RDP 2012-09: A History of Australian Corporate Bonds 5. 1980s to Today: Deregulation and Capital Account Liberalisation

The stock of corporate bonds outstanding has increased significantly over the past 30 years, with the market now equivalent to around 62 per cent of GDP. At the same time, there has been an increase in the diversity of issuers (especially by credit rating), a sectoral shift in the issuer base from non-financial corporations to banks, and increased utilisation of offshore bond markets. The deregulation of the banking system in the 1980s and the floating of the exchange rate and abolition of capital controls in 1983 contributed to these changes. The removal of capital controls and the introduction of compulsory superannuation have also driven changes in the composition of the investor base, with holdings by non-residents and institutional investors largely replacing direct holdings by households.

5.1 Changes in the Issuer Base

5.1.1 Shifts in issuer concentration

As mentioned above, the Australian bond market has become more diverse over the past century and a wider range of private corporations are now able to tap both onshore and offshore bond markets. A measure of this broadening is the proportion of issuance accounted for by the twenty largest issuers. Prior to the 1950s, the twenty largest issuers accounted for over 90 per cent of issuance (Figure 4). This share declined over subsequent decades and reached a low of 24 per cent in the 1990s. However, the trend reversed in the 2000s as banks reduced their relative use of deposit funding and accelerated during the global financial crisis as banks utilised the Australian Government Guarantee Scheme in place between October 2008 and March 2010.^[8] The four major banks have accounted for around 60 per cent of total issuance since mid 2007. Non-financial corporations also found it more difficult to issue during the crisis due to the end of credit-wrapped issuance.^[9] After initially turning to banks for funding, these entities then chose to reduce their debt levels, with debt-to-equity ratios for listed non-financial corporations declining from over 80 per cent in 2008 to around 50 per cent currently.

While concentration among large issuers has not changed a great deal over recent decades, there has been an increase in the diversity of credit risk of Australian corporate issuers over this period (Table 1). In the 1980s, the market was mostly rated AAA or AA. As it has developed over time, it has become more diverse as corporations rated A and BBB have also been able to issue bonds. The share of junk bonds (i.e. bonds rated BBB− and below) issued by Australian corporations is very small, although there have been a few issues in the US market. In fact, part of the increasing diversity of issuers by ratings reflects the internationalisation of our market, with lower-rated issuers typically issuing in the US private placement market.^[10]

5.1.2 Increased issuance from financial corporations

The strong growth in the bond market since the 1980s, and the shift towards private issuance, was largely driven by a significant increase in bank bond issuance.

Historically, Australian banks largely used deposits as a source of funds. However, this declined markedly during the 1980s as banks broadened their funding sources to include capital market funding; the deposit share of total liabilities fell from around 80 per cent in 1980 to 55 per cent in 1989 (Figure 5).

This shift in behaviour was driven by deregulation and liberalisation. Financial deregulation began slowly in the 1970s before accelerating sharply in the early 1980s in response to the Campbell report (Australian Financial System Inquiry 1981).^[11] In particular, controls on interest rates that banks could pay and charge customers were removed, causing banks to shift from asset management to liability management (Battellino and McMillan 1989). This enabled banks to compete more effectively with NBFIs, which had benefited from the high regulation of banks, and banks expanded their balance sheets significantly. As a result, NBFI's share of the issuer base fell from 27 per cent to 13 per cent over this period, consistent with the decline in NBFI's share of financial system assets.

Over this period, banks increasingly tapped bond markets – both onshore and offshore – to help fund growth in their assets. During the 1980s, banks' share of total bond issuance was around half and increased to around three-quarters in more recent years. The stock of financials' bonds outstanding increased from less than 5 per cent relative to GDP prior to the 1980s, to over 40 per cent currently (Figure 6).

Another regulatory change that has influenced the pattern of bond issuance is the abolition of capital controls. Prior to the 1980s, capital flows into Australia were predominantly equity investment and almost all debt flows were of a direct nature (for example, between an overseas parent company and its domestic subsidiary) (Tease 1990). There were a range of constraints on capital flows that were intended to prevent or discourage firms from undertaking foreign borrowing. These included:

• During the period from the 1950s to the 1970s, permission from the Reserve Bank was required before borrowing from overseas.
• An embargo on short-term borrowing that was periodically introduced in the 1970s.
• A variable deposit requirement which increased the cost of borrowing in the 1970s.

Since the general capital account deregulation during the 1980s, banks and other corporations have obtained a significant proportion of funding from offshore bond markets. Since 1986, the stock of bonds issued offshore by Australian residents has exceeded the size of the onshore market; at the end of 2011, the stock of bonds issued offshore represented 34 per cent of GDP, compared to 22 per cent for onshore issuance (Figure 7).

The liberalisation of the capital account and the floating of the Australian dollar also contributed to the development of the non-resident Australian dollar bond market. Since the mid 1980s, and increasingly since the late 1990s, non-residents have issued significant amounts of Australian dollar-denominated bonds, both onshore (Kangaroo bonds) and offshore (Australian dollar Eurobonds) (Figure 8).

Kangaroo bonds represented less than 2 per cent of the onshore non-government bond market in the early 1990s, but this share has risen sharply over the past decade to around 30 per cent as at end 2011.^[12] The strong growth in the Kangaroo bond market over the past decade has reflected a desire by Australian investors to diversify their exposure as well as cross-border portfolio investment by foreign investors (Ryan 2007).

Kangaroo bond issuance was also encouraged by, and further contributed to, the development of an active cross-currency interest rate swap market in Australia. Non-residents tend to swap Australian dollar funding into foreign currency, and as such are natural swap counterparties for Australian resident issuers of foreign currency bonds who require Australian dollars. During the 1980s, offshore bond issuance by Australian residents was mostly denominated in Australian dollars (Australian dollar Eurobonds). The tendency to issue bonds offshore denominated in foreign currency has increased since that time, alongside the development of liquid cross-currency interest rate swap markets in which issuers can hedge their foreign currency risk. Today, almost all bonds issued offshore by Australian residents are denominated in foreign currency (mostly US dollars and euros). Australian banks account for the bulk of this bond issuance and hedge virtually all of this debt through derivatives. By swapping the foreign currency cash flows into Australian dollars, they effectively obtain Australian dollar funding (to match their assets which are mostly denominated in Australian dollars).^[13] The banks issue bonds offshore to minimise their funding costs by arbitraging potential differences between the costs of onshore and offshore issuance, diversify funding sources by accessing foreign investors and increase the tenor of their issuance (Black and Munro 2010).

A further change in the type of issuance that has occurred in recent decades has been the strong growth and subsequent easing of the asset-backed securities (ABS) market. ABS issuance picked up sharply in the late 1990s to mid 2000s; the stock of ABS (issued onshore and offshore) increased from 2 per cent of GDP in 1995 to 22 per cent of GDP in mid 2007. In Australia, ABS have predominantly consisted of residential mortgage-backed securities (RMBS). The increase in RMBS issuance was driven by:

• Strong growth in housing finance in Australia.
• Increased competition in the mortgage market, with a growing share of lending done by mortgage originators, who rely exclusively on securitisation for funding.^[14]
• Increased securitisation of residential mortgages by traditional mortgage lenders like banks, credit unions and building societies (Bailey, Davies and Dixon Smith 2004).

These factors saw the share of housing loans funded through securitisation increase from less than 10 per cent in the late 1990s to a peak of 27 per cent in mid 2007. However, around the middle of 2007, there was a global reappraisal of the risks associated with investing in structured credit products as credit problems in the US subprime housing market became evident. Despite the continued strong performance of Australian RMBS due to the quality of the underlying assets, and the absence of issues of transparency and complexity, investor appetite declined markedly. Prior to the financial crisis, at least one-third of the investors in Australian RMBS were offshore structured investment vehicles (SIVs). These entities funded themselves with short-dated paper, of less than 365 days, to purchase longer-dated assets such as Australian RMBS. However, during the financial crisis, SIVs had difficulty rolling over funding and were forced to liquidate their assets, leading to over-supply in the secondary RMBS market.

RMBS issuance has subsequently picked up a little, assisted by government support through the Australian Office of Financial Management (AOFM). The AOFM has invested over $15 billion in the RMBS of regional banks and non-bank mortgage originators since 2008, although its share of issuance has declined noticeably in the past year or so. The share of housing loans funded through securitisation is currently around 7 per cent and the stock of bonds issued by securitisation vehicles has declined sharply, from 22 per cent relative to GDP prior to the financial crisis to now be less than 10 per cent.

5.1.3 Declining share of issuance from non-financial corporations

Deregulation and liberalisation of capital flows had two main (offsetting) effects on private non-financial corporate bond issuance. First, corporations were able to access the large offshore bond markets to fund domestic investment, in particular large-scale resource projects during the resources boom in the 1980s and again during the current boom.^[15] This has supported issuance volumes for non-financial corporations. Second, increased competition for business lending, including the entry of foreign banks, meant many non-financial corporations found it more attractive to obtain intermediated funding. During the 1950s and 1960s, bonds accounted for around 20 per cent of total (intermediated and non-intermediated) debt outstanding; this halved post-deregulation to around 10 per cent.

The stock of non-financial corporate bonds outstanding offshore is now more than double the non-financial stock of bonds outstanding onshore. Non-financial corporations tend to issue offshore as they can issue larger, longer maturity and lower-rated bonds at a cheaper price. In part, this reflects differing domestic and foreign investor appetite for credit risk, as illustrated by Australian investors' low allocation to fixed income compared to elsewhere. While almost all Australian corporations that access bond markets are investment grade (i.e. BBB− and above), most are rated at the lower end of this range at BBB and domestic investors, particularly managed funds with investor mandates, tend to have a preference for higher-rated bonds. Foreign investors also have a strong appetite for exposure to Australian mining corporations. Around half of non-financial corporations' foreign currency debt is hedged using derivatives (D'Arcy et al 2009). However, corporations also borrow in foreign currency to match their foreign currency revenue streams (for example, exporters), as this provides a natural hedge.

Overall, the growth in the stock of non-financial corporate bonds outstanding was more moderate over the past three decades than for financials. The ratio of non-financial corporate bonds to GDP averaged just over 5 per cent between 1950 and 1980, but it has increased to around 15 per cent in recent years. Most of this issuance has been by private corporations, due in part to widespread privatisations since 1990, which has also contributed to the trend away from publicly owned issuers. Many PTEs owned by state governments (primarily electricity and water utilities) and the Australian Government (such as Telstra) were privatised during the 1990s, along with state government-owned banks. These privatisations were part of an increased emphasis on commercial viability, operating efficiency and profitability. Privatisation continued during the 2000s, and included sales of additional tranches of Telstra and some city airports (such as Sydney Airport).

5.2 Changes in the Investor Base

The internationalisation of the bond market as well as changes in government policies have caused significant changes in the investor base of corporate bonds during recent decades. The investor base has shifted away from direct holdings by households towards indirect holdings through superannuation/managed funds and non-resident investors (Table 2).^[16] Foreign investors now make up the largest share of the investor base.^[17]

5.2.1 Australian households' direct holdings

Historically, households had large direct holdings of bonds, accounting for between one-quarter and one-half of the investor base until around the 1980s. War bonds had helped to familiarise households with bond ownership and many bonds were listed on a stock exchange – particularly up to the middle of the 20th century – making it relatively easy for households to purchase bonds.

Households' direct participation in the bond market is now less than 1 per cent of bonds on issue. This low participation reflects two main factors. First, the introduction of compulsory superannuation in the early 1990s has produced a pool of household savings that is invested via the funds management industry rather than directly by households.^[18] Second, the disclosure requirements for issuers that raise funds from retail investors mean that it has usually been more cost-effective to raise debt from institutional investors. These factors have contributed to institutional investors' large holdings of bonds, at around one-third of all Australian corporate bonds.

5.2.2 Australian institutional investors

Australian institutional investors – authorised deposit-taking institutions (ADIs), superannuation funds and other managed funds – have participated in the corporate bond market since its inception. Unit trusts, traditionally the most common structure for managed funds, were one of the earliest institutional investors, having been established in Australia in the late 1920s as a vehicle for households to acquire financial assets indirectly (Merrett 1997). The importance of Australian institutional investors in the investor base has varied substantially through time, often in response to changes in regulation.

For example, managed funds' share of the corporate bond investor base fell sharply during the 1970s, from 35 per cent to around 25 per cent. This partly reflected the imposition of the ‘30/20’ rule for life insurance offices and superannuation funds between March 1961 and September 1984, which exempted them from income tax provided that least 30 per cent of a fund's assets were held in government securities (including PTEs), with at least 20 per cent invested in Commonwealth Government securities (CGS).^[19]

Another example is that prior to deregulation of the banking system, there were incentives for ADIs' to hold corporate bonds:

• Under the Liquid Assets and Government Securities (LGS) convention, introduced in March 1956, trading banks agreed to hold a minimum proportion of deposits in liquid assets and government securities, including bonds issued by government-owned corporations.^[20] In addition, savings banks were required to hold 70 per cent of their assets in the form of government securities. This skewed banks' portfolios towards bonds issued by government-owned corporations, which typically offered a higher yield than bonds issued by Australian governments.
• ADIs held bonds directly issued by private corporations to fund these businesses when direct lending was constrained by both qualitative and quantitative lending directives. These directives emphasised that longer-term capital for financing investment and the development of new enterprises should be obtained from outside the banking system, with banks confining their lending to short-term finance, such as overdrafts and working capital (Grenville 1991).

Following deregulation, ADIs' holdings of corporate bonds fell from around 20 per cent to around 10 per cent.

5.2.3 Foreign investors

Foreign investors made limited purchases of corporate bonds prior to capital controls being lifted in the 1980s; purchases constituted less than 10 per cent of the investor base. Adamson (1984) and Salsbury and Sweeney (1988) note that foreigners' purchases of Australian financial assets were largely confined to government bonds and equities, both of which tended to be more liquid than corporate bonds, although the size of these holdings were constrained by the existence of capital controls.^[21]

Following the liberalisation of the capital account and the deregulation of the banking system, foreign investors became significant investors in Australian corporate bonds. The introduction of exemptions for some non-residents from interest withholding tax (IWT) – a federal tax applied to foreign investors' income from Australian investments – also played a role.^[22] This facilitated an increase in corporate bond issuance offshore, as well as more non-resident participation in the local bond market. The development of liquid interest rate and foreign exchange derivatives markets contributed to this activity, and foreign investor participation enhanced these markets. Foreign investors now hold around 70 per cent of total Australian corporate bonds on issue onshore and offshore.

Footnotes

For more information on the Australian Government Guarantee Scheme see Schwartz (2010). [8]

Prior to the global financial crisis, many of these companies issued bonds that were credit-wrapped by monoline insurers to boost their rating, usually to AAA, in the domestic market; this practice has largely been discontinued as most of these insurers have been downgraded significantly in recent years. [9]

The US private placement market consists of bonds sold to a small group of institutional investors (mainly pension funds and insurance companies). Disclosure requirements are generally less stringent for this type of issuance and credit ratings are less important than in public markets, due to the expertise of the investor base. [10]

Changes included: the introduction of a tender system for selling Treasury bonds; removal of controls on the interest rates that banks could pay and charge; the floating of the Australian dollar and removal of capital controls; and the entry of foreign banks. [11]

Here, the non-government bond market is defined as the sum of the Australian corporate bond market and the Kangaroo bond market. [12]

For more information on foreign currency hedging see D'Arcy, Shah Idil and Davis (2009). [13]

Mortgage originators came to prominence in the mid 1990s, in part because the decline in the general level of interest rates reduced the banks' competitive advantage from being able to raise low-cost retail deposits. The high level of mortgage interest rates relative to capital market interest rates meant that mortgage originators were able to remain highly profitable despite funding their lending through the wholesale market. [14]

There was also an increase in equity investment overseas that was financed by foreign borrowing in the 1980s (Tease 1990). [15]

Government entities have historically accounted for a small share of corporate bond purchases, though in recent times purchases of RMBS by the AOFM has led to a modest increase. [16]

For a discussion of trends in ownership of Australian bonds and equities through the financial crisis, see Black and Kirkwood (2010). [17]

Although compulsory superannuation was first introduced in Australia in 1986, the system initially applied only to employees on Federal awards. Today, over 90 per cent of Australian workers are covered by the Superannuation Guarantee Charge (SGC), which requires contributions of 9 per cent of taxable income; these funds are generally not accessible until retirement. See Commonwealth Treasury of Australia (2001) for more information on Australia's compulsory superannuation scheme. [18]

These regulations did not limit institutional investors' participation in the PTE segment of the corporate bond market, although participation in the overall corporate bond market would have been constrained by these regulations. [19]

The LGS ratio was replaced in May 1985 by the prime assets ratio arrangements, under which a proportion of a bank's total liabilities (excluding shareholders' equity) were invested in Australian prime assets comprising, inter alia, notes and coin, balances with the Reserve Bank, Treasury notes and other CGS. [20]

Debelle and Plumb (2006) discuss the evolution of exchange rate policy and capital controls in Australia since the 1970s. Non-residents' purchases of government bonds were primarily through issuance of Australian dollar-denominated debt in offshore markets. Prior to the 1980s, non-residents' holdings of domestically issued Australian government bonds represented less than 1 per cent of the investor base (Caballero, Cowan and Kearns 2004). [21]

Section 128F of the Income Tax Assessment Act 1936 specifies the conditions required for an exemption for foreign investors from IWT; in particular, securities issued by Australian corporations must satisfy the ‘public offer’ and ‘associates’ tests which essentially require that the securities be issued publicly. Key IWT exemptions were introduced in 1997; non-residents were exempted from IWT on interest income derived from offshore borrowings by Australian corporations and, in 1999, non-residents were exempted from IWT on interest earned from bonds issued onshore. [22]