This article appeared in the December 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Dr Philip Bayley, Australia Ratings
Bonds are an essential asset class in a balanced investment portfolio. They add diversity to a portfolio and reduce the volatility of the returns generated by the portfolio.
Put simply, an appropriate allocation to bonds within a portfolio can optimise the income generated while reducing the overall portfolio risk. However, investing in bonds poses some challenges for retail investors.
These include the limited range of bonds available to retail investors for direct investment and the availability of sufficient information to make an investment decision. Ensuring there is sufficient information is the more significant challenge.
Without information, markets do not function, and if there is no market there will certainly be no bond issuance to expand the range of investment opportunities available.
The Simple Corporate Bonds Bill that passed through Parliament on September 2 will allow the supply of simple corporate bonds listed on ASX to increase, but investors must be informed about the benefits and risks of bonds if demand is to increase.
Any new simple corporate bonds will add to the debt securities already available. These range from Commonwealth Government bonds to corporate bonds to hybrid securities, all offering different rates of return and risk profiles.
The value of a credit rating
Issuers and investors may ask whether there is any value in having a credit rating. Credit rating agencies have been widely disparaged since the GFC.
The fundamental role of a credit rating is to provide investors with information on which they can base an investment decision; it is not a recommendation to buy or sell a security. The information provided by credit rating agencies facilitates the development and efficient functioning of financial markets.
My own research in this area, in the Australian market, has shown that issuers that seek a credit rating will achieve a lower cost of debt than those that do not. The reduction in the cost of debt can amount to millions of dollars over the life of the rated security issued.
The reduction in the cost of debt facilitated by having a credit rating can be achieved regardless of from where the debt is sourced, whether a bank or debt markets. The reduction can also be achieved regardless of whether the rating is "investment grade" or not.
The reason is simple. Without a credit rating the credit risk of an issuer is a secret, known only to the issuer and any lender that goes to the trouble of undertaking their own investigation. With only one or a few informed lenders there is little or no competitive pressure to bid down the cost of the debt.
By providing a credit rating, the rating agency undertakes the investigation of the issuer's credit quality and provides the information to the market at large. The range of potential lenders is greatly expanded and the process of providing the debt sought becomes competitive.
The ASX debt and hybrid research scheme
ASX is committed to developing a more active retail corporate bond market and recognises the importance of increasing the availability of information to retail investors if this goal is to be realised.
The equity research scheme developed by ASX is now in its third year of operation and has already generated research coverage for 159 companies that were under-researched or received no coverage from brokerage houses. The scheme has been very well received by ASX participants and retail investors.
Now ASX is about to launch its debt and hybrid research scheme. It has two key elements:
- Incentivising debt and hybrid research providers to facilitate greater levels of research on ASX-quoted debt and hybrid securities.
- Incentivising credit rating agencies to assign credit ratings to all debt and hybrid securities traded on ASX.
Assigning credit ratings
Australia Ratings has been appointed by ASX to assign the credit ratings. Australia Ratings is the only rating agency in Australia holding a retail Australian Financial Services Licence issued by the Australian Securities and Investments Commission.
As such, it is the only credit rating agency in Australia licensed to assign credit ratings to debt securities (and other products) offered to retail investors in Australia. The credit ratings assigned by Australia Ratings under the scheme will comprise two components which, combined, make up the rating.
The first is an assessment of the probability of the issuer defaulting; in other words, the probability of the issuer becoming insolvent. The traditional rating scale categories of AAA, AA, A, BBB, etc, will be used to reflect this assessment for each issuer.
The second component is a Product Complexity Indicator (PCI), used to reflect the nature of the bond or debt security being rated.
The PCI uses a colour scale to convey these differences: Green for a simple corporate bond, Blue for subordinated debt, Yellow for more complex subordinated debt, and Orange and Red for hybrid securities of increasing complexity.
Thus the rating assigned to a security might be AAA/Green in the case of Commonwealth Government bonds or BBB/Yellow for a more complex subordinated corporate bond. The credit ratings assigned will provide a readily understandable assessment of the default risk of the security issuer and the risks attached to the security itself.
However, issuers and investors should be aware of the limitations of the credit ratings assigned under the scheme. Importantly, Australia Ratings has been engaged by ASX to provide the credit ratings, not by individual issuers.
The credit ratings assigned will be point-in-time ratings. In other words, they will be Australia Ratings' assessment of the default risk of the issuer and the risks of the particular security being rated, based on publicly available information at the time of making the assessment.
Australia Ratings is now determining credit ratings for the debt securities currently issued on ASX and will provide credit ratings for new issues six months after issuance takes place. Alternatively, issuers wishing to market their new debt security issue to retail investors with a credit rating in place can engage Australia Ratings to provide a full rating service.
There is measurable value in having a credit rating. Investors can accurately determine an appropriate return for risk and issuers can ensure they get the lowest available cost of debt.
About the author
Dr Philip Bayley is a director of Australia Ratings and the principal of debt capital markets consultancy, ADCM Services.
Bonds provides information on the features, benefits and risks of various debt securities.
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