Monday, August 2nd, 2010
Professor Kevin Davis, Director - Research, Australian Centre for Financial Studies, states “ASIC’s relaxation of information/disclosure requirements for retail bond issuance are warranted, but successful development of the retail bond market may require further steps to facilitate efficient issuance methods and investor demand”.

The retail (and wholesale) market for corporate bonds in Australia has been largely non-existent, despite the growing volume of potential investors such as Self Managed Super Funds. Whether this has reflected inherent market economies of alternative corporate funding arrangements or regulatory impediments is open to debate, but relaxation of excessive regulatory constraints is to be welcomed.

Following responses to its December 2009 consultation paper CP126 , ASIC released Regulatory Guide 213 “Facilitating Debt Raising” in May 2010 setting out simpler issuance requirements for “vanilla” corporate bonds which are to be listed on the ASX and sold to retail investors.

“Vanilla” bonds are defined as unsubordinated bonds with a defined term of 10 years or less, paying interest at regular dates at either a fixed or a floating rate (at a fixed margin to a market indicator rate), with principal repaid at maturity. Issues must be for $50 million or more to achieve secondary market liquidity for investors. Required disclosures include key features of the bond (term, interest rate, payment dates etc), key financial information such as gearing, interest cover, working capital ratio, senior debt outstanding, plus information about the effects of the transaction on the company. Detailed corporate financial data is not required, provided that it is available via continuous disclosure requirements.

The issuance requirements introduce a simplified “vanilla bond” prospectus which can be used by listed companies which are eligible to issue a transaction-specific prospectus for new issues of listed (continuously quoted) equities. There is also provision for a two part prospectus approach in which a first-part prospectus with a life of two years can be issued, enabling the company to make a number of separate bond issues during that time each requiring a second-part prospectus detailing only the bond characteristics such as interest rate, term, etc. For these latter documents, relief is granted from the exposure requirement (usually that 14 days public exposure of the document is required before funds can be raised).

In effect, the rationale for these changes is that, other than transaction-related information, investors should not need more information to assess the investment risks of “vanilla” bonds than they do for shares. Since both are claims on the company’s assets and cash flows, albeit with different cash flow characteristics and control rights, this has considerable merit for which support can be found in finance theory.

An important distinction in practice, however, is that a market valuation of shares is already available, whereas there is no market valuation of yet-to-be-issued bonds. Most investors, who are unable to derive a fair bond price (yield) from first principles using share price data and company financial accounts, require some other source of valuation information. In particular they will want to know the appropriate credit spread (risk premium) for the issuer over government bond rates. Ratings agencies can provide comparative information if the bond issue is rated (although they may not always get the rating “right”), and investors have ready access to market determined yields on bonds of similar rating.

Regulatory Guide 213 is silent on the need for a rating, but the ASX listing rules for debt (Chapter 1, section 1.8) require a rating of at least investment grade. While this provides useful information, for most retail investors decisions to invest in new bond issues will be significantly influenced by issuing procedures and the advice and information associated with those processes. Regulatory Guide 123 is also largely silent on this issue, other than the requirement that “vanilla” bonds must be sold at a price common to all investors.

Standard bond issuance procedures operate much like those for an Initial Public Offering of shares, with the issuing company hiring the services of an investment bank to underwrite, market, and distribute the bonds to potential investors. This can be a relatively high cost exercise, particularly if retail investors are the target, and may inhibit development of the market. And the ability of investors to assess whether the issue price (yield) is “fair” remains questionable, raising issues of incentives of parties in the transaction. Dividing an issue into a wholesale component where a “bookbuild” through institutional investors generates an issue price which is then applied for the retail component is one way of addressing this issue. But there are others methods of price discovery and distribution potentially available.

Recognising that bonds, like equities, are ultimately claims on the company’s assets suggests that issuance of “vanilla” bonds by way of a renounceable rights issue to shareholders might be a feasible approach. Any mispricing of bonds is then offset by equivalent gains or losses on the share price. Investors (such as institutions) not wishing to hold such securities could offer their rights on the exchange and price discovery would occur through the rights trading.

While issuance costs would be low, a pro rata bond-rights allocation may mean that significant trading of rights is required for small shareholders to build a suitable scale investment, while institutional shareholders not interested in such investments may be substantial sellers. An alternative may be to allow companies to make a (non pro rata) “placement” of renounceable bond-rights to a particular group of (or all) shareholders. Provided that the issue size was limited relative to market capitalization (as occurs for equity placements) and that the issue price was pitched at (or near) fair value, there is probably less risk of inter-shareholder value transfers than currently exists from the ability of companies to make placements of shares.

An alternative approach would be a placement of bonds to a financial institution which would then on-sell the securities to retail (or other) investors via the stock market (as currently occurs with listed warrant products created by investment banks), relying on financial advisers etc to alert investors to the availability and value of such securities. Whether this low cost issuance method would generate adequate price discovery and ensure fair pricing for retail investors is open to question.

Professor Kevin Davis concludes that “if a retail bond market is to be encouraged, it is likely to take more than changes to disclosure. Serious examination is warranted of whether alternative efficient issuance and distribution mechanisms are also inhibited by regulation.” –END-

This paper is part of the Australian Centre for Financial Studies' Financial Regulation Discussion Paper Series prepared by Professor Kevin Davis, Research Director of ACFS and Professor of Finance, the University of Melbourne.

Download PDF version of ACFS Financial Deregulation Paper Series

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Australian Centre for Financial Studies

The Australian Centre for Financial Studies facilitates industry-relevant and rigorous research and consulting, thought leadership and independent commentary. Drawing on expertise from academia, industry and government, the Centre promotes excellence in financial services. The Centre specialises in leading edge finance and investment research, aiming to boost the global credentials of Australia’s finance industry; bridging the gap between research and industry and supporting Australia and Melbourne as an international centre for finance practice, research and education.

The Centre provides access to and links between academics, finance practitioners and government and draws on expertise and experience from across these groups, to facilitate and disseminate knowledge creation and transfer throughout the greater finance community via its various activities.

The Australian Centre for Financial Studies (previously known as the Melbourne Centre for Financial Studies) is a not-for-profit consortium of Monash University, the University of Melbourne, RMIT University and Finsia having commenced in 2005 with seed funding from the Victorian Government.
Professor Kevin Davis
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Australian Centre for Financial Studies, Professor Kevin Davis, ASIC, retail bond, Financial Regulation Discussion Paper



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