Greg Michel, head of fixed income at INGIM said the global appetite for Australian bonds is likely to continue with investors drawn to current yields of 5% to 6%, outstripping available yields available from global alternatives.

“The Australian economy has proven to be resilient to the effects of the GFC and continues to expand at a robust pace. The bond market has been in a bear market phase since early 2009 and bond yields are now close to long term average levels,” he said.

Global bonds are a different story, and INGIM expects flat to negative returns in 2011.

While the major European economies are expanding strongly, aided largely by a weak currency and accommodative monetary policy, the peripheral Euro markets continue to be held down by the large levels of sovereign debt and associated funding challenges.

“On balance we believe the combination of improving economic growth and high sovereign debt levels will result in Euro bond yields continuing to head higher in 2011,” said Mr Michel.

Credit best performing sub-sector

Turning to fixed income sub-sectors, INGIM said credit is expected to be the best performing assuming the default cycle pans out as expected.  While underlying interest rates will rise, continued credit spread contraction should see credit perform in a relative sense.

“The rally we have seen in credit markets over the past two years has been strong, supported by improving fundamentals and monetary and fiscal stimulus in the economy.  That being said, there is a sense the rally has overshot the fair value mark and there are few catalysts to drive spreads tighter,” INGIM’s head of credit research, Scott Rundell said.

For issuers, Mr Rundell said offshore markets continue to be more competitive than the Australian bond market with some suggesting several large players are demanding unpalatable spread levels.

“It’s relatively easy for investment grade credit to issue long dated loans or bonds into the US market.  New issuance is likely to be low and we expect few first time local issuers in Australia,” he said.

Global government bond yields on rise

Looking to Australian government bonds, INGIM is expecting limited further tightening in monetary policy in 2011 and now expects government bond yields will remain at or near current levels for the rest of the calendar year. Demand for local government bonds will continue to be dominated by offshore investors.

Despite recent geo-political tensions in the Middle East and North Africa, global government bond yields are expected to continue to rise over the medium term.  US government bonds yields are also expected to continue their upward rise as the market prices in the recovery.

“We’re now seeing ongoing evidence of a broad based economic recovery in the US and government bond yields are set to continue to rise through 2011 as the global economic recovery gathers pace,” said Mr Michel.

World issues cause headwinds

Meanwhile European sovereign debt challenges will continue to cause headwinds for fixed income. In particular, forced losses (or ‘haircuts’) on Irish senior bank debt could create contagion risk to other EU banks, causing the cost of bank funding to spike.

“We also advise monitoring changing bank regulatory regimes and structures as they will impact capital flows and the cost of credit in general,” Mr Rundell said.

Other world factors to watch include Chinese growth and demand for raw materials and the impact of recent events in the Middle-East and North Africa on oil prices.

“The management of many global companies may look to appease shareholders who have experienced negligible growth with capital initiatives aimed at increasing their returns. This could also be a negative credit event,” Mr Rundell said.

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