Fitting the Bill

Funding diversification to reduce financing risks in the Retail Corporate Bond Market and Alternative Debt Markets
April 2013

The number of Australian businesses who truly achieve funding diversification to reduce financing risks are in the minority. Other than those with the ability to access offshore debt markets or the domestic wholesale bond market, most Australian companies rely on banks as their primary and often sole source of external debt funding. Thats why recent developments in the Australian fixed income market from Government initiative to improve the retail corporate bond market to evolution in the alternative debt markets are of particular interest for companies looking to diversify their funding approaches away from traditional bank financing.
The highlights of these developments are:
Federal legislation has been introduced into Parliament which seeks to encourage more retail bond issues by Australian companies by simplifying the issuance process This reform could present an attractive possibility to those companies that fit the bill This reform will have limited applicability in the broader commercial world and some material challenges remain in further developing the retail corporate bond market in Australia and widening its effective use to more borrowers There are also encouraging developments elsewhere in the Australian fixed income market which could provide valuable funding diversification options for these and other companies

Key amendments
The Bill will amend existing legislation so as to simplify regulatory requirements on simple corporate bond issuances to retail investors by: introducing a mandatory, simple twopart prospectus regime for the issue of simple corporate bonds removing presumptive civil liability provisions for directors relating to an issue of simple corporate bonds.

Australian companies in issuing retail bonds. There are some challenges which are detailed a little later, but even against this background we believe the Bill can create opportunities for those Australian companies that fit the Bill. It is not uncommon for many listed midcap Australian companies to have a single borrowing platform, provided by one or a group of banks,which may be provided on a secured or unsecured basis. Simplification of the retail bond issuance process under the new legislation means that these companies could take advantage of the reliefs available under the Bill to tap the retail bond market and achieve valuable funding market diversification. Here are some reasons for this: listed mid-cap companies with good

corporate brands positively recognised by retail investors can leverage their brand value. Whilst these companies may not be big enough to warrant accessing wholesale domestic or offshore capital markets, the volume available in the retail bond market could provide a meaningful borrowing size for these companies, without the credit rating requirement of typical wholesale investors (which would be hindered by their size in any event); rapidly growing self managed super funds (SMSF) sector through retail bonds, these companies can tap the SMSF sector which, at $470 billion and growing by $30 billion each year, is an increasingly important investor segment; and higher upfront costs and margin can be offset by tapping longer tenors

What does this mean for Australian businesses?

Simplification of the disclosure regime and easing of directors civil liabilities, together with clarification on due diligence defences for criminal liabilities, are a positive step forward in addressing some of the reluctance amongst

March 2013

often available through this alternative bond market. Whilst the sweet spot for the bank loan market remains at around three years, the retail bond market offers typical tenors of five to seven years for corporates, absorbing the upfront cost premium over a longer period and offsetting a possibly higher margin. These benefits could also equally apply to companies unable, or for other reasons unwilling, to issue simple corporate bonds but these companies would need to follow the full prospectus process once the reform is legislated.

Equity-focused asset allocation. Australian superannuation funds have around 50% average allocation to shares (highest in the developed world), with only 14% allocated to bonds. This compares with 56% average allocation to bonds in Japan, 50% in the Netherlands, 35% in the UK, and 27% in the US. In the rapidly growing SMSF sector, less than 1% of the current estimated A$470 billion investment is invested in debt securities, although this latter point signals more an opportunity than a risk for retail bonds Lack of availability of credit ratings to retail investors. Since November 2009, retail investors have been precluded from accessing credit ratings of issuers except for ratings issued by agencies holding a retail financial services licence (which the three major rating agencies do not). Retail investors therefore do not have access to the same credit assessment and comparison information as wholesale investors, creating an uneven platform and a deterrent for retail investor interest in corporate bonds High issuance costs. Retail bonds typically require distribution through extensive adviser and broker channels that demand commission, as well as prospectus and due diligence costs to support the offer. This results in a substantially higher issuance costs for retail bonds when compared to wholesale bond or bank loans. Currently, upfront issuance costs for retail bonds are typically upwards of 200 basis points, compared to sub-100 basis points for wholesale bond issuances or bank loans.

If you want to learn more about the background, the Bill and how corporate bonds work
The Commonwealth Government has introduced the Corporations Amendment (Simple Corporate Bonds and Other Measures) Bill 2013 (Bill) into the Parliament on 20March 2013. The Bill follows ASICs May 2010 Class Order for issuers of vanilla bonds and the Treasurys consultation paper on the Australian retail bond market released in December 2011. The Bill forms part of the Governments broader regulatory initiative to develop a deeper retail corporate bond market in Australia. The amendment is intended to facilitate increased offerings of retail corporate bonds by simplifying regulation governing the issue of simple corporate bonds to retail investors. In addition, the Bill clarifies the application of due diligence defences for issuers and their directors in respect of disclosure documents.

There are some challenges

There are some aspects of the legislation that will likely limit the Bills applicability in the broader commercial world. These include: Priority the Bill requires simple corporate bonds to rank at least equal to unsecured obligations (including trade creditors) of the issuer. They can, however, rank subordinate to debt owed to senior secured lenders to the issuer. This means that the subordinated hybrid and mezzanine funding instruments that have proved popular amongst the retail investors in the listed market will remain subject to the current more onerous issuanceprocesses. No deferral or conversion the vast majority of retail securities on issue in Australia are hybrid instruments, which are subordinated and allow issuers to defer interest payments and/or convert securities into equity or another form of security at a pre-agreed date. Again, this type of security would not qualify for the reliefs under the Bill. In addition, whilst the Bill addresses some of the supply side issues of onerous disclosure and liability regimes that existed, there remain many challenges that will continue to deter growth of the retail corporate bond market. For example: Australias dividend imputation tax system favours dividend over interest income, creating retail investor preference for shares over bonds. This has meant that retail bonds have typically needed to offer more attractive yields to compensate for the investors adverse tax position. This in part explains the popularity of hybrid instruments which are riskier offerings and hence justify the yield premium Separate wholesale and retail bond markets. For the Australian corporate bond market to have any meaningful depth and liquidity compared to the offshore markets, it needs to be driven by the wholesale market which clearly dwarfs the retail bond market in terms of size. Accordingly, for the retail bond market to become meaningful to the likely corporate bond issue candidates, it should be co-joined with wholesale market

Opportunities in Alternative Debt Markets

Retail bonds may not be suitable for all companies. If that is the case, there are also many positive developments in other parts of the Australian fixed income market that are encouraging for companies looking for capital management efficiencies through funding diversification beyond bank and other traditional mid-market financing markets. These include positive developments in the private debt market where a growing number of institutional and alternative asset investors are looking for direct lending opportunities to companies, as well as specialist fixed income groups with access to professional and wholesale investor bases delivering alternative funding instruments to the traditional wholesale or retail bonds. The key benefit of these alternative funding options is that they can be structured to suit an individual companys existing financing arrangements, whether they be subordination (to secured or unsecured creditors), alternative security structures, and/or payment flexibilities.

What are simple corporate bonds?

The Bill defines simple corporate bonds as debentures (as defined in the Corporations Act 2001) that satisfy a number of conditions. Most of the conditions are procedural in nature, dealing with listing, currency (AUD), offer size (minimum $50 million and maximum $1,000 per bond) and structure (homogenous pricing, maximum 10 year term, limited redemption rights and no reduction in fixed interest rate or floating interest margin). However, there are also conditions on the specific terms of the bond that need to be satisfied, namely: interest must be paid periodically with no ability to defer or capitalise, and bonds cannot be converted into another class of securities bonds must not be subordinated (other than to secured debt) and rank equally with the issuers unsecured creditors upon a wind up. In addition, the issuer or its guaranteeing parent is required to be a continuously listed entity with a good record of continuous disclosure and a clean audit status.

Contacts:
If you have any questions or would like to discuss any of the matters discussed in this paper:

Michael Branson
Managing Director Debt & Capital Advisory +61 (2) 8266 3279 michael.branson@au.pwc.com

Matthew Santoro
Managing Director Debt & Capital Advisory +61 3 8603 4707 matthew.santoro@au.pwc.com

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