Wednesday, January 18, 2012

Structure and Role of Bond Markets

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Table of Contents

1. Introduction

. Structure of Australia’s bond market

.1 Commonwealth government securities

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. Present trend of the CGS market

. State and Territory government securities

.4 Corporate bond securities

. Functions of a bond market

4. Future of the Commonwealth government securities

5. Role of CGS in Australia’s bond market

6. Conclusion

7. References

8. Appendices

“Briefly describe the structure of Australia’s bond market and explain its role in the financial system”

1. Introduction

A Bond market plays a pivotal role in any developed financial system. And Australia is no exception. Australia today boasts of having one of the largest and most sophisticated debt instrument markets in Asia Pacific region. The Australian bond market has evolved over time to become an important source of finance for long term borrowers and a safety haven for risk averse investors. Typically borrowers resort to banks when they require large funds to finance their long term activities. This generally proves to be costly for the borrowers because the banks charge them a high rate of interest taking into consideration that they undertake the credit risk posed by the borrowers. But the existence of a developed bond market would facilitate borrowers to tap finance at the lowest cost as bond markets are generally efficient because the rates are determined by supply and demand. The bond market in Australia has developed quickly in recent years as large companies and government institutions have moved from borrowing from banks to obtaining financing directly from capital markets. This has been in tune with global trends.(Hunt & Terry)

The bond market in Australia like the equity share market has both a primary and a secondary market. Treasury bonds are issued by the RBA. The yields for the bonds are determined through a tender process. Generally treasury bonds are issued in a manner that when a bond series matures, a fresh issue is made to pay off the retiring bond series. In the case of fixed-rate bonds, each tender is announced on Monday, with the closing date being the next day at 1.45. The results of the tender process are issued after lunch at pm. Settlement is on a T+ basis meaning successful tenders have to exchange cash for securities by Thursday of that week. Another important feature of the fixed rate bond is that only bond dealers with Exchange Settlement accounts with RBA are allowed to take part in the tender process.

The minimum bid at the tender is for a parcel of 100,000 worth of bonds with increments being at least $1000(which is the face value of each bond) (Hunt & Terry)

The secondary market for bonds is a very liquid because of their high liquidity and thus performs the price discovery function for wholesale amounts of long-term funds. (Hunt & Terry). Trading in bonds is mainly undertaken by professional dealers who quote buy and sell yields. In this market dealing is undertaken over the telephone on the basis of a standard protocol, under which the dealers identify themselves and the state the particular bond series and amount for which they are seeking quotes. The major dealers are banks namely the “big four” and the main wholesale banks such as Macquarie Bank, Bain & Company, C S First Boston and fund managers like AMP. In the secondary market trades are cleared on a T+ basis through RTGS. (Hunt & Terry)

Bonds generally refer to a form of long term debt. They usually have cash flows that are similar to that of a fix-term loan which carries interest. In the case of a bond the interest is called the coupons. The coupons are paid on a semi- annual basis. A bond security is an obligation by one party to make payments to another party in future. These securities take different forms. Generally they have a fixed maturity date on which the debt has to be repaid. The level of interest paid may either be fixed or variable although long term bonds gave a fixed rate of interest.

. Structure of the Australian Bond Market

As we are aware of, the bond market carries out the function of facilitating market participants to borrow money and invest their money. The three main groups that issue bonds in the Australian bond market Commonwealth government, state/territory government and non-government. Appendix 1 shows the proportion of fixed coupon bonds on issue according to the issue types. Each of the three issue groups account for around one-third of the total $155 billion of fixed coupon bonds outstanding.

.1 Commonwealth government securities.

CGS currently issues two kinds of bond instruments. Treasury fixed coupon bonds and treasury indexed bonds. Table 1 shows you the quantum outstanding as per the two instruments.

In Billions

16 17 18 1 000 001 00

Treasury Fixed Coupon Bonds 77.1 7.5 70 65. 5.1 5.7 51.1

Treasury indexed bonds .7 4.5 5. 5.6 5. 6. 6.4

Source (Commonwealth Debt Management Review Discussion Paper, 00)

As you can see from Table 1, the treasury coupon bonds have been declining gradually since 16 from $77.1 billion to $51.1 billion in 00. Treasury fixed coupons account for around 80% of the CGS outstanding

Appendix shows the treasury bench mark bond and their outstanding. The chart shows a total of 1 series of which the 10% 00 has already been retired. The Commonwealth is the highest rated issuer in the country and all major rating agencies like Moody’s and Standard & Poor give the highest possible rating. The CGS is taken as a benchmark for risk free assets as their repayment is guaranteed through tax collections by the Commonwealth government.

Treasury indexed bonds are different from the fixed coupon bonds because these bonds guarantee their holders a real rate of return. These securities make payments that are adjusted for the inflation rate. The coupon of these securities is linked to a measure of inflation (normally consumer price index). (Hunt & Terry) Appendix shows the outstanding position for the treasury indexed bonds.

. Present trend in the CGS market

Over the last couple of years the government’s bonds outstanding has reduced from $14 billion (June 15) to $11 billion (June 000). Whereas during this period the issues by non-government bonds increased sharply from $ billion to $6 billion. . The decline has been most acutely felt in the Commonwealth Government market where the total level of bonds on issue has fallen from more than A$100 billion in 16-7, to around A$60 billion in early 00(see Appendix 4). As a result of this decline, there has been a corresponding fall in market turnover with annual volumes falling from around A$1.0 trillion in 16-7 to A$550 billion in 001-0. (AXIZZ AUSTRALIA � The Australian Debt Securities Market).

Another interesting fact about this trend was that while a majority of these securities had a AAA rating, about a third had a rating below AA. The issue of low grade bonds shows that investors were willing to take a higher level of risk provided they got higher returns. The emergence of this trend has been along the US lines, where majority of the bond issues are rated below A+. The growth in non-government issues is associated with the decline in government securities. The Commonwealth government had been forking out budget surpluses for a couple of years and has thus reduced its dependence on borrowed funds to finance its activities. The increase in demand for non-government bonds is part of the securitisation trend. (Hunt & Terry) This trend has seen a fall in proportion of household assets held as deposits and an increase in assets held as claims in life insurance and superannuation funds. Also another reason for the growth in non-government bonds is the renewed interest of investors in corporate debt as a result of the booming stock markets and growing corporate profits.

. State and Territory Governments Bonds

State and Territory government bonds constitute around $48.5 billion or around 1% of the fixed coupon bonds outstanding (Commonwealth Debt Management Review Discussion Paper, 00). The major issuers are New South Wales, Victoria and Queensland. And for every state there is a central borrowing authority (CBA) that borrows on behalf of the relevant government. CBA’s use a range of funding instruments but fixed coupon bonds seem to be the main instrument used. Appendix 5 shows that the amount of semi-government bonds on issue.

.4 Corporate Bonds

The size of the corporate bond market in Australia stood at $1 billion at the end of April 00 (RBA Bulletin online). It stood at almost four times its size five years earlier and well above the current levels of the Commonwealth and State governments bonds on issue. In fact, the size of the non-government bond market, in terms of face value of bonds, is almost as large as large as the Commonwealth government bond market at its peak during 17. Corporate bond comprises of asset-backed (around $0 billion outstanding), banks and other financial corporations ($ billion outstanding), non-residents (17 billion outstanding) and other (i.e. corporate and trading enterprises with $1 billion outstanding). Appendix 6 shows a further bifurcation of the corporate bond market. Australian companies that issued bonds in the domestic market were mainly rated A and BBB. They included companies such as BHP, Optus and Fairfax. The amount issued was generally several hundred millions and the yields were 0 to 10 basis points above the Treasury bond rate. (Hunt & Terry)

. Functions of the Bond Market

The bond market performs a number of important functions in financial system. A few are enumerated below.

• Source of long term funds for borrowers and investors (including investment managers)

• Acts as a tool for interest risk management through interest rate swaps

• Acts as a reference for long term interest rates through the Bond Futures

• Performs the important function pf ‘price discovery’ of funds over the long term

• Influences the monetary policies of the government by injecting and absorbing liquidity from the financial system

• Provides investments a safe haven in times of financial instability

• Helps attract foreign capital inflows.

4. Future of the Commonwealth Government Securities

During the 16-7 budget the government introduced its medium-term fiscal strategy to maintain the budget balance. The fiscal strategy and the sale of assets led to a drastic reduction in the percentage of net debt to Gross Domestic Product (GDP) from a peak of 1.1 % in 15-6 to 5 % in 001-0. ( see Appendix 7). (Commonwealth Research Submission to the Treasury, December 00)

This resulted in a net debt repayment of around $60 billion. This was partly financed from the proceeds of the Telstra sale in which the government diluted its stake by 50%. The government was also kindling with the idea of exiting out of the CGS market. This was because the government was forking out budget surpluses for the last couple of years and did not need further borrowings to finance its activities. The last time the government went out to the debt market was in 16. The government maintains that the medium-term fiscal policy was responsible for the sound macroeconomic framework and sound economic prosperity that Australia enjoyed. And the government was committed to maintaining this strategy. However the drastic reduction in the share of CGS in the bond market raised concerns amongst leading economists and market participants about the long term implication of this course and about the future viability of the CGS market. They argue that the CGS plays an important role in the economy that the private players cannot easily replicate. The market participants argued that other OECD economies that have well developed financial markets operated with a significantly higher level of government debt. (Commonwealth Research Submission to the Treasury, December 00)

So what do the proponents of an active CGS market vie as an appropriate size of the CGS market? If the government decided to go ahead with their idea then the government would have to maintain $50 billion of the benchmark treasury bonds as the minimum requirement for a liquid and viable market. Also the market would have to grow in nominal terms to maintain its relative size which means that the government would have to keep borrowing from the market. They also argued that if Australia wanted to project its bond markets as a safe haven, provide a long term investment vehicle and maintain Australia’s position in the global bond indices then the CGS market may need to grow at the same pace of the financial assets. This has been around 1 % in the recent years. (Commonwealth Debt Management Review Discussion Paper, 00)

5. Role of CGS in the Australian bond market

Markets in which government debt securities trade have distinctive elements that may be important for developing sophisticated and well-functioning financial markets. A couple of them are enumerated below.

• Government securities offer minimal credit risk. This is because the possibility of the government defaulting its obligation is very low as the government raises taxes to meet its debt-servicing obligations.

• Government securities usually are issued into a limited number of maturities. For example the Commonwealth government currently has 10 benchmark security bonds with around $5 billion on average on issue on each line. The l0% 00 series was retired last year. The concentration of issuance into a limited number of benchmark lines promotes market liquidity. A market is considered liquid if market participants can readily buy and sell large quantities of debt securities without significantly influencing the market price. This speaks about the ‘market resilience’ and ‘dept’ of the markets.

• Government debt securities are usually spread over a wide range of maturities. The commonwealth’s 10 benchmark lines are reasonably distributed over a span of less than years to 1 years to maturity. This allows the government to target high investor demand for a particular period. Also it reduces the risk that the maturing debt is refinanced at a higher interest rate.

• A government debt market is likely to develop key elements of the financial market. It encourages the growth and development of skilled workforce in the debt market who provide price discovery in the securities which is necessary for a liquid market. It also helps in the establishment and development of the derivative markets such as the government debt futures market which is very important for fixing interest rate swaps used in interest risk management.

• The CGS market provides information about the yields at different maturities and this is important for benchmarking against other debt securities. The CGS yield is considered as the risk free rate of return in Australia.

• The CGS market has always been lucrative in the eyes of foreign investors. Global investors are an important component of the CGS market. The stability of the Australian economy coupled by financial prudence on the side of the government has promoted Australia as a global financial centre(Commonwealth Debt Management Review Discussion Paper, 00).

6. Conclusion

The government in its 00-0 budget announced its decision to maintain the CGS market. This was a decision taken in consultation with major economists and market participants. This means that the government would have to ensure a sufficient CGS market remains on issue to support the Treasury bond futures market (Budget 00-04). This move would only strength the financial system in Australia as government debt is an important component of any sound financial system. These are reasons why some countries have engineered a domestic government bond market, when the need for one has not existed. The authorities both in Hong Kong and Singapore, for example, have issued bonds in recent years even though the governments concerned have no reason to borrow. (Hunt & Terry)

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