Brent Sheather: The primary bond market - By invitation only

Due to regulations and, frequently, a minimum bid size of $1 million or more the primary market is basically off limits to retail. Photo / Thinkstock

As we saw a few weeks ago the Code of Conduct for Financial Advisers requires advisers to put their clients' interests first. This is, despite the problems identified, obviously an admirable objective however actually doing the "right thing" is somewhat constrained by the environment within which advisers operate.

Specifically whilst the Government legislates that advisers must put clients' interests first other branches of the Government and in particular the NZ Debt Management Office and State Owned Enterprises organise their affairs such that retail investors are disadvantaged.

That is a particularly unsatisfactory state of affairs, not least because the public of NZ own the institutions who conspire to disadvantage them. To clarify we are referring to the bond market and in particular the primary, high quality issuer market. In this murky world of banks, underwriters, fees and favours the Government and State Owned Enterprises sell their debt, in the main, exclusively to institutional investors, often based overseas.

Due to regulations and, frequently, a minimum bid size of $1 million or more the primary market is basically off limits to retail. This has the effect of allowing institutions to arbitrage these issues in that by virtue of their size and access they can buy bonds on the primary market then sell them, at a profit, to retail investors.

To understand the problem we first need some background as to what a retail investor's bond portfolio should look like - the local bond market is dominated by Government debt, SOE debt, bank debt and city council debt so it is pretty clear that a "best practice" portfolio should comprise mainly this sort of stuff.

There are two ways of buying bonds - you can either buy them directly off the institution - the primary market - or on the secondary market where someone who already owns them decides to sell to you. This is typically a bank who might buy a bond at a yield of 5 per cent and sell it in smaller parcels at 4.9 per cent thereby pocketing a capital gain.

That is not unreasonable however imagine the outcry if Fletcher Building shares cost retail investors more than institutional investors. Therefore the secondary bond market could benefit from some improvement too. For a start pricing is opaque and it is very difficult to tell what margin the selling bank is making when it peels off $50,000 of its holding in a long dated bond for Mr & Mrs Smith, retired and living in Kawerau.

This isn't at all satisfactory especially given bonds represent 40 per cent of an average portfolio so its hugely surprising that in the numerous reforms of the financial markets overseen by the great and good in the last ten years that this anomaly hasn't been highlighted.

Just recently we had a Government sponsored enquiry designed to improve the functioning of the capital markets with some emphasis on improving outcomes for retail investors. The Capital Markets Task Force recommended in its 2009 report "broadening the range of high quality debt offering on the market by increasing the availability of retail offerings from government, local authority and government owned businesses including long dated debt".

The report went on to recommend that the regulatory authorities should "encourage the Debt Management Office to expand the range of government debt securities debt on offer including publicly listed retail issues". A key part of the task force's recommendations were the flotation of SOEs. This has been achieved but we have had absolutely no action in the debt market which is a major failing.

These same issues are starting to come to the attention of regulators in the US. SEC member, Daniel Gallagher, in a recent speech said "although retail participation in the bond market is high these markets are incredibly opaque to retail investors". He called for moves to improve price transparency and noted that a more centralised market would also have benefits in terms of lower transaction costs. "The amount of pricing information available is very limited and not widely available to the investing public. In addition information is often restricted to participating dealers and select customers."

The SEC is going to prepare new laws to enhance the public availability of pricing information in the fixed income markets particularly with respect to smaller retail size orders. These same issues are holding back the efficient allocation of capital locally, raising the cost of capital and allowing the finance sector to extract high profits.

But we are getting off the track. Today's topic is the primary market where for example SOE Transpower sells a bond to institutional investors and mum and dad aren't able to participate. A case in point occurred in April 2010 when Transpower issued some ten year inflation indexed bonds. These bonds were issued at a huge 4.00 per cent real yield thus investors who bought them then today enjoy a real yield equivalent to a bank deposit rate plus whatever inflation is plus an insurance policy against unexpected inflation.

In short these bonds were highly attractive and ideal for many retail investors however because the time and expense involved in structuring the offer for retail investors was deemed excessive by Transpower the issue was only made available to institutional investors.

But it gets worse - even today most retail investors can't own these bonds in the secondary market because there is a minimum holding of 100,000 face value. Totally unsatisfactory especially when you consider how easy it is to buy junk debt which really has no place in a sensible portfolio.

Back in 2010 I tried to buy some of these 2020 bonds for my clients and was only able to buy small volumes for "wholesale investors". I contacted the Chief Executive of Transpower, the Minister responsible for State Owned Enterprises and the then Chief Executive of the FMA about this unfair situation and was told that whilst we appreciate your concerns commercial realities dominate.

In other words "our objectives are to minimise costs related to the issue and we don't care about retail investors, the depth of the market or whether or not increased participation might mean a lower cost of funding".

The FMA, whose responsibility includes getting a fair deal for retail investors, needs to get involved. This is far more important than hassling some dodgy finance company with next to no funds under management that hasn't filed their returns on time.

Despite the report from Capital Markets Task Force things are no better in the primary bond market. Just recently the NZ government through its agent the NZ Debt Management Office issued some 2035 Inflation Indexed Bonds. These were priced to yield 2.74 per cent and given their long maturity, their low risk nature and the fact that many individuals wish to preserve the real value of their assets they were potentially attractive to retail investors.

However retail investors were virtually locked out of the transaction because there was a minimum bid size of $1m. So we have the perverse situation of NZ Debt Management Office, an agent for the NZ government, owned by the people of NZ selling debt at an attractive yield relative to similar overseas bonds, to overseas institutions in preference to the public of NZ.

Why would SOE Treasurers and the NZ Debt Management Office act in this manner? The main reason is cost because under the laws designed to protect retail investors it costs a lot more to issue a prospectus for retail than it does for wholesale investors.

I asked the NZ Debt Management Office whether they would consider acting in a more retail investor friendly manner. They issued the following statement: "The minimum parcel size for bids in the primary tender and syndication process is $1.0m. However, the minimum parcel size thereafter for nominal bonds and Inflation Indexed Bonds in the secondary market is $10,000 (with increments of $1,000 thereafter) and $1000 respectively. These minimum parcels have been set specifically to allow retail investor participation in New Zealand government bond offerings.

Retail investors are able to purchase bonds and bills in the secondary market through the retail platforms offered by the major banks or through brokers. The banks' retail platforms offer a wider range of products, including local government, SOE, corporate and bank bonds. This infrastructure makes a wide range of investment products accessible to retail investors via direct inquiry or through online services.

Importantly, these platforms also offer investors the ability to sell back their marketable securities should they need or choose to do so. This ability to sell is one of the factors that should be taken into account when investors are making choices between buying marketable securities as opposed to term deposits.

The role the banks play as intermediaries is a critical part of a well functioning capital market that supports retail investors. Direct selling by the NZDMO would add no value over the retail support provided by the banks and broker community. In fact, it could be argued that our presence in direct retail issuance would undermine the banks' and brokers' ability to maintain the infrastructure to offer these services, thereby reducing secondary market liquidity and reducing overall options available to investors."

So there you go. The NZDMO are advocating the two tier pricing model and effectively giving the public of NZ the one finger Whakatane salute.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.