The world’s largest bond manager, PIMCO, has forecast a positive investment outlook for Australia, due to its fiscal and monetary policy flexibility and its relatively clean banking sector, which differentiates it from most of its developed world peers. This comparative advantage is set to continue and in this climate quality Residential Mortgage Backed Securities (RMBS) stand out as offering attractive relative value, according to Rob Mead, PIMCO Head of Portfolio Management, in the fund manager’s 6-12 month cyclical outlook.

“The comparative advantage between Australia and its developed world peers has been enhanced over time, especially as fiscal positions in the developed world are forecast to diverge further, with Australia expected to be comparatively better off,” Mr Mead said.

As a result, Australia has presented more of a credit opportunity than an interest rate opportunity for most of 2010, and only recently have opportunities reappeared in Australia’s interest rate structure, he said.

“Having already raised rates by 150 basis points (1.5%) since the crisis lows, the Reserve Bank of Australia retains its mild hawkish tone.

“PIMCO continues to believe the RBA will raise rates towards 5%, implying a tightening bias, versus a New Normal neutral rate expectation, which would be approximately 4.75%. However, with the Australian dollar trading close to parity with the US dollar, near-term pressure for the RBA action is reduced slightly,” Mr Mead said.

“As global credit markets have rallied strongly, carefully selected Australian residential mortgage backed securities continue to stand out as offering potential attractive relative value, especially when considering the majority of Australian RMBS naturally de-leverage over time and are self liquidating as mortgages are paid down.”

“While some commentators have claimed Australian housing has become a bubble, various RMBS features provide downside risk mitigation against potential house price volatility. In particular, increased subordination on current vintage RMBS securities provides a cushion for investors while declining loan to value ratios in older vintage RMBS securities provides further protection,” Mr Mead said.

Advice for investors

Mr Mead said investors should look to generate real investment returns with manageable levels of risk using active management.

“Given the RBA’s inflation management credibility, which has realised a CPI rate of approximately 2.5% for the past 15 years, Australian investors have an excellent opportunity in the current markets to earn real (net of inflation) returns of 3%-4% via Australian bonds or global bonds hedged to Australian dollars.

The investment landscape is also expected to remain volatile, which provides active managers with significant opportunities to obtain alpha for investors through both top down and bottom up drivers.

“Investing passively in this environment or with too narrow a focus could result in lower return expectations,” Mr Mead said.

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