Guy Debelle: The Australian bond market
Address by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, to the Economic Society of Australia, Canberra, 15 April 2014.
* * *
I would like to thank Ivailo Arsov, Mathew Brooks and Karl Stacey for their assistance in preparing this speech.
Thank you for inviting me to talk at the Economic Society here in Canberra. Today I am going
to walk you through the current state of the Australian bond market. The bond market plays
an important role in the financial structure of the Australian economy and it is timely to
examine its structure and functioning with the financial system inquiry underway.
I will start today by providing an overview of the composition of the Australian bond market
and how this has changed in recent years. Then, I will discuss more recent developments in
the market since the start of 2013, focusing particularly on two trends that emerged last year:
the nascent signs of deepening of the domestic corporate bond market and the pick-up in
securitised issuance. I will also talk a little about the prospect for market-based finance, of
which bond issuance is an important part, playing a larger role in the future than it currently
does.
Shape of the Australian bond market
The evolution of the Australian bond market over the past several years has been shaped to
a large extent by the fallout from the global financial crisis. Prior to the crisis, the market
comprised mainly bonds issued by the Australian banks and asset-backed securities.
Together these accounted for just over half of the outstanding stock of Australian bonds in
June 2007. Bonds issued by the public sector were a relatively small share of the market, at
16 per cent of the total outstanding (Table 1).
Overall, the size of the bond market in mid 2007 was equivalent to around 84 per cent of
Australia's annual GDP. In the subsequent seven years the stock of Australian bonds on
issue has increased to reach the equivalent of nearly 100 per cent of GDP. The increase has
mainly been the result of debt issuance by the Commonwealth and state governments to
finance their budget deficits as they sought to support economic growth through the crisis.
Bank bond issuance has slowed down in the last couple of years as Australian banks have
sought to shift towards more deposit funding. However, the stock of bank bonds on issue is
significantly higher than it was just before the start of the global financial crisis, reflecting the
strong issuance of bank bonds in 2008 and 2009 as the financial system was
reintermediated because other forms of non-bank financing dried up.1 One of the areas of the
market that suffered the greatest impact from the crisis was asset-backed securities, due to
the loss of investor confidence in this asset class globally. This resulted in the stock of
outstanding Australian asset-backed securities nearly halving, in nominal terms, and
declining three-fold relative to GDP since mid 2007.
Table 1
Australian Bonds Outstanding*
Overview of developments since 2013
Conditions faced by Australian bond issuers have continued to improve since early 2013,
reflecting the markedly better conditions in global financial markets as the global economic
recovery has become more entrenched and as European sovereign debt concerns have
eased.
Issuance has been generally strong and has been met by robust domestic and offshore
demand. The only exception to this was the month of June which saw virtually no issuance of
non-government bonds as issuers and investors stood on the sidelines while financial
markets were assessing the prospects and implications of the start of the US Federal
Reserve's tapering to its asset purchases program. However, this episode proved short-lived,
with Australian and global bond market activity resuming quickly and continuing apace when
tapering actually started in December.
The past year in the Australian bond market has been most notable for the signs of the
improvement in investor sentiment extending along the risk spectrum towards lower rated
corporate bonds and to parts of the fixed income market that have been, unfairly, at least in
the case of Australia, tarred by the loss of global investor confidence. Issuance in the
domestic market of lower-rated corporate bonds, which in the case of Australia means those
rated BBB+ to BBB-, was the strongest on record, and, notably, at longer than usual
maturities. The securitisations market, particularly for residential mortgage-backed securities
(RMBS), also recorded a significant increase in activity.
These trends in issuance were also reflected in the pricing of Australian bonds, with the
difference in yields between these bonds and CGS narrowing across the risk spectrum since
early 2013 (Graph 1). Although, the pace of narrowing has slowed relative to 2012, spreads
are now at their lowest levels since the end of 2007. Borrowing costs for Australian
corporates and states are at very low levels historically, while wholesale funding costs for
banks, which are more a function of bond spreads rather than bond yield levels, have
declined further.
Graph 1
A further sign of the improved market conditions has been the continual extension in bond
maturities across most market segments (Graph 2). The lengthening in maturities reflects
principally two developments: improvement in overall risk sentiment; and the search for yield
in a low interest rate environment pushing investors out along the yield curve in search for
yield pick-up.
Graph 2
Recent issuance trends
I will now go through these developments in more detail.
Public sector
Since 2013, net issuance of CGS and semis has slowed down from the pace in recent years.
Based on the latest borrowing programs and budget forecasts, the stock of public sector
bonds outstanding is expected to increase to around 40 percent of GDP by 2016/17, before
stabilising at that level (Graph 3). As you are aware, this is considerably lower than in most
other countries. Beyond 2016/17, it is desirable to maintain a reasonable amount of CGS on
issue to support a liquid government bond market and thereby provide a risk-free curve off
which other debt instruments can be priced.2
Graph 3
Demand for Australian public sector debt has remained high due to Australia's solid
economic performance and high credit ratings of the public sector. The federal government is
currently one of only 13 AAA-rated (by S&P) sovereigns globally, attracting continuing
demand for CGS, particularly from official reserve managers. This demand has facilitated the
lengthening in the maturity profile. In November last year, the AOFM issued a 20 year
nominal fixed rate bond raising $5.9 billion. This was Australia's largest bond issue (until the
$7 billion 2026 CGS issue in March this year) and it generated significant demand with nearly
$9 billion in bids and 60 per cent foreign investor participation.
Bond issuance by the state borrowing authorities in recent years has featured increasing
issuance of floating-rate notes (FRNs). Since early 2013 around one quarter of the issuance
has been FRNs (Graph 4). The increased FRN issuance has been designed to meet the
demand for such paper from banks who want to hold state government paper to meet the
soon to be implemented prudential liquidity requirements.3 Banks have a natural preference
to hold FRNs to match the floating rate nature of their liabilities.
Graph 4
Financial sector
Gross bond issuance by Australian banks over the past year has been around its average
level since 2007. Roughly three-quarters of banks' issuance was offshore, mainly in US
dollars and euros. Banks have slowed down their issuance of covered bonds now that their
covered bond programs are maturing, having only been able to issue under them since late
2011 (Graph 5).4
Graph 5
There has been minimal net bank bond issuance in recent times, with banks basically
content with their existing level of bond funding.5 Banks have been comfortably able to fund
asset growth (which has been relatively subdued) with deposits.6
Securitisations
The continual improvement in broad market sentiment has been seen strongly in the
Australian asset-backed market, particularly in the market for RMBS. The volume of issuance
of RMBS in 2013 was the highest since 2007 (Graph 6). The majority of issuance continues
to be in Australian dollars, as has been the case in recent years, and in fact, the total
Australian dollar issuance in 2013 was only exceeded by the level of Australian dollar
issuance in the two and a half years immediately preceding the onset of the financial crisis.
Graph 6
Despite the low level of foreign currency issuance in 2013, foreign investor demand for
Australian RMBS has been quite high, reflecting the lack of supply of RMBS in foreign
markets, the global search for yield, and confidence in the high quality of the underlying
collateral of Australian RMBS. Publicly available data indicate that, on average, around
40 per cent of each deal in 2013 was placed with foreign investors, and foreign investor
participation at issuance has increased significantly.
The gradual improvement in RMBS market conditions since mid 2012, particularly the
increase in private investor demand, led to the AOFM ceasing its RMBS purchases in 2012
and the government announcing the formal end of the AOFM's RMBS investment program in
April 2013. Since the start of 2013, the AOFM has sold around $1 billion of its RMBS
holdings in five transactions, including in February this year the sale of a large part of its
holdings of mezzanine tranches following strong investor demand for such exposures.
The improvement in the RMBS market conditions has also been reflected in a number of
other dimensions:
Deal sizes have increased, especially for RMBS issued by the major banks, where
•
the average size has increased to $2.5 billion.
• Issuance has picked up not only for the major banks but also for regional banks and
non-banks (i.e. credit unions and mortgage originators), with a number of smaller
issuers returning to the market after an absence of several years.
• RMBS issuance spreads, over the last year or so, have remained at their lowest
level since mid 2007; despite the significantly larger volume that has been brought
to market (Graph 7).
Graph 7
Deal structures have continued to evolve with further issuance of bullet tranches to manage
prepayment risk. One recent deal was structured without a serial pay trigger, which has been
the norm in recent years, apparently in anticipation of the changes to the APRA's prudential
standard on securitisations outlined late last year.7
2013 saw the first Australian CMBS issue since 2011, and although volumes have remained
low this has been followed by a further two transactions. Issuance of other ABS has
remained strong, with 2013 recording the highest level of gross issuance on record with a
sizable pick-up in Australian dollar issuance.
Corporates
Australian corporates have continued to have good access to bond markets both
domestically and offshore, raising a total of $35.1 billion of new bonds since the start of 2013
(Graph 8). While the amount issued has been less than in 2012, issuance that year was
underpinned by significant bond issuance by the large Australian miners. Part of the reason
for that strong issuance was that the miners were able to access the market at least as
cheaply as the banks, so this was very cost effective for them. As these companies have
reduced capital expenditure, their need to tap the bond market for long-term funding has
declined, leading to a drop-off in their bond issuance.
Graph 8
The main development in the corporate bond market over the past year or so has been the
significant pick-up in lower rated issuance into the domestic market and at longer maturities
than have been previously achieved domestically. While domestic tenors remain well below
the tenors at which corporates can raise bond funding in some offshore markets,
particularly in the US, this is a very much welcomed development, reflecting the continuing
maturity of the domestic market. Investors have become more comfortable with moving up
the maturity spectrum and down the ratings spectrum in the domestic market in order to
pick up yield and corporates are finding the pricing more attractive. The seven year
maturity was the favoured point for the domestic issuance by BBB+ to BBB- rated
Australian corporates, with $2.2 billion raised by 9 issuers across 10 bonds (Graph 9).
How much of this will be sustained when we are no longer in a very low interest rate
environment remains to be seen.
Graph 9
Last year, the Reserve Bank began publishing more comprehensive measures of spreads
and yields on Australian non-financial corporate bonds, covering points on the yield curve up
to 10 years.8 This additional information will bring greater transparency about bond market
conditions faced by these issuers.
Investor base
Non-residents' demand for Australian fixed income securities remains strong. This is
particularly the case for CGS, where the share of the market held by non-residents remains
close to its historical high, despite declining slightly in mid 2013 (Graph 10). A sizeable share
of this demand comes from official reserve managers who are attracted to the relatively
higher yield on Australian government bonds, the high and stable credit rating of the
Australian government and Australia's strong and stable economic performance.
Nonresidents' holdings of semis have continued to decrease, while the semis holdings of
Australian banks have continued to increase. This reflects the demand for semis from the
Australian banks, given that these securities qualify as high quality liquid assets under
APRA's rules, and offer a (small) yield pick-up over the other high quality liquid assets in
Australia, CGS. The share of holdings of financial bonds by non-residents remains below the
pre-crisis level as the Australian banks have reduced their funding sourced from offshore. On
the other hand, the share of non-residents' holdings of Australian corporate bonds remains at
a historically high level as Australian corporates have continued to have good access to
international bond markets.
Graph 10
Conclusions
Although Australia avoided most of the more severe disruptions in financial markets during
the global financial crisis, the turmoil has left its mark on the Australian bond market
landscape. Conditions in financial markets have been improving steadily since mid 2012;
2013 and the first quarter of this year have resembled what normal bond market conditions
may look like in a post crisis world. Looking forward, we can expect the Australian bond
market to solidify this normalisation. Credit spreads are likely to remain higher than their
precrisis levels, reflecting the repricing of credit and liquidity risk, while yields are likely to remain
low for some time as central banks only gradually normalise their monetary policy settings.
We are likely to see some further growth in the size of the public sector bond market in
Australia for a little while longer, but the stock of outstanding bonds is expected to stabilise
as a share of GDP by mid 2017. Issuance by the Australian banks is likely to remain
subdued as they continue to favour deposit funding.
Total corporate bond issuance may remain subdued in the near term as the main potential
issuers - the large diversified mining companies - have a focus on increasing production
from already developed projects, containing capital expenditure, and, more broadly, large
Australian companies have accumulated significant cash balances since mid 2007.
However, while bank-based finance remains dominant today, in the future we may well see
the Australian financial system move to more market-based sources of finance, particularly
bond issuance. The regulatory changes have increased the relative cost of bank
intermediation, as liquidity is now more appropriately priced and the cost of maturity
transformation has increased. As a result, market-based sources of finance are now more
cost effective for a wider range of companies and one would expect them to respond to this
with increased bond issuance.
At the moment, parts of the corporate sector can access the bond market at a cheaper price
than banks can. As mentioned earlier, there has been increased appetite for debt issued by
lower-rated companies at attractive prices for the issuer and at longer maturities than they
would normally get from a bank. How much of this is a function of the current global interest
rate environment remains to be seen, but there is a reasonable prospect that some of these
developments will be long-lasting.