OTC vs ASX listed market securities

In Australia around 95% of bonds are traded in the “over the counter” market (OTC) which is worth an estimated $1 trillion (including hybrids) with a diverse range of issuers and investors.

In order to buy and sell in this market you need to find a fixed income dealer or broker as the bonds are traded OTC, similar to the foreign exchange market, meaning there is no central exchange. This feature is a global bond market characteristic and not particular to the Australian market.

Traditionally, the OTC market in Australia served wholesale investors with minimum face value transactions of $500,000 and it excluded all but the most wealthy, individual investors. Dealers such as FIIG have identified bonds that can be traded in face value parcels from as low as $10,000, opening the market to more investors so that they can build their own diversified bond portfolios.

Advantages

• the Australian domestic bond market is a very large and diverse market with over 230 domestic and international issuers
• the ability to invest in non-ASX listed companies, including large international companies issuing in AUD and foreign currency bonds
• a direct bond portfolio can compliment equity and property holdings and minimise allocation to companies and sectors where investors already have an exposure
• a good mix of fixed, floating and inflation linked bonds available with a wide range of risk and returns
• the very large range of securities available in the OTC market mean a portfolio can be constructed to suit the individual’s circumstances i.e. for those in pension mode wanting income or for those in accumulation mode looking to build and preserve capital
• better understanding of, and thus pricing of, risk by large institutional investors
• superior liquidity

Disadvantages

• minimum face value investment ranges from $10,000 up to $500,000
• no electronic exchange so investors must seek a broker or dealers’ price for price discovery or valuation (note; FIIG publish a weekly Transparency Report of bond transactions)

ASX listed market

By way of contrast the ASX listed fixed income sector is much smaller with fewer issuers and less than 60 companies issuing securities. Over 80% of the securities are floating rate and while many investors cite the benefits of franking credits, less than 50% have franking credits attached. These are the higher risk securities which are predominantly preference shares and some perpetual instruments.

Advantages

• small minimum investment amount, as little as $100
• transparent market with price discovery readily available
• while retail investors are attracted to the high yields on offer, issuers consider issuing to retail investors a cheap form of funding

Disadvantages

• small market dominated by financial institutions and higher risk hybrid securities
• fewer securities available with a narrower range of issuers and most are ASX listed companies
• does not have the diversity that the OTC market offers with most securities being floating rate
• generally very complex hybrid securities where the terms and conditions listed under each prospectus is different and difficult for investors to appreciate fully
• many securities involve an element of call risk where if the issuer fails to call at the first opportunity, the security becomes perpetual with no maturity date or a very long time to maturity
• targeted at retail investors with little understanding of the wholesale market’s pricing of risk
• questionable liquidity
• many distributions are franked which means there is a timing delay in receiving the income and may not be suitable for international investors and other participants that cannot use franking credits