Some CFOs are beginning to re-assess their interest in Australia's corporate bond market as it starts to mature. Corporate bonds have the potential to provide new options for mid-market businesses to issue debt securities. This important development could help businesses diversify their funding sources.
Corporates usually have the choice of accessing debt financing through a bank or through the bond market.
Traditionally, banks would lend money at a slightly lower rate than the cost of a bond, but would demand greater security in the form of specific assets pledged as security.
In contrast, the bond market tends to function more in the 'unsecured' lending space, with a resultant increase in the cost of funding but more flexibility for the borrowing entity.
Garreth Innes, investment manager, Aberdeen Standard Investments, describes the current environment for issuing bonds as being one of low yields, tight spreads and an insatiable thirst for income from global investors.
“Compared to long-term history, the current backdrop is very attractive to corporate borrowers because the cost of debt is very low," he explains.
“Unconventional monetary policy from global central banks has squashed bond yields to very low levels, and investors have been forced to pay up for riskier debt. This has compressed credit spreads, the additional compensation required to invest in a riskier asset," says Innes.
“Today, lower-rated investment grade borrowers, that is, entities with a credit rating of at least BBB-, can borrow money for 10 years at an all-in cost of 4%," he explains.
“As a result, recent levels of issuance have surged as corporates attempt to lock in a low cost of debt before the expected interest rate hikes from global central banks," he adds.
Understanding the role of bonds
Innes says corporates usually include debt in the capital structure because of the relatively favourable cost of funding compared to equity funding, which can dilute existing shareholders' interests.
He gives the example of a wholly equity-funded company needing capital to invest in a new factory or mine.
To make the investment, the company would then need to either borrow the money, or issue more shares - requiring current shareholders to stump up more cash to maintain their ownership level in the company.
Companies may also raise debt to fund takeovers of other corporates, and to ensure they have an efficient capital structure, he says.
“In many jurisdictions, there are tax advantages to financing operations with debt due to deductibility of interest payments. This can also increase the value of the company as its after-tax cash flows end up being higher by incorporating debt into the capital structure," says Innes.
In Australia, Innes says the major banks, as well as the international investment banks, have close relationships with bond investors and are able to arrange bond issues in the Australian market, as well as global markets.
However, John Ricciotti, Head of Debt Securities, FIIG Securities, explains corporate bonds are not as well understood in the Australian market as they are overseas.
In markets like North America and Europe, upwards of 80% of debt borrowed across companies of all sizes, from small to large, typically comes from the bond market, he says. The remaining 20% comes from the bank market.
“Offshore, businesses are not that reliant on the bank market. They use bank funds for short-term financing needs and the bond market for long term financing," he says.
Conversely, Ricciotti says in Australia 80% of corporate finance comes from the bank market and about 20% from the bond market.
If you're a corporate considering issuing a bond, it's important to recognise the investor's perspective.
To be able to raise debt finance, a business generally needs to generate earnings before interest, tax, depreciation and amortisation (EBITDA) of at least $10 million.
Debt investors are also attracted to attributes such as a sound operating history, and a unique product or service in a growing sector. These give investors more confidence in the sustainability of earnings.
“Long-term contracts or government business gives investors comfort around the predictability of the business," says Ricciotti, adding that investors also look for diversification.
Priorities can shift depending on an investor's goals, he adds. “Fixed income investors are looking to generate regular income, so they are not looking for the growth gains you get with equity."
FIIG offers a bond trading platform to enable institutional investors to invest in mid-market companies' bond issues.
“We connect corporate borrowers that have an identity, a story to tell and good credit quality with investors that are looking for unrated bonds," Ricciotti says.
An example of a bond FIIG has issued was a $30 million, six-year bond for Silver Chef, a company providing finance for hospitality businesses.
It was a senior unsecured bond, and bondholders ranked behind senior secured lenders. The bond paid 8.5% and was oversubscribed.
“Companies are comfortable using FIIG to raise bond financing, because in a situation like Silver Chef, at the time, they could only get so much money from their bank. We raised a bond that sat next to bank debt, to fund their growth and expansion," Ricciotti explains, adding that the business paid the bond back early.
Keeping options open
Given the current very flat interest rate curve structure (the difference between the yield of long-dated bonds and short dated bonds), corporates have looked to issue bonds giving 7-10 year debt maturity.
“Both bank loans and bond markets are very flexible on tenor and features, so CFOs can be creative in structuring something that works for them, as well as the ultimate lender," Innes says.
CFOs will generally consider a variety of funding sources to manage refinancing risk and to ensure the business isn't reliant on a narrow range of debt instruments. Maturity in Australia's bond market could add a new option to their list.
- Traditionally Australian corporates have not relied on bond financing as much as their overseas peers have.
- Investors are attracted to issuers with predictability of earnings that operate in a growing market.
- Bonds offer an alternative to bank finance and a way to diversify funding sources.