Labor’s plan to axe cash refunds from excess dividend imputation credits will provide a fillip for Australia’s $1 trillion corporate bond market.
While the policy change for franking credits will hurt many equities investors, it will absolutely give the local corporate bond market a boost, according to Elizabeth Moran, FIIG Securities director education and research.
Currently, shareholders who pay little or no tax receive their franking credits as cash payments - if the credits exceed their tax liability. That will stop in July 2019, if Labor is elected to government.
"At that point when investors start assessing assets on a risk and return basis, corporate bonds will look more attractive than either shares or hybrids," Moran said.
“There is no doubt that if the capacity to claim franking is entirely lost then the hybrid return is far too low for the risk involved.
"If we look at other investments in a bank’s capital structure starting from least risk and increasing, investment in the hybrid could not be justified on a relative risk and return basis.”
Moving towards bonds
Moran’s comments came just as FIIG - and Deloitte Access Economics - jointly released new research predicting that the share of private investors iwho own corporate bonds is set to increase from 16 per cent to 29 per cent over the next 12 months.
“This would be the equivalent of almost $30 billion in additional corporate bond investment by private investors, though it still represents a relatively small share of Australia’s $1 trillion-plus corporate bond market," the report found.
The number of Australian investors invested in corporate bonds remains low compared to other countries: private investors hold less than 1 per cent of all corporate bonds on issue in Australia compared to almost 20 per cent in the US.
Worse, Australian superannuation funds hold only 10 per cent of their assets in bonds and bills compared to an OECD average of 40 per cent.
However, the authors of the report suggest that a number of conditions – such as an increasingly ageing population – will help the corprate bond market grow over the coming years.
Tax policies benefit bond holders.
The research showed that over the next 12 months, almost half the private investors who already hold corporate bonds in their portfolio intend on increasing their corporate bond investments.
Conversely, just under half were worried about Canberra's tax and super policy were not so eager to jump into bonds.
Clearly the report’s authors are pinning their hopes on a friendlier political climate eventuating for bond investors.
"Corporate bonds do not receive the tax benefits that some other investments receive, such as dividend imputation for shares or the possibility of negative gearing for investment properties," they noted.
"So any future changes to franking credits under the dividend imputation system could affect returns earned on share investments, but bond investments would be unaffected as they currently do not receive special tax treatment."
As at June 2017, total bonds on issue by Australian banks was around $540 billion with another $460 billion on issue by other financial institutions, and $255 billion by non-financial corporates.
Around half of all corporate bonds outstanding issued by Australian companies are currently owned by overseas investors.
The gross annual return of Australian bonds was 6.1 per cent between 2006 and 2016, compared to 4.3 per cent for Australian shares and 5.5 per cent for global shares.