Sowing the seeds for a retail bond market

Australia's financial system while sophisticated overall, still lacks a domestic retail bond market. This could soon change given today's developments in the Senate.

Two years ago Wayne Swan announced that he would facilitate the retail trading of Commonwealth government securities. Today, with the passage of legislation through the Senate, he’s finally made good on a promise that has the potential to create longterm structural changes in Australian markets.

It is unclear why it has taken so long to do something that has been talked about for years and to which there are no obvious objections but it is better late than never and comes at a time when the prospects for a retail market in bonds are as fertile as they have ever been.

The absence of a developed corporate bond in this market has noted over the decades but until the financial crisis erupted not a top-of-mind issue for policymakers, despite the fact that it is a glaring missing piece of an otherwise very sophisticated financial system. The larger Australian corporates could readily access wholesale funds offshore and smaller companies were well-serviced by domestic and foreign banks.

The crisis revealed that those global debt markets and foreign banks were a source of vulnerability for the Australian financial system and economy.

Even the major banks, with their elite credit ratings, were at times shut out of debt markets that were malfunctioning. The foreign lenders withdrew, the domestic market for asset-backed securities shut down and the crisis resulted in increased concentration of the domestic system.

Having been rudely alerted to the reality that equities are riskier than bank deposits (particularly when those deposits are guaranteed) there was, and is, a flood of retail investor funds out of equities markets into bank accounts and an increased emphasis on yield over capital gains.

The past four years have emphasised the need, and pointed to the demand, for a domestic retail bond market.

There have been some issues of corporate bonds, particularly issues of hybrid securities, and they have tended to be massively over-subscribed as investors have scrambled for access to higher yields but it is a niche rather than a deep and liquid market.

That’s where, in theory at least, making Commonwealth government securities available to retail investors might help. At the moment trading in those securities is essentially confined to institutional investors.

Making them available, presumably on the ASX platform, will provide a baseline pricing reference point – other bonds can be priced and traded at yield premia over the risk-free benchmarks they will create. They may also provide an introduction to traded bonds for risk-averse investors until they become more comfortable with holding non-government securities.

A functioning domestic bond market with real liquidity would provide the banks and, initially, blue-chip companies with an alternative to offshore wholesale debt markets. It would enable them to diversify their funding sources without foreign exchange risks or costs.

It would, if the market flourished, reduce the refinancing risk of dealing in distant markets potentially influenced by very different settings and issues to those in this system and economy.

If it developed into a deeper market, it would also represent a competitor to the banks for corporate financing in a system where there are lots of complaints about the paucity of competition to the majors.

Investors, having been confronted quite brutally by the realities of equity risks during the crisis, have been steadily shifting out of the managed superannuation system and into self-managed structures that aren’t as highly-exposed to equities as most funds managed by third parties.

Government bonds – federal, state or semi-government – and the securitised debt of major corporates should be an appealing asset class for a DIY fund and in tune with the broader switch to a more defensive mode among Australian savers.

Thus there are a raft of reasons why the passage of the legislation clearing the way for trading of Commonwealth securities on exchanges is a potentially very significant day in the history of Australian securities markets and the financial system.

Now the government, the ASX (and perhaps other platforms), market participants and an investment industry geared towards promotion of equities need to do what they can to ensure that the market is established and developed.

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