Exchange traded bond units

03 June 2015

 

XTBs: “packaging corporate bonds into digestible, tradeable blocks that can be brought directly through the ASX, giving investors the opportunity to buy into the corporate bond market, previously restricted to institutions.”

Every week YieldReport carries news and pricing of new corporate bond issues and the question most asked of us here at YieldReport is, “How do I invest in corporate bonds?” The reality is that it is indeed tricky as the issue terms typically deem that the investors must be a ‘wholesale client’, the minimum investment size may be too high for many clients or because their broker does not offer them the opportunity.

All that could be about to change if Richard Murphy, CEO and co-founder of the Australian Corporate Bond Company (ACBC), has his way. As reported in YieldReport (11 May – 15 May 2015) ACBC has launched Exchange Traded Bond Units, or XTBs – the initial series of 16 XTBs gives investors exposure to the returns from individual corporate bonds issued by top 50 ASX listed companies. Each XTB offers investors an ASX tradable security that tracks the performance of a specific underlying bond after fees and expenses with no minimum investment. XTBs provide investors with the flexibility to select from 16 specific corporate bonds with various maturities and yields. All coupons and principal repayments made by the bond issuers flow through to the XTB investor.

What is the typical profile of investors choosing to use XTBs? Murphy says they are, “SMSFs, individuals investing out of the fixed-income part of their portfolio, individuals looking at effective yields on term deposits, some sophisticated clients. It’s a pretty broad group of investors.”

It is easy to imagine that the same sorts of dynamics that have seen a boom in the ETF and managed funds sectors in Australia will play into the hand of ACBC and their new investable instruments. But Murphy won’t be drawn on speculating on the potential size of the audience for XTBs. “It’s easy to say ‘it’s all Australian investors’, because they all have a need for fixed income and a lot of them have money in term deposits but more realistically we look at the number of trustees in existence for SMSFs and that’s 600,000. There’s $707bn in term deposits according to the last numbers from the RBA in household deposits and that is eight times higher than it was pre-GFC. That’s obviously a lot of individuals but we are not really focusing on that. We are not aiming at a small target market, we are aiming at fairly broad one.”

Shifting the investing behaviour of an entire segment to include corporate bonds could be a challenge and so it makes sense that ACBC chooses bonds to underpin the XTBs from brand names that their target will be familiar with. “We started with 17 corporate bonds but we have effectively dropped Novion because it is in a takeover situation. The fate of the bond is still unknown so we thought that we had better not offer it. So we have 16 at present. The first criteria is that we wanted to start at the quality end of the market so we started with the top 50 securities, recognisable brand names but the real main determinant was conversations with the market maker around liquidity and availability and size of a particular issue. If there were issues out there that we really wanted to cover but that were so tightly held that there was no liquidity in the wholesale market, there wasn’t much point in putting them up in the first place. So really it came down to brand and liquidity.”

While all 16 names will be well-known to most Australian investors, at present there are no bank issues include within the mix, which is unusual considering the fact that they are some of the most frequent issuers of corporate debt in Australia. The banks “were slightly reluctant for us to cover them because they were slightly cautious about anything new whatsoever,” says Murphy. Perhaps they felt that it “might further cannibalise TDs”. “So we took a decision that we would not do banks for now. We are in the process of putting the second lot together now and there are banks in there.”

One of the most pressing questions that the potential investing audience in XTBs will have will concern what sort of liquidity they can expect when they want to sell their XTB. “Liquidity is always going to be linked to the liquidity of the underlying,” says Murphy. “The market maker will always provide a reasonable bid which is what they have agreed to do but if there is no liquidity in the underlying then that’s it. Tthey can’t be expected to keep on buying them back. This is made pretty clear in the PDS but of course people can always hold to maturity and as soon as the bond matures then the XTB matures and the payment will flow through. But on exchange liquidity is always going to be driven by whatever there is in the underlying.”

With the RBA squeezing the cash rate lower and hinting that there are more cuts to come, the chastened investing environment and the hunt for yield could be seen as providing the perfect environment in which to launch XTBs. But will yield-starved investors turn to XTBs or will they turn to other asset classes like equities? “I think if we were still pre-GFC then people might say, oh forget about the risk and let’s just pile into equities and that obviously happened in Australia in the 30 years leading up to the GFC but what we have seen in talking to all the planners and brokers and banks is genuine asset class diversification discipline within firms increasingly,” says Murphy. “We have gone into brokers who are now talking to their clients about fixed income. The brokers have so much on their menu that they are keen to see what we are doing. Their clients would be in term deposits and fixed income managed funds or ETFs and that is one data point. How come the funds invested in term deposits keeps rising even though rate have come down? The $707bn invested in term deposits in the last quarter was only $600bn at the beginning of 2014. Has the GFC finally taught Australia the lesson that it needed to learn? They have figured out that their portfolio needs something that is negatively correlated with the equity market. The feedback that we get is that there is a much greater focus on diversification. At some point we will get to the bottom of the rate cycle and at that point people will start to ask about floating rates and we are already looking at that closely.”

As with any new type of instrument, investors are always wary of the fees and costs involved and will want to understand them fully before taking the plunge. ‘’We charge one fee,” says Murphy. “We don’t charge an MER like many funds do. We charge an upfront fee and the way it work is that XTBs don’t exist on a day and Deutsche Bank or any other market maker will say I have $1m worth of bonds and I want to give them to you and you give me back $1m worth of XTBs, something a little more convoluted than an asset swap. The point is: bonds in; XTBs out. They pay us the fee at that point so if it was $1m of 1y bonds, they would pay us 40bps on that so it would be $100 plus $0.40 and that is essentially our fee and then they pass that on. The XTB is offered in $100 lots so if the wholesale price is $100 then it becomes $100.40 and if it is for 2y then it is $0.80. Investors will look at that in terms of its effect on the yield so if you flick that around to look at it in yield terms them it becomes around 40bps. It will be between 38-41bps impact on yield so a 3.90% yielding bond in the wholesale market becomes a 3.50% yielding XTB in the retail market. And that’s it. There are no other fees.”