Reforming the current dislocation of financial markets
Mark Twain once famously quipped “history doesn’t repeat itself, but it often rhymes”. The current dislocation in financial markets as a result of the COVID-19 pandemic looks on the surface unique, but there are echoes of the past in the present.
In this context, let’s hope some of the lessons from an earlier crisis are better learned now. Most especially, action to help corporate Australia reduce its reliance on banks and offshore markets for funding.
During the GFC, banks had limited ability to expand their balance sheets for corporate lending. In fact, they had to recapitalise to ensure ongoing viability.
Capital rules enacted since then to ensure that they are “unquestionably strong” have meant the banks entered this current economic crisis in a very strong position. Yet corporate Australia’s dependence on banks and offshore markets for debt financing has often meant that only domestic equity raisings are possible during times of stress.
Of equal significance is the heavy weighting towards equity markets among retail investors – a rare situation within developed economies. The benefits of a more diversified investment strategy are especially highlighted during times of financial stress.
If we are not to waste this crisis, there has never been a better time to ensure that Australia’s sizeable domestic savings pool is also available to efficiently provide debt financing to Australian corporates.
While there are domestic corporate bonds issued over the counter (OTC) and purchased by wholesale fixed income fund managers, these are in the main not accessible to retail investors.
Now’s the time for reform.
ASX welcomes the current parliamentary inquiry conducted by the Standing Committee on Tax and Revenue (“The Inquiry”). While the Inquiry was already underway prior to the market disruptions caused by COVID-19, the current situation highlights why we should not delay in putting in place the reforms that have been recommended by a number of earlier reviews.
How we got here
Some changes were made in 2013 by then Treasurer Wayne Swan to create the Simple Corporate Bond regime. However, the more significant reform argued for by the industry at that time was not fully implemented.
The modest reforms that were put in place had minimal impact on market development, with extremely limited take-up of the new regime’s disclosure requirements. Some have argued this shows that a deep retail bond market is not viable or possible in Australia. But given the impediments that still exist, it is surely too early to reach that conclusion. This is particularly so when the benefits of such a market development are so attractive to both investor and borrower.
Financial System Inquiry (“FSI”) – 2014
The FSI recommended that the government further ease disclosure requirements for large listed corporates issuing ‘simple’ bonds and encourage industry to develop standard terms for ‘simple’ bonds.
The government responded to this recommendation with an agreement to “develop legislative amendments to modernise and simplify disclosure requirements for large corporates issuing ‘simple’ corporate bonds to the retail market” and work “with ASIC and market participants to assess the need for further improvements to support the corporate bond market.” While the government’s response to this was originally due in mid-2016, it is certainly a case of ‘better late than never’ to see in last year’s federal budget that the matter is now being reviewed by the Standing Committee on Tax and Revenue.
Why is there a lack of retail bond issuance?
It’s unwise to be definitive about what is holding back the development of a vibrant retail corporate bond market. Clearly, there are some major structural reasons which complicate the picture, but at the same time, there are definitely some impediments, which if removed, will give the market the best chance to grow.
Ease of access to offshore markets
Corporates in Australia with a good credit rating are able to tap both the public and private placement 144A market in the United States, as well as raise debt in other offshore markets. This has been helpful for corporates over time, especially to diversify funding sources. However, in times of stress – such as the GFC – this has proven problematic and/or expensive. It also comes with a cost if the funding is required in AUD – a cross currency swap has become very expensive as a result of reforms in the OTC derivatives market since the GFC. Changes to collateral requirements due to non-central clearing and credit charges are examples of such changes. Cross currency swaps also require systems to manage the risk and come with mark-to-market complications that would not be faced if debt was raised within Australia.
Alternative interest bearing investments, bank deposits
With APRA’s liquidity rules and competition for term deposits, rates in this market are quite attractive relative to the RBA cash rate and other short-term highly rated investments.
This situation will not change any time soon. However, what should be noted is that these returns are normally only available out to about six months, rather than giving investors a known income stream for a number of years – something that corporate bonds can offer. Corporate bonds would also offer debt investment opportunities much broader than just to the banking sector.
Importance of investor education about corporate bonds
Australia has clearly been an equity loving nation historically. There is a view that retail investors understand equities better than debt. But surely this is an argument for further education rather than reinforcing bias through restricting access to debt products. The opportunity for retail to invest in high quality, interest-paying instruments has traditionally been limited to products like term deposits.
The difference in the tax treatment between equity dividends, via the franking system, and interest received from debt products like bonds, for example, is also relevant. Investors pay tax on interest at their marginal tax rate, while tax on dividends is paid on their marginal rate less the attached franking credit (usually the corporate tax rate).
Often, this means that there is a refund available to retail investors where the marginal rate is less than the corporate tax rate (such as in SMSFs). This makes the after tax return of equities relatively more attractive than interest.
ASX notes the taxation issue for completeness, and is not suggesting any change is feasible or recommended in this complex area of public policy.
So what can be done to give the market the best chance of success?
Even if all these hurdles could be overcome, issuers may still be reluctant to access the market, including due to impediments in the Corporations Act.
These have been flagged previously to governments of all persuasions and remain the essential ingredients for real progress in market reform and retail investor participation.
In ASX’s view, the reforms recommended below are incremental, modest and non-controversial.
In essence, the proposals seek a gradual opening up of the retail market for the issuance of simple senior listed bonds by the most creditworthy public companies, with investor protections leveraging off the existing robust corporate continuous disclosure regime.
The key matters for regulatory reform can be summarised as:
- Relying on existing continuous disclosure to allow more flexible and cost-effective disclosure for listed bonds. In particular, recommending that ASX 200 companies be allowed to list senior bonds with a term sheet and cleansing notice (no prospectus).
- Permitting early redemption of bonds to align with OTC issuing terms.
- Building on the Simple Corporate Bond regime by fixing a number of anomalies.
ASX will be making these arguments very strongly in our submission to the Inquiry.
As the health crisis begins to abate and the economic costs are realised, the government will be looking for reforms to facilitate an economic recovery and bolster the future.
This must include a serious discussion about the development of the retail bond market and the role it can play to strengthen our economic credentials.
The current Inquiry is the best opportunity for this to be considered. It will require both political will and industry solutions. This combination will give reform the best chance of success and lead to great outcomes for the Australian economy in the years ahead.
Ken Chapman is Head of Strategic Delivery, Capital Markets, and Grant Lovett is Head of Government Relations for the Australian Securities Exchange (ASX), www.asx.com.au.