonds on offer.

There is another obvious and more structural explanation for why investors – superannuation funds and non-super investors – favour equities, and especially Australian equities, over bonds.

In the 1970s there was a strong and functioning domestic market for fixed interest securities and retail investor appetite for government, semi-government and corporate bonds and debentures.

Indeed, the rigid regulation of bank interest rates and banks and insurance companies’ liquidity -- they had to meet reserve and liquidity ratios that forced them to buy government and semi-government securities -- ensured there was a market for bonds, while bank regulation created a big non-bank sector of finances companies and the like that issued higher-yielding debentures and unsecured notes.

The deregulation of the system that started in the 1970s and accelerated through the 1980s (and some spectacular collapses of finance companies) saw the banks’ share of the system, which had been as low as about 40 per cent in the early 1980s, grow rapidly. The bigger non-banks, including the finance arms of the banks created to circumvent the stifling regulation, progressively disappeared as the banks were freed up.

One of the great changes in the Australian financial system -- and a key factor, perhaps the key factor, in the shape of the system today -- came in 1987 when Paul Keating introduced the dividend imputation system removing the double taxation of income that had previously existed.

It was in a number of important ways a very positive reform. Apart from the inequity of taxing the same income twice it shifted corporate incentives away from debt to equity and lowered the cost of equity capital for Australian companies.

Given the ravaging of the corporate sector (and the taxation base) that the incentive to leverage caused during the 1980s, the longer-term outcomes from the introduction of imputation were -- and remain -- desirable. It did, however, create a major bias away from debt towards equity.

Imputation interacted with another Hawke-Keating reform, the introduction of the superannuation guarantee system in the early 1990s and the compulsory flow of savings into superannuation funds.

Where previously there had been a flow of savings into bank deposits and other forms of fixed interest securities, a significant proportion of those funds began flowing into superannuation.

Banks recognised the long-term implications of the change -- funds that they had previously accessed directly to fund their lending would now have to be bought back from super funds – and collectively plunged into a frenzy of funds management acquisition to gain an exposure to superannuation. They also continued to grow their offshore borrowings.

The impact of imputation on the appeal of equities and the dividend income they generate and the diversion of funds from banks to superannuation funds have created quite a distinctive financial system and one not particularly conducive to issues of corporate bonds.

Over time, and in a different interest rate environment, that may change at the margin if the growth in self-managed funds continues, the ASX-listed bond market really develops and central banks elsewhere stop flooding markets with cheap liquidity and creating floods of ultra-cheap credit.

While it would be preferable for there to be a deeper source of domestic funding for another of those moments of crisis that close offshore markets, like the collapse of Lehman Bros, Lowe was right to ask whether it matters.

Apart from the demonstrated ability of the Australian banking system to function (albeit with some government support) through a crisis and continue to lend, and of the Australian equity market to supply risk capital to corporates through that crisis, it is probably a more realistic ambition to have a deeper bond market rather than a market as developed as some of those offshore.

The structure of our system that has developed over the past four decades and the investor incentives it creates probably ensures that is the most we can aim for.