While Australian investors have a bias towards listed investments purchased via a centralised exchange, there are many benefits to Direct Bond ownership accessed through the Over-The-Counter (OTC) market. Here we discuss the many opportunities and benefits, ranging from better returns from a risk-reward perspective to lower costs and liquidity.
Overview
There are some misconceptions about Direct Bond ownership and the OTC bond market. Investors who access bonds only via the listed options are missing out on higher returns from a risk-reward perspective, better diversification, and the ability to tailor a fixed income portfolio to their needs. Direct Bond ownership accessed through the OTC market offers these benefits and many more.
Liquidity
First, a definition: the OTC market is where bonds are traded between directly between two parties and not through a centralised exchange. The global OTC bond market had $140.7 trillion outstanding in 2023, which is more than the global share market (market capitalisation of $115.0 trillion in 2023), according to SIGMA. Locally, the Australian bond market is significant, with over A$1.8 trillion of government, corporate, asset-backed securities and residential mortgage-backed securities outstanding. The size of this market provides a large pool of potential buyers and sellers, as well as access to issuers that aren’t listed on the ASX (such as non-listed and international corporations).
Transparency & low costs
As well as providing liquidity, another benefit of the OTC bond market is transparency in terms of costs and pricing. There are relatively low costs involved in managing a Direct Bond portfolio, which are listed on the FIIG website under Fees & Charges. Unlike managed funds, where you pay ongoing management, performance, and entry or exit fees, the cost of investing in the OTC bond market is built into the rates of return a client is shown. It’s similar to buying foreign currency, where a margin is taken between the buy and sell price. FIIG publishes a daily bond rate sheet that lists the prices of over 700 Corporate Bonds and is available via the FIIG website. Furthermore, FIIG clients are also able to view bond pricing when they log into their FIIG portal, where they can also place an order to buy or sell.
Tailored portfolios
Another advantage of Direct Bond ownership is the ability to tailor a portfolio to suit an investor’s investment preferences, income goals and outlook. This gives an investor greater flexibility and more control. The coupon payments of bonds in the OTC market are variable with monthly, quarterly, half-yearly and yearly coupons available - allowing an investor to select bonds based on their own income requirements. Furthermore, Direct Bond ownership allows an investor to easily switch out of bonds and replace with new bonds that are better suited to upcoming market and interest rate movements, thus managing market risk and limiting downside performance. Bond Exchange Traded Funds (ETFs) do not allow for this, rather an investor would need to completely exit the ETF and purchase a new one that is more suitable to the market outlook. For example, Bond ETFs that track a government bond index (which typically is exposed to longer dated maturities and sensitive to interest rate moves), would see weaker performance with capital price depreciation in a rising interest rate environment.
Better returns from a risk/reward perspective
Historically, there has been a bias from investors to purchase ASX-listed Additional Tier 1 (AT1) bank hybrids. However, the decision by the Australian Prudential Regulation Authority (APRA) to phase out bank AT1 hybrids by 2032 will likely see an increase in Tier 2 notes issuance. Tier 2 notes are typically purchased in the OTC market, rather than on the ASX, and we have for many years noted the better risk-reward Tier 2 notes offer compared to ASX-listed AT1 hybrids. While both Additional Tier 1 hybrids and Tier 2 Capital notes are considered fixed income instruments, AT 1 hybrids (as the name suggests) also have equity-like features, making them inherently riskier. The periodic payments on listed hybrids are at the bank’s discretion, providing no certainty of income, and there is no obligation that skipped payments must be repaid at a later date. On the other hand, periodic payments on Tier 2 Capital securities are a legal obligation, and any missed payments accumulate until payment is made. Due to the higher inherent risk of these equity-like features, listed AT1 hybrids should provide a higher rate of return compared to regular debt securities. But current hybrid pricing does not seem to compensate investors for the additional risks.
Conclusion
Direct Bond ownership accessed through the OTC market offers bond investors many benefits and opportunities that the managed bond funds, Bond ETFs and ASX-listed hybrid securities don’t offer. A well-constructed and diversified portfolio should include an allocation to Direct Bonds for the ability to tailor a portfolio, transparency and better returns from a risk-reward perspective. Please speak with a Fixed Income expert to find out more.