The debt dilemma

The shrinking size of the Commonwealth government bond market has brought the efficiency of the Australian financial market into question, with the debate focusing on two themes – the growing number of superannuation assets under management and the reliability of a less liquid government bond market as a benchmark for pricing credit risk.

Some argue the government’s maintenance of around A$50 billion ($27.6 billion) worth of government bonds is too small to meet demand from superannuation funds, which hold some

A$600 billion worth of assets under management. Stephen Halmarick, Salomon Smith Barney’s (SSB) director and co-head of economic and market analysis, based in Sydney, says: “At the same time as the amount of Commonwealth bonds on issue decline, the demand for these securities is rising dramatically through the compulsory pension system – you have a mismatch.”

Paul Bide, head of the debt markets division at Macquarie Bank in Sydney, notes that five years ago, there was about A$100 billion in government bonds outstanding, while the superannuation pool amounted to around A$300 billion. “The structural change in the size of the investor pool versus the amount of assets that can be bought has been phenomenal,” he says.

Some, however, argue that there are clear alternatives to the government bond market, through the growing corporate bond market and by reallocating money to foreign assets. “The two main ways that fund managers have been able to accommodate the large rise in assets under management and the shrinking government bond market, has been to access corporate bonds and to also increase the allocation to foreign fixed-income,” says Peter Jolly, head of research, global markets division, at National Australia Bank (NAB) in Sydney.

Over the past five years, the corporate bond market has grown substantially from a weighting of 15% in the UBS Warburg Composite Index to 35% by the end of the first quarter of this year. However, Deutsche Bank’s Sydney-based head of fixed-income trading, Alastair Wait, comments that while there has been a great deal of corporate issuance over the past two years, liquidity in the secondary market is sparse as most investors have a buy and hold mentality. “You don’t really see any turnover,” he says.

But as the government sector continues to privatise, boosting government coffers, market participants are focusing their attention on the viability of the government bond market as a benchmark for the issuance of corporate bonds and the pricing of credit risk.

The government has said it will reduce outstanding debt by A$4.23 billion from the proceeds of the recent sale of Sydney airport, while the sale of Melbourne-based telecommunications company Telstra could potentially wipe out gross government debt altogether. The Australian Office of Financial Management (AOFM), which manages government debt, says that, for the time being, the government bond market can perform efficiently through the maintenance of A$50 billion in outstanding issuance. “The amount of bonds that need to be on issue at the moment should not exceed anymore than A$50 billion–60 billion,” comments an AOFM official. He adds that the government acknowledges the concerns raised by market participants about the impact of a declining government bond market, and will be meeting with financial institutions to discuss the future viability of the market.

“[The AOFM] is in a difficult position from a debt management perspective,” says NAB’s Jolly. “It doesn’t need all the money that it is raising so it faces the issue of what to do to maintain A$50 billion–60 billion of government bonds out there.”

Nonetheless, many bankers argue that more outstanding debt is needed to ensure efficiency in the market. An alternative, however, is to use the swap curve as the benchmark given its liquidity and increasing profile in corporate issue pricing. “In Australia, when a corporate bond is issued it’s not so much priced relative to where the government curve is, it’s priced relative to where the swap curve is,” says Jolly. He notes that in the US a few years ago, every issue was priced relative to US Treasury bonds, but increasingly issues are also being measured relative to the swap market. “The slippage in Australian government bonds on issue has enhanced the importance of the swap market and looking forward we expect liquidity in the swap market to improve further,” he adds.

Deutsche’s Wait agrees the swap market will become the benchmark for pricing corporate issues if the government bond market ceases to exist. “But you’re going to have liquidity issues,” he adds. “The swap market works well now because you have a very liquid futures market and the futures market is obviously priced on the bond market. You need a building block to put everything on and, at the moment, the bond curve is that building block.”

But whether the government believes a vibrant debt market is worth salvaging or not is still uncertain. SSB’s Halmarick points out that, while Australia may edge towards reducing its government debt, others have been working to increase it. Citing moves by the Singaporean government to increase Singapore government bonds from S$20.1 billion ($11.53 billion) in 1998 to S$53.7 billion in 2001, he says: “If they’ve got that view and we’re moving in the other direction, then somebody’s right and somebody’s wrong.” SF