Like many other governments around the world, the Australian Labor government recently extended a lifeline to banks, guaranteeing all cash deposits and offering to guarantee bonds with a maturity of up to five years. So far, Commonwealth Bank of Australia (CBA) is the first and only mover, announcing plans to issue $1.25bn ($826m) in new debt, $750m of which will be government-guaranteed bonds with five-year maturities. However, it will not be the last.
Michael Bush, head of fixed-income research at National Australia Bank, says the market expects other major banks to use the guarantee in the offshore market. He says: “ANZ and Westpac were looking intently at the US market to issue that debt and Macquarie is also said to be considering it.” No announcements have yet been made but Mr Bush is certain further issuance is imminent, saying that he expects more issuance in the new year.
A crowded international market will not deter local lenders, who hope that wider spreads will make their offerings compelling. The swap price itself reflects the government’s risk-free rate and the bank’s credit risk rate. CBA’s guaranteed bonds are, at time of writing, priced at 180 points more than the five-year swap spread of 4.76% for the year, or 4.4% for three years.
Compared to prices elsewhere, those spreads will prove very attractive. In the UK, for example, banks which used the UK government guarantee and issued three-year bonds in October saw spreads of 25 points over swaps.
Many hope that lower fees will help to encourage issuers into the marketplace. The guarantee fee charged to the big four Australian banks by the federal governments is lower than most international jurisdictions. At 70 basis points, the fee makes Australian dollar bond funding cheaper compared to both the 100 points that US institutions have to pay and the higher, variable rates that UK banks have been charged.
Australia is also one of the few countries that offers a five-year guarantee on bonds. While that may not be a big advantage today, it could be next year, says Mr Bush. “The appetite is for three-year bonds, [but] next year, once people are more comfortable with the guarantee, it will be a good differentiator.”
Reward for risk
However, some people question whether the guarantee bonds will end up cannibalising the government’s own debt programme. “It remains to be seen whether people will swap them for their current government holdings; [it] will depend on their price and the subsequent liquidity in the market,” says Roger Bridges, head of fixed interest at Tyndall Investments.
| For some, the reward for risk is too compelling to ignore. Bill Bovingdon, CEO and head of fixed income of Aberdeen Asset Management Australia, says their funds are underweight Commonwealth bonds and overweight corporate and asset-backed securities. It is a move that he puts down to “exceedingly expensive” Commonwealth bonds, and is a bet on where he believes the current 4.25% interest rate will go from here. |
“We have 15% of the average fund invested in asset-backed security or RMBS [residential mortgage-backed securities] and 60% in corporate and supra bonds, with the rest in government bonds,” says Mr Bovingdon. “We made a rallying call to investors just over six months ago, saying we thought bonds was the place to be from an asset allocation view. That was a two-edged strategy because we thought we’d get lower cash rates, and therefore bond rates, as the economy slowed. We think those elements are behind us now, and we think the bulk of those gains have been had.”
Although their composite funds have underperformed against the UBS Composite Index, Mr Bovingdon expects the tide to turn and that institutional clients will begin to reallocate away from their overweight in cash as they face a 5% reinvestment rate.
“We were telling people [earlier] the best time to invest in bonds is when historical returns are low and cash rates are high. Because cash rates will fall, and then bond yields will fall, and they get capital appreciation. Now, the second part of the strategy comes into play as there are once-in-a-lifetime opportunities in high-grade credit spreads which means bonds, especially corporate, can continue to perform well in future,” says Mr Bovingdon.
Other asset management firms are being tempted into the market by similar risk/reward calculations. QIC’s managing director of active management, Susan Buckley, says QIC is also looking to invest in high-grade mortgages and AAA credit in 2009. “Now you get paid 4% over the risk-free rate so you are well rewarded to hold corporate risk,” she says. “Implied default risk is way above any historical experience, if we can choose the credit risk we’re exposed to and we’re comfortable with their probability of defaulting then we can manage it.”
Getting Alpha from Beta
So when the source of ‘beta’ looks more like ‘alpha’ on a risk and reward basis, should the market rethink its definition of fixed interest? Some say it is a portfolio allocation question that is already being reconsidered.
Ashley O’Connor, an asset consultant with Melbourne-based Frontier Asset Management (FAM), says that he is not alone in considering whether corporate bond mandates should be hived off from government bonds and managed as a separate asset class altogether.
FAM provides strategic asset allocation advice to 17 ‘industry’ superannuation funds, with a combined client size of $90bn in funds under management. He acknowledges that the theory remains untested but says that, ideally, clients would re-allocate between 2% and 4% of the fund to be managed by a specialist corporate bond manager, with holding ranges of 4% to 0% allowing them to underweight.
“You would need a specialist manager with the resources to be able to pick those companies that are least likely to default,” says Mr O’Connor, adding that the managers are out there, but it places much greater emphasis on in-house resources, particularly in credit analysis.
At QIC, the credit analyst headcount has grown from two to eight in four years and their roles are more vital than ever, given the uproar surrounding credit rating agencies, admits Ms Buckley.
“Certainly [the rating agencies] have let down many investors. There has been blind faith in credit ratings by some institutions; a false blind faith,” she adds. “Hopefully [the industry] is now taking up that role.”
Asset class revival
Over the past few years, institutional and retail investors alike deserted traditional fixed-interest assets; their defensive qualities were forgotten as lagging returns failed to compete with the growth momentum of other asset classes. But now, even government bonds are playing their part in the asset class revival.
Fund manager Morningstar’s head of adviser research, Anthony Serhan, says that while fixed-income assets have been de-weighted in many investment portfolios in the past three to four years, stellar returns could mark a turning point.
According to Morningstar, Australian bonds are the best performing asset class in the year to November 30, at 13.35%. Once the favourite of fund managers, Australian equities have been decimated with returns of about -39.95%, with lows of -50%.
The dramatic 3% fall in Australian interest rates since September is largely responsible for the rally, steepening the formerly flat yield curve, meaning short-dated bond yields are lower, while capital gains on longer-dated maturity government bonds will continue to climb.
The trend is likely to continue and the market is pricing in interest rates of 3% by early next year as the country teeters on recession, while others predict it to fall even lower. Bill Evans, chief economist for Westpac, recently admitted he had revised his rate forecast from 3.5% to 2.75% by mid-2009.
AMP Capital economist Shane Oliver also predicts a fall. “Either way, that downward trend is placing downward pressure on bond yields, which makes them more attractive,” he says.
Issuance to break drought
The domestic funds management industry in Australia, with approximately $1500bn in funds under management according to analysis firm Rainmaker Information, will also continue to fund the local government bond market. But until recently, even if local or offshore investors had wanted to participate in this rally, a liquid government bond market was wishful thinking.
Historically, the Australian bond market, which comprises primarily of Commonwealth government securities (CGS), semi- government securities (semis), corporate bonds and asset-backed securities – which includes RMBS, has waxed and waned.
In 2003, amid a long drought in issuance and doubts about the ongoing viability of an Australian sovereign debt market, the Federal government made a guarantee to prop up the market with a budgetary allocation of $50bn in CGS issuance that has been honoured by successive governments since.
Already this year, the Labor government has added $5bn a year to its annual issuance. As it looks to fund the fiscal and stimulus packages, it is expected to announce more next year. It is a small but sure sign of things to come.
| Debt-besieged Australian states are also actively participating. Stephen Knight, CEO of Australia’s second largest semi-government bond issuer, New South Wales Treasury Corporation, claims greater demand from offshore investors, rather than ballooning state debt estimated at a $917m budgetary deficit for 2008/09, is what is driving a $10bn increase in its annual issuance. |
“All governments in Australia are going through a period where there are now significant capital works programmes, so we are issuing more debt,” says Mr Knight. “As the government was continuously recording surpluses, our bonds on issue from the mid-1990s to two years ago was fairly static at $30bn. Now, it is up to $40bn.”
That increase, along with the decision to issue new consumer price index-linked bonds last year to domestic investors, was met with enthusiasm, “because there is good liquidity in our government and semi-government market”, says Mr Knight.
Government stimulus
The prospect of now buying semi-bonds, tax-free, should serve as a lure for international fixed-interest investors shopping around. In a bid to grow international participation, the Australian government has extended a tax break normally restricted to the domestic market to foreign investors, passing a bill to abolish the 10% interest withholding tax on domestically issued semis.
Concerns about the future strength of the US dollar and the pressure that mounting debt will place on US treasuries, may present a further opportunity for Australian dollar bonds. International central banks and institutions are rumoured to be seeking more diversity in currency and foreign debt reserves.
According to a recent Reuters report, academics and some policymakers in Beijing are worried that the value of China’s holdings of US treasury bonds are vulnerable to a sharp sell-off in the US dollar and are warning that they should diversify their risk. The Chinese government holds more than 60% of its $2000bn of reserves in dollar assets, with a sizable amount in debt issued by the Treasury and troubled mortgage lenders Fannie Mae and Freddie Mac, both effectively government-owned.
Mr Knight says that desire for foreign reserve diversity generates much offshore business. “There has been a trend in recent years for central banks to accumulate foreign currency reserves. They have primarily held a large proportion of those reserves in US treasuries but increasingly they now look at the sovereign debt of different currencies. The reasons mainly come down to foreign reserve management and to diversify their risk,” he says.
Hazard or opportunity?
However, there are challenges ahead for the Australian bond market, particularly for overseas investors. Whether investing in corporate or government and semi bonds, offshore investors will have to carefully manage the volatile movement of the Australian dollar.
Until recently, Australia was a ‘high-coupon currency’ relative to the rest of the world, with interest rates of about 7% to 8%. That was very attractive for Japanese investors, in particular, struggling with domestic rates of about 0%. But as a proxy for commodity currencies, the Australian dollar has seen a dramatic reversal in its fortunes in the latter part of this year, translating into huge losses for unhedged investors.
In October, the Australian dollar fell by 34% against the yen and 26% versus the US dollar as global markets sold off ‘riskier’ currencies and commodities. Japanese investors, traditionally unhedged against currency moves, were the hardest hit.
“Coming from such a low cash rate, [they] were getting good returns on Australian dollar bonds before the fall in the Australian dollar, now it has come off a bit, and they would have suffered heavy losses when it fell,” says Tyndall Investments’ Mr Bridges.
Richard Borysiewicz, CEO of Credit Agricole Asset Management Australia, says the best way around the currency volatility is to invest in Australian dollar bond futures; this is a more “efficient” strategy, he says.
However, where there is risk there is also return, and a lower Australian dollar also represents better buying opportunities for offshore investors.
Richard Grace, chief currency strategist at the CBA, says that once global appetite has recovered, investors prepared to buy and hold bonds its maturity should find attractive opportunities to pick up cheaper, AAA rated bonds.
Mr Grace says: “If investors maintain a positive outlook for the Australian economy and are not so damaged by global events that they are not buying anything, then they can pick up good yields and return on capital gains both from the depreciating currency and as the bond reaches maturity.”
