Inflection point?

In my defence, I was hardly alone in this view. Predictions of double-figure unemployment and a housing-market collapse abounded, and the failure of Virgin Australia – briefly the shining light of the emerging Australian dollar high-yield bond market – certainly did not portend a rapid rebound. Meanwhile, the massive fiscal response to the crisis also took the market’s leading credit benchmark – major-bank issuance – off the menu.

Of course, things played out rather differently. Unprecedented government support propped up the economy and household balance sheets through lockdown, meaning asset quality held up and market confidence returned within a few months. Without losing sight of just how frightening the early days of the pandemic were, it is possible to make the case that 2020 was actually a pretty good year for Australian dollar credit.

Far from being an impediment, the absence of bank supply actually cleared the field for a more diverse range of supply. The two sectors that took longest to recover after the financial crisis, nonfinancial corporate and nonbank financial issuance, rebounded hard in H2 2020 to arguably their most conducive conditions ever.

Nonbanks in particular have been huge beneficiaries of the absence of authorised deposit-taking institutions (ADIs). Investors that had traditionally been leery of the securitisation asset class – for its limited liquidity and amortising nature more than because of any concern about credit quality, for the most part – have been compelled by the simple unavailability of alternative bond supply to engage with the asset class.

Nonbank securitisation issuance has soared in the past couple of years, to an all-time high in 2021 that will almost certainly pass A$30 billion (US$21.5 billion) by year end. Issuers report unprecedented scale and breadth of demand, even in the absence of some of the largest international buyers that have seen a gradual erosion of relative value as Australian spreads have ground ever-tighter.

The volume story is not as obvious in the nonfinancial corporate market, though this is more the product of supply-side factors than demand for corporate issuance. Australian corporate bonds continues to be mostly a refinancing market – but the evidence suggests a larger proportion than ever of what supply there is gets printed domestically. In particular, Australian issuers have come to favour the local option over the US private placement market in recent times.

It is impossible to know exactly to what extent this positive environment for alternative credit issuance is the product of bank absence in and of itself, as opposed to other factors such as the hunt for yield in an ultra-low rates environment or the straightforward growth of the Australian credit investment pool. What is clear is that the drying up of bank deal flow certainly did not kill market momentum – quite the reverse, if anything.

On this basis, it might seem paradoxical to suggest the return of the banks is also going to prove positive for domestic credit. But that is exactly what I am going to do. The rationale comes down to the difference between outright market scale and issuance diversity.

There is growing expectation that the banks are not just returning to issuance – as they have always been expected to do after the end of the term funding facility (TFF) – but they will be doing so in scale comparable to, and perhaps even greater than, their pre-pandemic funding tasks. This marks a change: as recently as mid-2021 the banks were forecasting smaller funding needs based on ongoing elevated saving rates and suppressed credit growth.

The signs are increasingly pointing in a different direction. Economic recovery could rein in savings and promote credit growth, while the banks are also confronting a TFF refinancing task of roughly A$180 billion by June 2024 and, most recently, the need to fund as much as A$120 billion of new high-quality liquid assets they will be forced to hold thanks to the end of the committed liquidity facility (CLF).

The CLF decision also means ADIs will likely have less ongoing appetite for each others’ bonds and securitisations. If this entails – as many think it will – reduced Australian dollar capacity for ADI issuance, the banks will be forced offshore to fill a funding gap that has snapped back with a vengeance.

One does not need a history of juvenile delinquency to imagine the effect of four big lads jumping on one end of a seesaw. In this case, the outcome is not ruined playground equipment but a structural change in cross-currency basis-swap dynamics.

In turn, this should provide an economic incentive for Kangaroo issuers. Supranational, sovereign and agency issuance in Australian dollars has held up reasonably well in the absence of offshore funding by the big-four banks, but a wider cross-currency basis could work wonders for deal economics – attracting volume from the biggest issuers and, potentially, greater diversity of supply. The Kangaroo market has supported greater volume of credit issuance at various points in the past – why should it not do so again?

This is where the difference between volume and diversity is important. Without banks buying each others’ debt securities in CLF-era volume, it is possible the outright scale of credit issuance in Australia will not immediately hit new peaks. But let’s be honest: purely in the context of being a functional, appealing capital market, banks buying each others’ debt securities is about the least constructive source of activity available. The market would surely be better off at a similar or even somewhat smaller scale but with more diversity of issuance.

Furthermore, this type of supply-demand dynamic could promote growth of its own. A structural replacement of bank supply with domestic securitisation and corporate bonds, and international credit is only likely to attract funds to the market.

For instance, Asian investors have been supportive of Australian credit but typically express frustration at the shortage of supply and its lack of diversity. A market where a supportive cross-currency basis helps offset the new-issuer premium typically demanded of debutants could become a more consistently appealing destination for the global buy side, too. Liquidity begets liquidity.

There is an even bigger story in the background. I am well aware that predicting the end of the bond-market super cycle is about the easiest way to make oneself look stupid in this market. So I will say no more than that noise about inflation will not go away, Australia’s nearest neighbour has already started hiking rates and, for the first time in well over a decade, there are starting to be whispers of borrowers possibly having to chase liquidity in future rather than the other way around.

The additional factor here is environmental transition. If Australia manages to engage with the critical need to take on this challenge – an outcome it has been conspicuously avoiding, at least in the federal-government space, for far too long – the scale of the financing task to support the economic change will be vast.

In this case, a functional and diverse capital market with a natural source of – in the most literal sense of the term – real money could become a very appealing issuance destination in the years ahead. For the first time, Australia’s vast superannuation pool could become a genuine pull factor for the local capital market – attracting incoming issuers with offshore funds following as diversity and liquidity grow.

I should say, my confidence factor on these predictions is medium at best. The conclusions may be extrapolating too far. But the premises are reasonably well established and should not change: the local credit market has come through the pandemic arguably in a better state than it went in while real money has been the driver – and will likely continue to be for the foreseeable future. It will be fascinating to see whether the local debt market can capture the opportunity.