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The future of bonds (no they’re not disappearing)

Bonds are going digital, but they’re not going away. Pendal’s head of government bond strategies TIM HEXT explains why

AS A financial markets under-graduate 30 years ago I was sent off to see the plumbing of markets — how trades were recorded and settled.

I spent a few weeks wearing out my new leather soles walking around town with the couriers, getting stamps on physical bonds, writing bank cheques and heading up to the registry office to lodge them.

It was all very manual. (Many bonds were still bearer bonds, so you didn’t want to lose them!)

By the turn of the century technology enabled everything to be stamped and lodged electronically, meaning our rather old couriers could finally retire.

But bonds fundamentally never changed.

A bond is basically a loan that can be easily traded in secondary markets. It enables investors and savers to bring forward or defer their investment and spending decisions.

The technology behind them will continue to become more efficient.

Which leads us to…

Blockchain and bonds

Blockchain is basically a secure and decentralised (or distributed) ledger which records payments or ownership of property, equities or bonds.

It basically eliminates the need for a centralised registry. Custodians may initially continue to offer their services managing the blockchain on behalf of clients — but ultimately they may not be required.

Settlements can be instant, reducing counterparty and operational risk.

The terminology will change. Digital bonds can now be called “tokenised securities”. Paper-based contracts become “smart contracts”. Payments from the traditional banking system will need “on-chain payments solutions”.

Eventually all bonds will be digital — likely within the next decade.

But they will not disappear.

Why bonds will remain and governments won’t surrender their currencies

What is a government’s greatest power? To set laws and enforce them.

I would argue a federal government’s most important law is control of its currency — and more importantly the ability to create currency.

If you think about why the Australian Dollar (AUD) exists — why we don’t just transact in US dollars for example — it’s because the government makes us pay taxes and demands they be paid in AUD.

This creates a fundamental demand for AUD which underpins its acceptance for payments and savings by all Australians.

Find out about

Pendal’s Income and Fixed Interest funds

The government can then create as many AUD as it wants to pay for goods and services.

The only limitation to this is inflation — putting too much currency in the system for the available resources.

The government therefore usually drains the currency back out of the system via taxes or government borrowing.

However they don’t have to, as recent effective monetisation by the RBA has shown.

If a government was to surrender control of the printing presses — via a monetary union like the Euro or via fixing to another currency or commodity such as gold — its actions become captive to forces outside its control.

Some purists may see this as a good thing, imposing the invisible hand of the market on the government.

History suggests otherwise.

Governments would become pro-cyclical and make inevitable private sector boom/bust cycles worse, as seen in the early days of the Great Depression. (For a recent example just ask the citizens of Greece.)

Can a central bank maintain control of a currency if it’s digital?

The answer of course is yes — provided the digital currency is still issued by them.

I doubt the government will be accepting taxes in US dollars any time soon and certainly not in crypto.

Central Bank Digital Currency (CBDC)

Currency is largely already digital. Some of us still keep banknotes handy but in the age of tap-and-go it is largely digital.

A Central Bank Digital Currency (or CBDC) would be a new form of digital currency — but importantly still issued by the central bank.

Unlike cryptocurrency, which has no backing, CBDC would essentially remain a liability of the central bank.

The unit of account is still the currency (so for the RBA still AUD), still legal tender and exchangeable for non-digital currency.

For small retail transactions there seems few immediate benefits. Banks have largely moved to live transfers between accounts, effectively making the payments system instant.

In the US Fed official Christopher Waller recently gave a talk “CBDC – A Solution in Search of a Problem”.

However the RBA could still issue retail CBDC if it was seen as supporting competition and efficiency in the retail sector.

Governments would probably like to get rid of cash — but that is a separate issue.

However, for wholesale transactions a CBDC could be very useful, effectively being part of the blockchain for tokenised assets.

Maybe you might accept Bitcoin when settling your house sale in a blockchain, but I know I would prefer the certainly of an AUD digital currency.

I would also want to know there was still a trusted party ensuring it all ran smoothly.

The Future

The Australian dollar and bond markets are not disappearing.

It is not in the collective interest of citizens to remove these powers from the government. Although far from perfect, the government is the only institution (at least in a democracy) which fundamentally protects the wider interest of society.

Some cryptocurrencies like Bitcoin will no doubt remain a store of wealth. Some like Ethereum, which supports smart contracts and efficient payment systems, will thrive.

The private sector will keep looking into the development of Stablecoins to help transactions, although they are likely to become more regulated around the assets that back them.

However an effective CBDC, backed by blockchain technology for speed and efficiency, could become the dominant digital currency, at least locally.

It wouldn’t be a cryptocurrency as such, given the Central Bank would likely control the ledger rather than a distributed ledger, for control and privacy. And cross-border transactions would still need intermediaries.

Digitalisation would also help finance become more decentralised over time as the use of intermediaries become less important.

It may take time for trust to develop, but in decades ahead it would likely all be second nature.

However, the need to borrow and lend money is as old as time itself — and the need for efficiency in buying and selling loans packaged as bonds will also remain.

The need to be able to assess credit may be helped by innovation but diversification remains an important investment concept.

Would you rather own a slice of a large pool of assets or just one randomly chosen asset?

For example buying a Westpac bond outsources the credit work that financing one individual loan or mortgage would entail.

Add liquidity and credit quality and it means government bonds are not going anywhere.

Though how we trade and settle bonds hopefully will evolve.

About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

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This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at March 3, 2022.

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