The super power of bonds

A properly functioning, liquid corporate bond market may encourage large super funds away from equities over-exposure to fixed interest – something which could, and should, occur without government intervention.

Former federal finance minister Lindsay Tanner may have been overstating the risk of government intervention to correct a perceived bias towards equities within superannuation fund portfolios yesterday but the issue he was highlighting is worthy of further discussion because it contributes to the debate about the need for a developed corporate bond market in Australia.

In a speech to the Ownership Matters conference in Melbourne yesterday Tanner actually approached the issue of the overexposure of super funds to equities from that starting point – the absence of a developed domestic corporate bond market.

The disproportionately high levels of exposure to equities in most balanced fund portfolios is only one strand of the explanation for the absence of a functioning domestic bond market, albeit a material one.

During the great decades-long bull market in equities leading up to the global financial crisis, the bias towards equities in most super funds generated returns that, from a long-run perspective, were aberrational. The GFC reminded investors, and super fund members, that while equities might deliver higher returns relative to most other asset classes over the long term they do so because they carry greater latent risk.

As the population ages, the tolerance for risk will decline. Indeed, with the GFC as a wake-up call, it has already declined. Hence the deluge of funds that has poured into term deposits and other fixed interest securities as investors and super funds have been introduced, painfullly, to the concept of risk-adjusted returns.

There are, as Tanner said, a host of reasons why a corporate bond market hasn’t developed here, some of which relate to the different tax treatment of debt and equity, interest rate differentials, the ability of large corporates to tap into massive and sophisticated securitised debt markets offshore and, of course, the higher nominal returns that equities have generated over the past several decades. The fact that fund managers can charge higher fees for equity products than vanilla fixed interest securities portfolios might also be a factor.

For the foreseeable future the environment for equity markets is likely to be quite different to that which prevailed before the GFC.

That’s not to say that there mightn’t be significant rises from time to time in sharemarkets but they are likely to be volatile and constrained by the probability that the austerity programs being imposed in Europe and the US and the impact of more rigorous capital and liquidity regimes on the global banking system are likely to weigh heavily on the markets and make them significantly less attractive to investors (as opposed to traders). The need to tackle and reduce the public debt burdens in the eurozone and the US suggests a prolonged low-growth era for the developed world’s economies and consequently for equity markets.

That would suggest that, particularly for the demographic bulge moving towards retirement, the appetite for equities will diminish and therefore the proportion of equities within fund portfolios will trend and remain lower than it was pre-GFC.

We’ve already seen a flurry of listed corporate bond issues earlier this year as companies have capitalised on the risk aversion and desire for yield of investors, particularly the rapidly-growing self-managed fund sector.

If the major banks were to issue listed bonds, and the federal government ever delivers on its promise to facilitate the listing of Commonwealth government securities – which would provide a pricing benchmark for all other issues – a properly functioning, liquid corporate bond market that can be accessed by retail investors and SMSFs could be developed, one which might also encourage the large super funds to become bigger players.

Given the post-GFC environment for the major banks – they are holding a lot more capital, more and more expensive liquidity, experiencing higher funding costs and face the imposition of a simple leverage ceiling within an economy where households and businesses are deleveraging and demand for credit is therefore very weak by historical standards – it is unlikely that they will return to intermediating mid-teens credit growth any time soon.

Indeed, having had a nasty experience during the GFC, when their own overexposure to wholesale funding markets highlighted their own vulnerabilities, it is likely that the banks will manage their balance sheets far more conservatively in future than they have in the past, with an acute focus on the stability of their funding.

One of the reasons the major banks built up their reliance on offshore wholesale funding was the increasing diversion of Australian savings from bank accounts to super – and a majority of it into equities – as the super system grew over the past quarter of a century.

What used to be cheap funding for the banks was either denied to them or, because of its limited supply, more expensive to access than funds available in the deep and competitive bond markets offshore.

More of those funds within the super system will, if fund members and their trustees shift to a more balanced and defensive posture and (thanks to the GFC) have a better understanding of risk-adjusted returns, become available to both the banks and corporate borrowers.

Given the size and growth rate of the super system, relatively modest re-weightings of fund portfolios away from equities to fixed interest securities could have very significant impacts and could – indeed, should – occur without any need for government intervention. There probably aren’t too many super fund members who’d be enthusiastic about the prospect of Wayne Swan dictating how their savings were deployed.