Retail bond markets — what is the point?


The editorial in the AFR today is advocating the development of a bond market for retail investors in Australia.  The editorial says “Yet it remains far more difficult for Australian retail investors to buy government and corporate bonds than in the US and most other developed countries”. The suggestion here is that the holdings of bonds by individual households are large in the US, but that is not true.

The US Federal Reserve publishes the aggregate balance sheet of US households in its Flow of Funds.  You can see the most recently published quarterly tables, up to March 2011,  here.  Go to Table B100 on page 118.  There you will see that the total assets of US households are valued at $72 trillion of which directly held credit market instruments are $4 trillion.  Table L212 on page 91 shows that of $11.3 trillion of corporate and foreign bonds on issue in the US, only $1.7 trillion is held by the household sector.  The household sector in the Flow of Funds includes the large endowments (such as the Harvard University of Ford Foundation endowments).  So, the volume of bonds held by actual households is considerably lower than $1.7 trillion.

Wealth surveys show that most of the bonds that are held directly by US households are actually municipal bonds (of states and local governments) which pay interest which is free from federal income tax (the US Constitution prohibits the Federal Government from taxing the states).  Moreover, most of the bonds are held by very wealthy households. The proportion of household wealth that is held as corporate bond issues by retail or emerging affluent (as opposed to high net worth) households is very small.  The idea that ordinary US households have a lot of their wealth tied up in retail bonds is simply false.

There are good reasons for not wanting households to hold bonds directly.

1.  It is difficult to achieve diversification in bond portfolios.  Whereas it only takes 20 or so stocks to eliminate nearly all of the non-systematic risk in stock portfolios, it takes over 100 bonds to achieve essentially full diversification in bond portfolios.  It is much better for households to invest the part of their wealth that is allocated to fixed income into low fee, managed bond portfolios, which can achieve low cost diversification for those households.

2.  We should encourage households to absorb the residual risk of projects.  That is, we should encourage the household sector to own shares,either directly or through managed funds.  If households don’t absorb the systematic residual risk of the real economy, then who will?  The greater the demand for systematic equity risk, the lower the economy wide equity risk premium, the lower the equity cost of capital of individual firms, the more projects that are approved by those firms, the higher the level of investment in productive capital, the faster the growth in labour productivity and real wages and the higher the growth rate of the economy.

2 Responses to "Retail bond markets — what is the point?"
  1. Might be hard to get retail investors to buy government bonds when banks are offering double the interest rate on term deposit specials.

  2. GF 
    It is anomalous that long term bank deposits are covered by the bank deposit guarantee.  So yields on 5 year Treasury Notes are %4.62 and 5 year Government guaranteed deposits are going for 6.50%.  Of course, you can sell the bond to access liquidity, whereas the term deposit cannot be exited without a penalty.  Nonetheless, it is a big difference.

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