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Tail wags dog in retail government bond market development?

Might come back to bite: the Federal Government is developing a retail government bonds market, but there are structures that would work better. Flickr/Matthew_Roberts

Most investors don’t know (or care) much about the mechanics of how the ownership of securities they buy is transferred and recorded in the back-office activities (clearing and settlement) of financial markets.

But it is those back-office arrangements which are driving legislation, passed by the House of Representatives and about to come before the Senate, aimed at facilitating the development of a retail government bond market.

Essentially, the Commonwealth Government Securities Retail Trading Bill provides for retail investors to own and trade “depository interests” in government securities – rather than the actual securities themselves. There is nothing necessarily wrong with this, but it should be asked whether it is the best approach for facilitating development of a market.

Underpinning the approach is the fact that the Austraclear system, in which ownership of government securities is held and transferred (on behalf of the ultimate owners) is not set up to easily deal with retail investors and the small transactions they undertake.

Thus, one or more intermediaries, known as a Depository Nominee, will create depository (beneficial) interests in a stock of government securities registered to it in Austraclear. Retail investors will be able to trade these interests which are to be recorded and transferred in a registry of such interests.

Who will be depository nominees, what costs are involved in such a model, and whether retail investors will feel comfortable with (or care about) not owning the real McCoy are questions yet to be answered.

There are other alternatives (none of which mean that the legislation which simply makes the depository interest model possible shouldn’t be passed). For example, looking at retail bond markets overseas, it appears that retail trading of the actual bonds, rather than such depository interests, is common. (Not that there is good information readily available or that there are many well developed markets).

Indeed, half a century ago, government bonds were directly listed on the stock exchanges in Australia, and accessible to retail investors, although most trading (by institutional investors) took place off-market.

One apparent merit of the proposed approach would appear to be that it will keep the pricing in retail and wholesale markets in tandem. One could imagine (and that is all that can be done without more details) that if a pricing gap emerges, depository nominees would buy in the cheap market and sell in the dear.

If, for example, the retail price was too high, they could buy bonds in the wholesale market, create depository interests over those, and sell those interests on-exchange to retail customers. It could work a bit like an exchange traded fund model.

But, realistically, is the objective of creating a retail bond market about “trading” as opposed to “investing”. One might expect (indeed hope?) that retail investors, such as self managed super funds, would be primarily “buy and hold” investors.

And if that is so, perhaps some other models should be considered. One would be the creation of special government bonds available only to retail investors. Something like the Australian Savings Bond of the 1970s – but without its serious design flaws – could be considered.

Another option could be to facilitate direct investment by retail investors, by allowing them to place non-competitive (final price) bids in tenders when primary issues of bonds are being made. (Many retail investors are familiar with this process through participation in off-market share buybacks). Whether this would lead to better yields for investors (and what back-office costs would be incurred) than the depository interest model, are questions worth considering.

Of course, any such attempts to develop a retail government bond market may be just a waste of time and effort. Despite talk of a budget “blowout” the simple fact is that there are not many government bonds to go around.

There is already lots of demand for what is available, both from offshore investors (who hold around 70% of what is on issue) and from banks and other financial institutions required, or looking, to hold safe, liquid, assets.

And for retail investors, with interest rates on three year term deposits (with government guarantees) currently two percentage points above three year government bond rates, what is there to like about investing in bonds?

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