Research Bonds

My fellow equities blogger Sell on News recent excellent post gave an credible rationale on why property has become the No.1 investment option for Australians – purely by default. This post will go over a very “beta” version of an idea I had awhile back in how to arrest the problem of an insufficient base of investment opportunities, particularly for savers/retirees/superannuants. The idea is not designed to bolster the banks deposit base (far from it) but to encourage and support the only industry that I believe will sustain our economic future.

First, I will say at the outset that this idea is somewhat “socialist”. In a (long winded) post on my old blog, I contended that Australians are all at heart, socialist in nature.

The classic phrase “Why doesn’t the government do something about it?!” is testament to that fact. When you even have the Liberal Party (what a misnomer!) advocating a paid parental system, it surely points out this Big Mother bias in our collective wishes.

Second, I don’t have the answer to how this particular idea is implemented at the coal face, I’m not a scientist, nor an engineer: I’ll explain that first before going on to the mechanics of an idea I call “Research Bonds”.

There’s Research and then there’s “Research”
Associate Professor Steve Keen recently posted an excellent expose about the unproductive nature and lack of suitable investment funds in research, particularly the problems at the Australian Research Council (ARC).

In his words (with my emphasis added)

The irony is that this “be careful with our money” attitude ends up ensuring that the money will rarely if ever be used to achieve fundamental progress. If they want ARC funding, academics have to spend literally months each year drafting proposals which are then reviewed by other academics to decide which projects actually get funding. This is inherently a way of ensuring that only ideas that are extensions of currently accepted thought will get funded.

The fallacy in this process is that it flies in the face of how scientific progress occurs–the concept that there are “paradigms” in sciences, that progress involves both work within a paradigm that advances it (“normal science”), and infrequent “paradigm shifts” that constitute a scientific revolution, have literally become cliches of modern speech (they were first developed by Thomas Kuhn, though the scientific area itself has moved on somewhat). Yet the ARC’s funding methods are eminently suited to normal science, and biased against scientific revolutions which are the events that really advance human knowledge.

“The Princess” – my wife – is a former research scientist and can attest to Prof. Keen’s dilemmas. Most research projects are only funded for 3 or maybe 5 years at maximum, and the scientist must submit a full costing and account for everything. It seems prudent, but flies in the face of doing actual scientific work – whereby highly trained and all-to-rare researchers are turned into accountants and bureaucrats, wasting precious time (sometimes up to a third of their 3 year research grant) on this treadmill.

Sometimes grant proposals are gamed so that they are more likely to be approved, which leaves little room for esoteric research or “stochastic fiddling” or what really matters – a long period of time to get actual work done.

Putting these issues aside for now, let’s finally look at my idea.

Bond, Research Bond (version 2).
I propose that the Federal Government raise (i.e sell) “Research Bonds” that have the following features:

  • initial capital supplied by Australian investors (targeted to superannuants (including SMSF and big retail/industry funds) and savers)
  • two tranches – 10 year and 20 year maturities
  • the annual coupon set at or 2% above (for 20 year bonds) the prevailing 10 year Federal government bond (currently approx. 5.5%)
  • the annual coupon is guaranteed and paid by the Federal Government to the investor (i.e is not the fiscal responsibility of the recipient of the funds of the bond)
  • the annual coupon is tax free with no means testing (which means the real rate of return usually exceeds that of a term deposit at a bank or a franked dividend from equity)
  • a market is created for buyers (authorised institutions e.g. CSIRO, university/corporate R&D departments, private equity) to be matched to sellers (the investors), with a PDS style compliance system overseen by ASIC.
  • any project that leads to a commercial venture for development converts the bond into equity (see below)
  • bonds that are converted to equity are then later sold are not subject to capital gains tax
  • at maturity, the bond converts into a standard 10 year Federal government bond (which can then be traded on the market for a capital return)

Debt to Equity
The debt-to-equity conversion is not that complex and is used in financial markets today. The idea is to create a nascent pool of development ideas for private equity/venture capital firms to step in and take a breakthrough research concept or idea and fund its development. The buy-out of that idea would then fund the conversion of the bond into equity.

Problems
The bond effectively becomes a contingent liability for the Federal Government and rightly so accounted that way. In effect the government is taking on a proxy debt – the considerably difference being they do not have to pay it back at the end, just fund the annual coupons.

Such funding could be easily matched by raising the GST to 12 or 15% and/or eliminating negative gearing (an annual $8 billion loss)- a long overdue taxation reform.

Older financial planners may note that the Research Bond closely resembles a short-term Term Allocated Pension (TAP) – which lost their popularity due to the government punishing savers again in the 2007 “Simpler Super” (sic) rules.

Another problem would be the unintended bias whereby underlying funds are allocated to research projects that have a possible commercial (i.e monetary) return, instead of other purely theoretical and esoteric projects that may provide better knowledge and insight – but nothing more.

Other potential problems include the tax-free nature of the bond – it may transpire that some people will use this to their advantage and have zero income from large amounts of capital. I would contend that the whole structure of how we tax investments (e.g term deposits, interest bearing bonds) and speculation (e.g investment property/shares and principal place of residence) is upside down and that this is not a problem. Why do we give capital gains tax concessions to the latter but fully tax (and thereby punish) the former?

Potential and Rationale

  • Channels scarce capital away from unproductive uses (e.g property and share speculation)
  • Allocates long term capital to researchers who can use their time more efficiently
  • Encourages a larger savings pool and a liquid market in interest bearing investments
  • Gives Government legitimacy to reform skewed sections of the tax code (e.g remove tax payable on interest)
  • Expands the sustainable research sector for future commercialisation with possible less reliance on “houses and holes” to drive the economy
  • Provides higher education facilities more flexibility in administration and revenue model (e.g less reliance on foreign students)

My strongest rationale is to provide a more sustainable economic base for the long term prosperity of the country. Sure, we are blessed with natural resources with very large reserves thereof. But at what cost? What has happened to our manufacturing sector? Why is the FIRE (financial, insurance and real estate) sector so large (and inefficient and reliant on external funds)? How can we sustain a tourism/education sector with a seemingly permanent high currency (as a result of the commodities boom)

Australia is a very small player in a big ocean – an increasingly Asian/Pacific ocean with growing, high-tech, highly educated and better structured economies. If we are to compete in the 21st century – even if we triple our immigration (good luck foreign finding professionals who can afford to live in the major capitals) – we will remain a small country. We need to act fast and build industries and technologies that can compete against better capitalised and bigger economies. Providing a strong system of encouraging research, higher education and commercialisation could be one way to achieve this.

Conclusion
As I said, this is just an idea, and I’m sure there’s plenty of flaws and unintended consequences I haven’t thought of (and I’m sure there are brigades of people out there ready to point them out!)

I just find it frustrating that the only type of financial innovation that our bloated FIRE sector can come up with are index futures over a residential property index or shared equity and reverse mortgages, or yep – residential property backed mortgage securities (which seem to be all the rage again. )

Perhaps we can start in a new direction based on engineering and constructing an economy, not selling it.

Comments

  1. Unavailability of sensibly directed research funding is not just an Australian problem – and the argument that “money is in short supply” grows a little thin when at the same time, money is being provided in abundance to often Politically “favoured areas” . In research, this is what leads to “Brain Drains”, where the able (but unwanted) simply up and relocate to where their abilities are both recognised, and funded! A very good (and infamous) example of this is the UK to US migration of higher graduates under Thatcher, and a good reason why the US succeeds – they are able to import useful people, and they consistently recognise their future value, not just the present value.

    In my case in the mid 1980’s I spent 18 months trying to secure funding for a Post. Doc., via all the relevant Government bodies (Sci.& Eng. Res. Council, Ag. & Food Res. Council, Natural Env. Res. Council), all required different, copious and accurate documentation (though ALL were based in the same London Office Block!), and although each application received an alpha award (i.e. should have been funded), none were, owing to “lack of funds availability”. Interestingly, the Arts Council had no such funding constraints (1985 being the year Tracy Emin obtained 2 million Pounds for her famous pile of bricks!), and there was obviously plenty of money in London’s “Square Mile”, with 1 and 2 million pound salaries commonplace.

    The UK situation has not changed materially since then – lots of talk re lack of research funding (as a result of the “Save British Science” campaign), but no significant change. Everyone’s keen on “Applied” research – conveniently forgetting that without basic research there is nothing to “apply”. Same here – uninterested bureaucracy, more interested in harvesting extra $$’s from graduates than providing a solid foundation for future research.

    Is the situation likely to change? No, unless there is a very major upset to our “complacent economy”; if there IS a major upset, it will be then too late, and will we be relegated to a “Johhny-come-lately” trying to attract Overseas research funding? With the recent “aren’t we so clever” attitude shown towards overseas banks and governments by ours – along the lines of “Our Banks are smarter than yours”, and “Our economy’s better than yours”, these overseas economies (which are a lot smarter than the Aussie Govt. likes to think) may well be inclined to turn the tables, and leave us to stew until such time as it is in THEIR financial interests to utilise our (by that time “dirt” cheap”) services and resources!

  2. Excellent post prince

    >The bond effectively becomes a contingent liability for the Federal Government and rightly so accounted that way. In effect the government is taking on a proxy debt – the considerably difference being they do not have to pay it back at the end, just fund the annual coupons.

    That doesn’t sound to different to a government guarantee for banking deposits caused in the most part by over dependence on housing “investment”. I know which one I would be happier to support.

    I actually think that the underlying premise of this could extend beyond research. Something I have discussed previously ( as has Leith ) is that massive taxation return given to people “investing in housing”. I think it is approaching $10 billion/year from memory. There is absolutely no reason why the government cannot incentivise more productive investments in the same way.

  3. Chemical and Process Engineer here, who has a passionate technical entrepreneurial bent…and thinks that more private avenues to funding are a brilliant idea.

    Please, if influential people are reading this blog, let’s get this sort of thing moving, before too many of our good scientific and engineering minds leave the country (or we stop producing the calibre on a large enough scale altogether).

    Stewart

  4. Great post.

    As DE pointed out, $10B is a lot of money to be putting into housing. Forget a carbon tax, they should be putting that money straight into a research pool on an annual basis and encouraging scientists of all fields to be applying for grants. And scientists focusing on solutions to the future pollution and energy crises should be at the front of the line.

  5. Got to agree with Steve Keen 100%.

    No one wants to pay market rates for government interference and inefficiency.

    Get off the gravy trains and push your own barrows. If “Angel investors” or other private funding doen’t want to invest why go to the government and force tax payers to pony up for lifestyle science with no or little benefit to the capital provider.

    Private industry has already been bitten. Once bitten, twice shy. Hence the opinion–R&D- RIPPED OFF AND DEPRESSED.

    Another cohort addicted to OPM-other peoples money.

    “Nothing in the world can take the place of persistence.
    Talent will not; Nothing is more common than unsuccessful men with talent.
    Genius will not; Unrewarded genius is almost a proverb.
    Education will not; The world is full of educated derelicts.
    Persistence and determination alone are omnipotent.
    The slogan “Press On” has solved, and always will solve, the problems of the human race.”
    –Calvin Coolidge.

  6. I’m not convinced aphorisms are really discussion points Seanm – and like economists there is one (on either side of the fence) for every occasion.

    The point the Prince makes is a good one. Currently there is a bucket-load of subsidies for non-productive (and even low-risk) capital. Perhaps some of these dollars can be used to encourage the social good of research based activites.

    I’ve worked in the corporate research sector for a pretty long time, and i’ve seen first hand the challenges technology teams face in getting long-term, speculative capital for high risk research/projects.

    It doesn’t take a macro-wizard to notice what Australia seems determined to pour its new-found fortune into.

  7. Thanks for the support AJ and you hit it on the head.

    Ideologically, I’m no socialist or wealth redistributor (far from it), but I live in a real world.

    Subsidising speculation or mal-investment (e.g cheap houses for low income workers supplied by cheap loans….or insulation schemes etc) is the antithesis of increasing prosperity and productivity.

    I’m not advocating a forced savings scheme here: just a mechanism for savers (particularly those maligned by the harsh superannuation rules) and investors (who need a better choice than bricks and mortar).

    In hindsight, given the term allocated annunity nature (i.e capital returns to zero) I think the bonds should be 20 years in duration, but for allocation on the ground, grants could of any length.

    After a vigorous discussion with The Princess on our nightly walk on the beach, she implored me to make sure any reference to the ARC or a State Government bureaucracy handling the allocation of funds is removed from my idea!

    To which Steve Keen heartily agrees: http://www.debtdeflation.com/blogs/2010/10/26/australian-research-funding/#comment-29282

  8. I like the line of thinking Prince, but i’m unclear on one thing: Debt-to-equity if the research pays off, but zero capital return if there’s no commercial return?

    I wouldn’t think I would put my super into that, as my pay off is either 10 years of interest but loss of capital or 10 years of interest plusequity (granted a large return on my capital). Too much risk of blowing my dough.

    My preferred structure (and i’m completely making it up here) would be a return in line with 10yr gov bonds (no premium), with capital returned/guaranteed by govt at the end of the period, and a debt to equity swap if there’s a commercial return.

    Govt then has to backstop the failed grants but get the successful ones funded by investors (perhaps Govt gets a slice of the upside on these as well?).

    • A very fair point. As I said I’m not 100% sure how to enact such a plan, and your variation would make sense.

      Something like this?
      1. Initial investor provides the capital for the research bond in 2012. Research funded
      2. Govt pays annual coupons
      3A. Term ends in 2022 – no commercial result. Bond converts to a new 10 year government bond (i.e government wears the cost) OR
      3B. Term ends in 2022 – research leads to possible development. Private equity bids for conversion of the bond to an equity share. If initial investor doesn’t want to convert, he gets a new 10 year government bond (like in Option 3A) or he gets shares in the new venture.

      I like it.

      Problems: it means any funds raised NOW are then possible liabilities for the Fed Govt in the future when it could possibly convert into a new Fed Govt 10 year bond.

      But: this is offset by keeping investors happy (and much less risk factor) and pushing that debt into the future (I hate using those words but there you go) and of course, all those nerdy scientists get their research money in between.

      Oh – yeah I would add that the Gov’t gets a slice too, since it is covering the costs. That would be implied in the debt-to-equity conversion (say 10c on the dollar goes to the government?)

      Thanks again Deenominator and others – this is a fun, if perhaps fruitless exercise.

  9. I’ve said it before TP and I’ll say it again, this is a brilliant idea. Nothing frustrates me more than watching so much capital tied up in super going into unproductive pursuits.

    This idea helps reduce research funding problems AND also provides more bond options for the investor (which the Australian market really lacks).

    • Thanks. I’m starting to develop contacts with people in the research community and hopefully we can bring something tangible out of this. Id like to have more time to do so, and as I said before, this is a “free” idea – if anyone wants to run with it, go for it.

      Unfortunately, both sides of politics have an unhealthy obsession with keeping government debt down, and pushing private debt to the moon…its the cynic in me, but I expect the housing vultures will attempt to access super with some schnazzy financial products to boost housing instead of actual real productive investment.