The RBA's "active taper" options and finding "greeniums" on ESG bonds

The Reserve Bank of Australia has reiterated that it will consider later this year whether there is a case for actively selling Commonwealth government bonds off its balance sheet once banks have repaid the first tranche of the circa $190 billion they borrowed off Martin Place during the pandemic.

This repayment process has been, and will likely continue to be, seamless. The nuance here, which is complex, is that when the RBA initially lent this money to banks in 2020, it created digital cash that was held on deposit with it. And as banks repay these loans, this cash disappears.

Crucially, the cash has been a large component of the liquid assets that Aussie banks hold as part of their regulatory buffers. As the cash vanishes, banks have to replace it with the two other forms of liquid assets the regulator accepts: Commonwealth and state government bonds.

The CLF was established by the RBA when there were not enough government bonds outstanding for banks to hold due to Australia’s prolific run of budget surpluses. The fiscal profligacy since the global financial crisis has resulted in the total government bond market swelling to more than $1.2 trillion in size. And it is likely to continue to grow rapidly.

Under the CLF, banks were able to hold comparatively high-yielding assets, such as internal loans, bank bonds and residential mortgage-backed securities, which paid superior interest rates to boring government bonds. They can no longer do so.

Demand for liquidity

What almost all bank treasuries had not figured out in 2021 was that their demand for liquidity was going to be vastly greater than the mere closure of the CLF implied.

Few seemed to appreciate that both the repayment of the money borrowed off the RBA and maturities of the $360 billion of bonds that the RBA had itself bought during the pandemic would trigger a need for somewhere between $300 billion and $600 billion of total additional liquid assets in the form of purchases of Commonwealth and state government bonds. Sell-side analysts were equally oblivious in 2021.

They appeared to get the message by mid-2022. And bank treasuries have predictably stepped up to the plate and purchased record volumes of state government bonds since. (They prefer state bonds because they pay a large spread over Commonwealth bonds.)

An “active taper” off the RBA’s balance sheet might make a lot of sense if it is convinced that the repayment of the $190 billion it lent banks does not create any financial system or market imbalances.

It would also be helpful if core inflation remains sticky (which it likely will) and demands the RBA lifts its cash rate somewhat closer to the level most peers have hit, exceeded or are heading towards. Active bond sales would be tantamount to another 30 basis points of interest rate increases and could substitute for the RBA lifting its cash rate, all else being equal.

The RBA has said one consideration is whether an active taper affects the power of any future quantitative easing, or bond purchase programs. It might worry if investors discounted future QE based on the fact that it could be subsequently unwound.

Yet this unwinding would be motivated by a desire to correct a policy that – with the benefit of perfect hindsight – one can say precipitated too much stimulus, which has manifest in the form of the elevated demand-side (or services) inflation we are witnessing.

ESG bond premium

On the subject of bond markets, one of the more interesting questions going around is whether bonds issued for environment, social and/or governance (ESG) purposes attract a lower of cost of capital than normal debt instruments without an ESG label. That is, whether there is a “greenium”, or bond price premium, as a result of these securities commanding lower interest rates than alternatives.

Coolabah’s 38-person team uses up to 30 or 40 different quantitative bond pricing models to revalue all debt securities globally that we are comfortable trading. And these models explicitly seek to identify the presence of a price premium for different types of ESG securities, which we trade in Aussie dollars, US dollars and euros.

We estimate that in 2022 there was a total of $US50.6 trillion ($81 trillion) of government and bank/corporate bond issuance, of which about $US827 billion (1.7 per cent) were ESG securities. Since January 1, 2022, we have traded around $99 billion of sovereign, bank and corporate bonds, and associated credit derivatives. ESG securities have accounted for about 7 per cent of our physical credit trading.

What we know from hard-won experience is that there is definitely an ESG premium in some market sectors at certain times. The challenge is that this ESG premium is constantly changing. It can appear in striking form and then fade away for a variety of complicated reasons. And this tends to be a function of market volatility.

Allow me to provide some examples.

In the state government bond market, ESG bonds trade on a slightly tighter spread, or interest rate margin, than non-ESG securities. In 2023, this ESG premium has ranged between one and three basis points (0.01 per cent to 0.03 per cent). Yet there have been periods in the past when it has been significantly stronger.

If we instead look at, say, the major banks’ bonds issued in euros, we find an ESG premium worth about five basis points in interest rate margin terms (ie, they trade on lower spreads). Once again, this premium has fluctuated strikingly over time and can disappear completely.

Interestingly, the ESG premiums attracted by both state government bonds in Aussie dollars and major bank securities in euros were much bigger in mid-2022 when markets were especially turbulent. This could reflect investors choosing to hold on to these securities during the chaos (ie, expressing a preference for selling normal bonds without the benefit of an ESG demarcation).

Staying in euros, the senior-ranking ESG bonds issued by British and French banks have consistently commanded a five to six basis point premium in spread terms. Current ESG premiums are a little higher than this longer-term estimate.

Finally, the senior bonds issued by US banks in US dollars have experienced a rather different trajectory. Between mid-2020 and mid-2022, there was a fairly stable five to 10 basis point ESG premium in spread terms. Yet this has more recently disappeared, perhaps as a result of the turmoil in the US regional bank market.

Back in 2019 Coolabah published detailed academic research on whether companies with positive ESG rankings drove superior risk-adjusted excess returns (alpha) and/or reduced systematic market risk (beta) in global equity and bond markets. We quantified statistically significant alpha and beta benefits in Australian and US equities.

There were also ostensible beta gains in the case of bonds. But what we discovered is a strong relationship between ESG rankings and credit ratings, which makes intuitive sense when you think about it.

If a company has significant ESG risks, that should also bleed into their credit ratings. Once our models formally controlled for credit ratings, the beta-reduction benefits were no longer statistically significant.

Of course, since there are time-varying ESG premiums in bond markets, carefully quantifying them dynamically across all global securities using an array of different valuation methods can provide considerable investment benefits.

This is particularly true if these premiums are not captured by bond issuers in the form of lower interest rates when they sell these securities to their investors.

First published in the AFR. Read more about our fixed-income strategies here.