Is a vibrant Australian retail bond market still a pipe dream?
The Australian retail share market is deep and liquid. So why is the retail bond market fledgling at best? Why can retail investors take ownership of parts of Australian companies with ease, yet they can barely access less risky debt investments in the same companies? Ian Paterson and Jo Dodd, partners at King & Wood Mallesons in Sydney, discuss the inconsistency behind Australia’s retail bond market.
The Australian regulatory regime is not geared toward the growth of a vibrant retail bond market. This is an issue market participants have grappled with for many years. Despite well-intended amendments to the regime over the past decade, it remains disjointed, unreasonably complex and expensive for widespread retail bond issuance.
In its 2021 report The Development of the Australian Corporate Bond Market: a Way Forward, the House of Representatives Standing Committee on Tax and Revenue described how a deep, liquid retail bond market will benefit domestic issuers – by providing an alternative source of funding – and retail investors, who can only gain access to corporate debt via intermediaries.
The report’s 12 recommendations highlighted features of the regulatory regime that operate as the primary points of friction for issuers. Achievable, incremental amendments to the regulatory regime could have a material impact on promoting retail issuance, the authors found. It is critical that a change in the political landscape does not halt momentum for reform.
PROSPECTUS AND LIABILITY REGIME
A vibrant market needs high-quality issuers with funding options in wholesale and offshore markets, but Australia’s prospectus and liability regime remains a significant source of cost and risk. In the absence of an exception, such as the simple corporate bond regime detailed in this article, the sale of corporate bonds to retail investors must comply with the full prospectus regime contained within chapter 6D.2 of the Corporations Act.
In the case of listed companies, it is anomalous to require a full prospectus for senior debt securities while allowing offers of shares based on a cleansing notice and, in some cases, offers of complex hybrid securities on a simpler section 713 prospectus. The effect is that retail issuance of standard bonds is prohibitively expensive and time-consuming in comparison with the obligations that apply to wholesale and offshore bond markets.
If the government wishes to promote growth in the retail bond market, reforming the prospectus and liability regime is fundamental. One option is to allow listed issuers to offer retail investors bonds using a longform cleansing notice similar to that used for regulatory capital – or hybrid – issuance by listed companies to wholesale investors.
For other high-quality credit issuers, such as sovereigns and supranationals, another approach would be to apply the Australian Commonwealth government bond depositary interest structure, which would allow retail investors to buy depository interests in bonds of these types of issuers directly, without the need for the issuer to publish a full prospectus. These regimes could be implemented as reforms to the simple corporate bond regime or replace it.
SIMPLE CORPORATE BONDS REGIME
The most significant attempt to improve retail investor access to bonds was the introduction of the simple corporate bond two-part prospectus regime in 2014. The regime permits a listed company to issue one or more simple corporate bonds to retail investors under a base prospectus, valid for three years, supplemented by a second, offer-specific prospectus with comparatively fewer disclosure obligations. However, only five simple corporate bonds have been issued since implementation. This is partly due to the regime’s restrictive parameters.
A simple corporate bond must conform with strict constraints. As it is, the regime prohibits subordination, nonfixed terms and certain redemption events, such as on a ratings downgrade. This rigidity makes the regime unattractive to many issuers and their lead managers, who require flexibility to match market dynamics and balance sheet demands.
The simple corporate bond regime also requires disclosure of impractical prescribed financial ratios. The regulations mandate disclosure of gearing, interest cover and working capital ratios, irrespective of the established accounting practices, business model and capital structure of the issuer.
The regime must give issuers greater flexibility while retaining appropriate protection for retail investors by ensuring timely and transparent disclosure of material information. In place of a prospectus, a longform cleansing notice like that used for hybrid issuance by listed companies to wholesale investors could be mandated. Disclosure should focus on indicators that are relevant to the issuer’s business, similar to the approach used in New Zealand’s vibrant retail bond market.
Simple corporate bonds should be allowed a greater variety of structural features, for instance by allowing for a variable list of standardised terms that are simple to understand yet give issuers the flexibility they require.
“The Australian regulatory regime is not geared toward the growth of a vibrant retail bond market. Despite well-intended amendments to the regime over the past decade, it remains disjointed, unreasonably complex and expensive for widespread retail bond issuance.”
CREDIT RATINGS AGENCIES
For all debt investors, default is the most important risk to assess. Established credit ratings remain the most effective way to communicate issuer or security risk – and yet the regulation of credit rating agencies in Australia seems geared toward preventing retail investors from accessing recognised, high-quality credit ratings.
Under the Corporations Act, the disclosure of a credit rating in a retail prospectus or issue document requires rating agencies to hold an Australian financial services license authorising the provision of financial product advice to retail investors.
Of the six licensed rating agencies, only one holds retail authorisation. For the others – including the ‘big three’ – the licensing conditions, notably the requirement for external dispute resolution and the possibility of civil liability, have suppressed the publication of their ratings to the market that most needs it. In New Zealand, by contrast, it is compulsory for credit ratings to be disclosed to retail investors considering bond transactions.
While the regulatory regime must protect investors and issuers with mechanisms for ensuring accountability, the unique function of rating agencies perhaps requires a more nuanced approach. The statutory duty of care regimes adopted in the EU, UK and US provide examples.
Making credit ratings more readily available to retail investors and rectifying this peculiar information asymmetry should be accompanied by efforts to make quality credit ratings more accessible for issuers. For many small companies, it is simply too hard to obtain a credit rating. Ultimately, a deeper pool of quality domestic rating agencies would benefit all market participants.
For retail investors, it is also a real benefit to know a trustee is ready to take control of enforcement proceedings should an issuer default. Chapter 2L of the Corporations Act requires that a trustee be appointed when bonds are issued. It also imposes broad duties on the trustee, including a requirement to monitor the issuer’s financial performance and compliance with its obligations under the bonds.
As the content of these provisions are now interpreted more broadly and class action regimes have increased the risk of litigation, the number of companies prepared to serve as trustee for a retail debt issue has shrunk. This has become another impediment to accessing the markets.
It is time to overhaul Chapter 2L. For listed issuers, the peculiar requirements for reporting certain matters to the trustee have been functionally overtaken by the continuous disclosure regime. The focus of the trustee’s duties, at least for listed issuers, should be on taking action on behalf of bondholders in the event of a known default.
THE REGULATION LABYRINTH
The application of some financial product regulation to corporate bonds, especially listed ones, is unnecessarily burdensome. It is also problematic where its application creates differences between the position of retail and wholesale investors in the same bond.
For instance, simple corporate bonds are subject to a prospectus disclosure regime and to the process for being quoted on an exchange. However, since the design and distribution obligations regime took effect in 2021, issuers must describe a class of investors for which the bond is suitable and take reasonable steps to ensure the primary distribution to retail investors is only to those within that target market.
While bonds are on offer for issue, their distribution is supposed to be reviewed periodically and investor complaints data collected despite the bonds not being issued. Criminal offences and civil penalties await issuers that fail to discharge these duties. Yet once the bonds are issued, anyone with access to the exchange can buy them.
This is not the limit of complexity. Simple corporate bonds are also a contract and a financial product between issuer and each investor. Could they fall under unfair contract terms legislation? Could determinations be made that apply to some bondholders and not others? How do regimes relate to the fundamental requirement that all investors are treated equally?
If there is to be a vibrant retail bond market, the laws must be framed and applied in a way that recognises the principles of tradability, encourages the participation of wholesale and retail investors, and ensures all investors are treated equally.
The government’s focus on the retail bond market is welcomed and the time is clearly ripe for reform. There is room for the government to be bold in its approach, which we hope will level the issuance playing field and encourage retail investors to have direct access to efficient and fair bond issuance.
The authors wish to thank George Osti, a solicitor in the banking and finance team at King & Wood Mallesons, for his assistance in the preparation of this article.
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