bird’s eye view Warren Bird f i x e d - i n t e r es t v e t e r an Drilling into corporate development The development of the Australian corporate bond market into a more broad-based and diversified investment universe seems at last to have gained some momentum. Although net issuance of fixed-rate securities in 2013 was slightly negative, at A$16 billion (US$13.9 billion) of new deals against A$17 billion of maturities, the list of issuers is expanding and the structure of the market is improving in terms of duration and credit quality. T o demonstrate this momentum, a good comparison is between the current state of the market and the end of 2006. Over the decade to 2006 the credit market had grown from very little to be 37 per cent of the UBS Composite Bond Index. By that time, a modest build up in lowerrated issues had commenced. With no net new issuance by the Commonwealth taking place during the latter years of the Howard government, the future of the overall Australian bond market seemed to be in the hands of issuers in the corporate sector. Then, during 2007, the financial crisis unfolded. The corporate bond market was set back considerably as demand for credit risk declined. This was a global trend, but hit small, relatively illiquid markets like Australia the hardest. Issuance patterns turned on their heads and Commonwealth and semi-government bonds again became dominant. Credit fell back to 15 per cent of the total market by the end of 2013. Nonetheless, within the universe of corporate bonds, there has been a revival during 2012 and 2013. How much further developed is the market now than it was before the crisis hit? Table 1 shows some key comparison data over the past seven years. A few pieces of information in this table caught my eye, which I want to unpack a bit further. S h a r p ly lo we r tr i p le -A issuan ce The proportion of triple-A bonds in the index is more than 7 per cent lower in 2013 than in 2006. In one way, this isn’t surprising, as in the post-financial crisis world there are fewer triple-A issuers globally, let alone here in Australia. Some of the issuers that were triple-A in 2006 are still in the market, but they have been downgraded since then – for example, GE Capital and Australia Post have slipped into the double-A band. Table 1: Corporate bond market data (As at Dec 31) 2013 2006 change by 2013 AAA (per cent) 20.8 27.9 -7.1 AA (per cent) 33.2 35.7 -2.5 A (per cent) 35.3 28.1 7.2 BBB (per cent) 10.4 7.9 2.5 Sub-IG (per cent) 0.2 0.4 -0.1 no. of issues 249 256 no. of issuers 129 124 no. of BBB issuers 49 25 +24 Market value (A$bn) 104.8 76.4 +37% Modified duration (years) 2.75 2.85 -0.1 Source: UBS Australia Credit Index february 2014 2 6 | K A N G A N E W S f e b r u a r y 2 0 1 4 Another group of issuers no longer sits in the triple-A band, but for good reasons. Several names initially came to market in the early 2000s with a triple-A credit wrap. Today, many of these issue with their own credit rating. It’s healthy for the domestic corporate market that companies like Sydney Airport no longer need a third-party financial guarantee to be able to sell bonds to local fund managers. These trends have offset the addition of Australian bank covered bonds to the triple-A universe. There were a couple of covered bond deals from offshore issuers in 2006, which were classified at the time along within the “other asset-backed” sector. Now the credit index includes almost A$15 billion of covered bonds, which have their own sector classification. Covered bonds make up 14 per cent of the AUD credit market and the lion’s share of the triple-A sector. In cr e ase d tr i p le -B i ssu an ce At the other end of the investmentgrade ratings spectrum, the increase in the proportion of triple-B rated issues is welcome. This rating band now comprises over 10 per cent of the market. Most of the increase in triple-B from the 2006 level took place in 2013, as the local investment community became more confident to go down the spectrum in search of yield and some diversity. This is the fruit of a focus by fund managers on building their credit skills in recent years. It also is due to the willingness of new issuers to come to the capital market for funding. The table shows that there kanga column are now 49 issuers in the triple-B band in UBS’s credit index, almost double the number in 2006. When you realise that some of the triple-B names in 2006 have departed the bond market – such as Fairfax, Coles Myer and Adelaide Bank – the increase is even more impressive. One of the main positives for investors from this trend is that triple-B issuers tend to be ‘true corporates’. The dominance of banks and financials in the Australian market is well known, but is gradually being reduced. Du rati on – b e gin n in g to l e ng th e n on ce m o re Another important statistic from table 1 is the modified duration of the index. At 2.75 years it is for all intents and purposes at the same level reached in 2006. What isn’t shown is the extent to which domestic credit risk exposure shortened after the financial crisis. With investors reluctant to commit funds beyond short tenor for a while, the credit market’s modified duration dropped to the 2.1-2.3 years region between 2008 and 2011. But not only are more issuers now coming to market, they are able to get deals done that are longer than the 3-5 year terms that have historically been favoured. We’ve seen more issues of seven years to maturity, with a few out to 10 years for higher-rated transactions. Thus, the overall credit duration of the market is lengthening again and has been restored to where it was before the crisis. Anecdotal evidence points to fund manager willingness to extend duration further. While the Australian market will likely remain much shorter than global indices, which are nearer to six-year modified duration, it is encouraging to see the maturity extension taking place. Stro ng q u al i t y in a po o r l y d i v e r s ifie d ma r k e t Table 1 also confirms that the Australian market is still dominated by double- and single-A issuers. Both in 2006 and currently, around two-thirds of the corporate bonds on issue are rated in these bands, more or less evenly split between the two. In global markets there is also a high proportion of securities rated single-A, but there is much less double-A and more triple-B than we have locally. Of course, given the lack of diversity in the Australian market, the risk-return position would be quite appalling if we didn’t have such high average credit quality. Global indices have thousands of issuers – in Australia, there are 129. We all hope that more companies are able to issue Australian dollar bonds and generate a more diversified investment universe. But until this happens we also need to see double- and single-A continue to hold the dominant position in the market. I n d us t r y se cto r s n o t b eco mi n g mo r e d iv er s ifi e d While on the subject of diversification, table 2 shows the industry sectors that were represented in the market in 2006 and the position at present. There is very little difference! The media sector is no longer represented in the index. In addition, there are no longer commercial mortgage-backed securities or commercial property issues. The only ‘new’ sector is autos, with Volkswagen being the largest of a few issuers that have come to market recently. Arguably, therefore, the industry representation in the Australian market has narrowed a little; at best, there is no broader diversification than seven years ago. Mar ke t v alu e – th r o ugh A$1 00 bi lli o n f o r th e f i r st ti me After 2006, the size of the market dipped below A$70 billion. Despite strong returns, total market value languished just above that level in 2008 and 2009, before beginning to struggle up to A$80 billion in 2010 and 2011. Since then it has started to rise more sharply, coming close to the century mark in 2012 and finally reaching that milestone in the year just gone. I’ve stated publicly many times my personal indifference to the development of an ‘Australian corporate bond market’ from an investor point of view. I believe that a betterdiversified portfolio will always be able to be put together in the global markets. Diversification is the key risk management strategy in credit investing. However, regulatory changes are undoubtedly increasing the cost of hedging. What’s more, there are domestic economic advantages to having a wellfunctioning and well-priced local bond market. Also, many local investors – retail and institutional – have a revealed preference for owning ‘local’ bonds. Given all this, it’s important to see the domestic corporate bond market develop in healthy ways. Clearly there is still a long way to go, but the setbacks experienced after the credit Armageddon of 2008 seem to have been put behind us and the market is growing and broadening. These developments are encouraging and hopefully will continue. • Table 2: Industry sectors change in UBS Credit Index (as at Dec 31) SECTOR AUTOS & COMPONENTS commercial mortgage-backed securities COMMERCIAL PROPERTY MEDIA 2006 2013 x ü ü ü ü x x x Source: UBS Australia Credit Index february 2014 2 7