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Wednesday 27 March 2024 by Philip Brown Education (basics),Education

Understanding the Semi-Government bond market

All bond investors would know of the Government bond market. In Australia, Government bonds are bonds issued by the Federal Government and go by the acronym ACGB, standing for Australian Commonwealth Government Bond.

Sitting alongside the Federal Government bonds are the State-Government bonds where the state governments borrow money. These are also called Semi-Government bonds, or simply Semis for short. These Semi-Government bonds are far less well-known but have a great deal to offer a bond investor. Like Government Bonds, Semi-Government bonds are also incredibly safe – even if not quite as safe as Government bonds - but offer a higher yield than Government bonds. 

Who Sells Semi-Government Bonds?

Each of the states and territories sells Semi-Government bonds. The bonds are sold through a special arm of the state’s Treasury Department, called a Treasury Corporation. For example, NSW sells its bonds through the New South Wales Treasury Corporation or NSWTC. Queensland sells its Semi-Government bonds through the Queensland Treasury Corporation or QTC. Victoria sells their bonds through their corporation which is called, slightly unhelpfully, not VTC, but instead the Treasury Corporation of Victoria, or TCV. 

Although these Treasury Corporations are separated from the Treasury in a legal sense, the state borrowing corporations each have the full guarantee of their respective state or territory government.

We highlight these corporation names because state government bonds will be labelled by the name or acronym of the Treasury Corporation in most bond market systems, including FIIG’s.

Although the Semi-Government market is not as well known, it is surprisingly large. As of 22 March 2024, there were over $A560bn face value worth of State-Government bonds in Australia. In the combined Government and Semi-Government market, the Federal Government is 61%, but the states are 39%. Not so long ago, there were actually more state government bonds than federal government bonds, though this hasn’t been true since the large Government spending during COVID.

Source:  FIIG Securities, Bloomberg

Amongst the states, the equal largest borrowers are NSW and Victoria, which have $A165.9bn and $A165.4bn outstanding, respectively. The next largest is Queensland, with $A124.3bn. The other states have materially smaller issuance.

Who buys Semi-Government Bonds?

The largest holders of State-Government bonds are, by far, the banks - particularly the bank balance sheets. Banks are required to hold capital and liquidity against the loans they make. The process for exactly which assets are eligible for banks to own as part of their liquidity is quite complicated, but the long and short of it is that Australian banks must own either cash, Government bonds, or State-Government bonds for the vast majority of their liquidity.

A second significant source of investment into Semi-Government bonds are the Superannuation funds. The more defensive portfolio mixes inside the Super funds will often own a disproportionately large amount of State-Government bonds.

For both the bank balance sheets and the Super funds the attraction of Semis is that they are usually ranked interchangeably with Government bonds for categorisation purposes but have a higher yield.

The final category worth mentioning for investors in Semis is the international buyers. These buyers are often from Asia and have, historically, been attracted to the higher yields available in Australia compared to other countries. At present, however, the combination of a weak Australian Dollar and high yields available in other markets (like the US, Canada and New Zealand) has seen the demand from Asian investors quieten. It may well be reawakened in the future, however, if the Australian yields once again become attractive on a relative basis.

What types of bonds are available?

The State-Government bond market is mostly Fixed Rate Bonds. Fully 89% of the semi-market is fixed rate bonds, but that still leaves space for 10% of Semi-bonds to be floating rate notes and 1% to be CPI linked. While 10% of the Semi-bonds being floating rate notes isn’t large, the same number for the Federal Government is zero. As a consequence, if you’re trying to access high-grade FRNs with very minimal credit risk the state government bond market is the main place you’ll find them.

Source:  FIIG Securities, Bloomberg

The other distinction that Semis offer is that there are many ESG bonds available. Different states come at this in different ways, but there are multiple opportunities to buy State-Government bonds where the state guarantees the funds will be spent only on projects that comply with responsible investment principles. The Federal Government is planning to issue its first ESG bond in the June quarter of 2024.

What sort of yields do these bonds get?

State-Government bonds get yields that are much higher than the corresponding Federal Government bonds. This is still lower than the yields available in corporate bonds, but the risk that a state government defaults and doesn’t return your capital is very low. That makes the 70bp or so extra yield available in a 10Y investment over and above Government bonds quite meaningful.

Source:  FIIG Securities, Bloomberg

The other interesting feature of Semis apparent in the chart is that while there is some differentiation among the states, the differences are very small. At present, the WATC bonds have the lowest yields which is because WA has had a period of strong revenues from iron ore which they have used to dilute the total debt outstanding.

What are the advantages and disadvantages of Semi-Government Bonds?

The main advantage of Semi-Government bonds is their higher yield than Government bonds, despite also having an incredibly low-risk profile. State-Government bonds are therefore a great way to access duration, without also having to take credit risk over a material period. While Government bonds can also be used for this, the State-Government bonds have a materially higher yield than Federal Government bonds.

The disadvantage of Semi-Government bonds mostly comes from their liquidity. State-Government bond markets can be very patchy and depend critically on exactly which State-Government bond you are talking about. The larger bond lines from the larger states are frequently greater than $A10bn and are very liquid. A smaller bond line from a smaller state might be more difficult to trade. This is particularly true of the ultra-long bonds where liquidity and pricing can suffer in periods of stress.

The natural owners of State-Government bonds tend to be bank balance sheets, but these buyers are sometimes limited by their policies to only purchasing bonds <5 years or <10 years. The shorter Semis have much better liquidity than the longer Semis.

Overall, Semis are an excellent option for more cautious investors who desire duration and fixed coupons in their portfolio, but who want a little more yield in their portfolio.