Australian bonds – a waiting game.

The rally in global bond markets has extended far beyond many observers’ expectations, with investors seemingly unwilling to allow any retreat from record low yields.

The liquidity glut created by central banks is forcing investors across the spectrum – from reserve managers to life insurance companies – to stretch valuations even further from economic fundamentals. Australian bonds have also been caught up in this yield-grabbing frenzy and, on some valuations, look expensive.

Asian buying has been particularly prevalent, as Japanese insurers look to diversify their large JGB holdings. That said there is no shortage of ‘bond bears’ waiting to challenge the bond market’s recent strength on stronger signals from central banks.

However, we advise caution. Given external vulnerabilities, notably a weaker Chinese economy, and Australia’s own uncertain domestic demand profile, the Reserve Bank of Australia (RBA) is likely to hold rates steady for longer than US and other major central banks. In the central banking world of shifting doves and hawks, a firmly neutral RBA gives welcome refuge for safe-haven flows, and so we continue to prefer Australian bonds on a cross-market basis.

Turning to look at the prospects for economic growth; previous investment in production capacity? should continue to support Australia’s external sector. However, while net exports added substantially to growth in the first half of the year, we expect some moderation going forward. The picture on the housing side is more complex. The contribution of residential construction to the economy remains elevated, as a contraction in mortgage-spreads has given investors and homebuyers access to record-low borrowing rates. Yet the Bank appears to be increasingly monitoring the risks that the buoyant housing market may pose to wider financial stability. Expectations that a bubble in the housing market will lead to higher interest rates in the near term appear wide of the mark however. Instead, the RBA looks likely to focus on macro-prudential tools, including efforts to curb excessive investor finance and reinforce sound lending practices.

There are other factors at play. Specifically, the high exchange rate raises concerns around domestic demand. An elevated Australian dollar will exert downward force on unit labour costs as the lack of external competitiveness forces greater internal competition.

For Australia, the real exchange rate remains significantly overvalued, creating difficulties for trade-sensitive sectors. During 2014, the currency has remained stubbornly high in the face of lower interest rate differentials and declining terms of trade. Nevertheless, like many other central banks, the RBA seems happy to wait for a shift in US Federal Reserve policy to do most of the heavy lifting.

Recent RBA minutes highlight concern around accuracy in economic forecasting, given the unusual global financial and economic environment. Ironically, this can have the effect of bolstering belief in the RBA’s forward guidance, as improving forecasts and official data can be met with a tinge of scepticism, keeping front-end rates firmly anchored.

From a monetary policy perspective, the most likely scenario at present is for the RBA to examine how the mining investment cycle recedes and the non-mining investment cycle recovers. Business investment intentions lend cause for optimism, although the RBA remains wary that ‘animal spirits’ may be lacking.

From a cautiously optimistic stance, we feel it would take a marked deterioration in either economic outlook or inflation to alter the current stable trajectory of monetary policy. If anything, the RBA’s apparent preference for macro-prudential tools in tackling any imbalances in the housing market reinforces our view that policy rates are unlikely to move any time soon.

In a world where central bank liquidity is king, this should be enough for investors in front-end ‘carry’ trades, as the path of least resistance, to continue benefitting. Ten-year Australian yields should pay some lip-service to global bond market developments and the much anticipated sell-off, although for the reasons outlined above we expect further yield compression versus the US.

By Liam O’Donnell – Investment Director, Standard Life Investments

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Mining: How deep is the hole?

Chart 1 shows that mining as a percentage of GDP is at record highs, although it has started to drop off. The rise in mining has resulted not only in mining capex rising as a percentage of GDP spending, but also that total capital spending has been boosted. We know that a sizeable decline in mining investment is approaching, with capex falling. However, the end of the investment phase of the mining boom is going to be partially offset by the increase in net exports as capital imports fall and exports grow, helping to support GDP growth as the production phase begins.

Nevertheless, the transition will entail jobs losses as fewer workers are required for the production phase. In addition, there will be an income shock for those transitioning away from mining since wages will be lower as non-mining jobs tend to pay less.

Exchange rate and interest rate sensitive sectors which have been hurt by the high Australian dollar and relatively high interest rates (such as housing, overseas education, and tourism) need to recover to help offset the drop in mining investment and they must grow to keep unemployment down. Low interest rates are currently helping housing and consumption but we also need a lower Australian dollar for tourism and education.

How does iron ore factor into the story?

The supply of iron ore has lagged the surge in demand for steelmaking in China, which has led to a quadrupling of its price over the past decade. While supply from India and Brazil has continued to lag, seaborne supply from Australia has increased due to production increases by BHP Billiton, Rio Tinto and, more recently, by Fortescue Metals.

Over the past five years, a lack of overseas iron ore supply to Chinese steel mills has meant that steel producers supplemented it with high cost, low quality domestic iron ore. This pushed up the iron ore price, which in turn gave strength to the AUD.

At the start of 2014, the market expected iron ore prices to fall, as has recently been seen, due to the removal of a large portion of this Chinese domestic supply. In addition, the iron ore market should transition from being in a deficit position to a mild surplus due to increased supply, largely from the lower cost producers in Australia, which will also help to subdue prices.

If iron ore prices drop, isn’t it bad news for the AUD?

Not necessarily. Although prices may fall slightly, the increase in volumes that Australia supplies to China should help to prop up the AUD, which in the past had been driven to some extent by the iron ore price (see chart 2). However, we can also note from the chart that the iron price started falling in September 2011 but this had little effect on the AUD.

Will iron ore exports help Australia’s current account position?

Australia has historically experienced current account deficits as the norm. Moving the budget from a deficit to a current account surplus will require, among other things, a shift to a trade surplus. There should be a significant rise in resource export volumes as the mining boom transitions from the investment to the production stage.

Despite the drop in iron ore prices, export values are increasing due to these greater volumes.  This is expected to continue since Australian iron ore is a low cost, high quality product and is replacing current production of high cost, low quality products in other major export markets. As a result, iron ore now represents nearly 30% of Australian total exports measured by value (see chart 3).

This added around 0.5% to December quarter 2013 GDP growth as the balance of trade went from a deficit to a surplus. The trade account has been largely in surplus from 2008-2012 due to the impact of higher terms of trade. Although the terms of trade remain high, they have fallen from the peak reached in 2012. However, the trade account has not returned to a deficit, like it did in 2009, because capital imports have fallen and volumes of iron ore exports have increased.

Will a current account surplus be positive for the AUD?

The trade account is likely to remain in surplus as the volume of iron ore exports accelerates. Additionally, this increase is currently offsetting the fall in the iron ore price so we should see the AUD more stable going forward. This impact from iron ore should be compounded as the liquid natural gas (LNG) projects are completed and proceed to the production phase, which should further underpin the currency.

What does this mean for the Australian bonds and the cash rate?

Australian government bonds are currently experiencing sustained low yields due in part to the current economic environment and offshore buying. 10-year bond yields are now sitting at around what we view as the new neutral rate of 4.00%, but 3-year yields remain much lower. In our view, we should expect lower rates for longer, which may keep a lid on yield rises. With the recent budget announcement of a reduction in bond issuance, there may also be a small positive effect on our bond market due to reduced supply.

In our view, the Reserve Bank of Australia (RBA)  is at the end of its easing cycle and our base case is that the RBA will keep rates on hold at 2.50% for some time to allow historically low rates to help the economy rebalance and that the next move in rates will be upwards.

However, the timing of rate hikes will not be as early as in previous easing cycles over the past two decades as the present shock to the economy, with the mining boom shifting from the investment to the production stage, requires low interest rates to help smooth the economy’s transition.

The drag on growth this year and next year from the budget is unlikely to be that great due to the government’s back loading of cuts, but it won’t help a fragile economy that is in the process of transitioning from the mining boom. Infrastructure spending will take a few years to come through and announced job cuts won’t help the unemployment rate.

If the budget measures negatively affect consumer sentiment for a prolonged period, then this could also be a drag on economic growth, as could any strength that it gives to the AUD.  All this is likely to keep the RBA on hold for at least this year and perhaps now for longer than previously expected.

Tyndall has launched Bonding with Income – an information kit which aims to help advisers educate their clients about investing in the asset class. Aimed at financial advisers, the guide explains how bonds work and how fund managers choose which bonds to buy, as well as outlining the risks and rewards of adding an active fixed income manager to an investor’s portfolio. Advisers can earn 3 CPD points towards their professional standards by taking the accompanying online quiz. Visit the Tyndall site to access the Bonding with Income guide and do the CPD quiz.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual.  The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

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The basic argument is that compared to other major countries Australian pension funds have a higher share allocation and a lower bond allocation and that this leaves members exposed should shares plunge. And after shares have underperformed bonds in recent years such concerns resonate. There are several aspects to this debate. Why is the share allocation relatively high? Is now a good time to be thinking about switching into bonds? Is the real issue the underdeveloped corporate bond market?

Share allocations – super versus total wealth
Roughly speaking the Australian superannuation system has about 50% invested in equities and 18% in bonds. The share allocation is higher than that of other major countries and the bond allocation is lower as can be seen in the following table.

While the share allocation in super may be relatively high, this does not appear to be the case if Australian households’ total wealth is looked at. Thanks to a huge allocation to housing, Australians tend to have a much higher allocation to non-financial assets compared to other countries and a relatively low exposure to shares outside of superannuation. As such the total allocation of Australian households to shares as a proportion of total household wealth is not out of line with households in other countries, being above the UK, Japan and Germany but below the US and Canada.

Shares in super
There are several reasons why Australian superannuation funds may have a higher allocation to shares. The first thing to note is over long periods shares provide higher returns than bonds and cash. This can be seen in the next chart which shows that since 1900 Australian shares have returned 11.9% pa compared to 6% pa from bonds.

Similarly the next chart shows that over most rolling ten year periods shares provide higher returns than bonds, and when every so often they don’t the share return usually rebounds.

Second, Australian shares have tended to do better than most over the long term, so the higher allocation to shares which has been biased to Australian shares may have served Australians’ well (notwithstanding poor recent years).

Third, dividend imputation provides a tax boost to the return on Australian shares equal to around 1.5% pa. In a world of relatively low returns where a diversified mix of assets is expected to return around 8% pa, this is quite significant.

Fourth, the government bond market is relatively small thanks to years of budget surpluses and asset sales which have led to a relatively low level of public debt. On average, countries in the OECD have a stock of government bonds equal to around 100% of GDP to invest in. By contrast, in Australia gross public debt is just 24% of GDP which means there is not a lot of public debt to invest in.

Fifth, Australia’s corporate bond market is relatively small as corporates have traditionally relied more on either the share market or banks for funding. And in recent years they have found it easier to issue debt overseas. In fact, this is a key issue because if there were a more developed corporate bond market it would provide a higher return alternative to government bonds with less risk than shares.

Sixth, reflecting its high immigration level and fertility rate, Australia has a relatively younger population compared to Japan and many European countries so as a result a greater proportion of pension fund members can afford to take the longer term horizon necessary for investing in shares. As such it stands to reason that the share allocation might be higher in a country like Australia, than in Germany or Japan.

Finally, and perhaps partly reflecting this, the “default” superannuation system has tended to focus on funds with a 70% allocation to growth assets (including shares & property) and a 30% allocation to defensive assets (mainly bonds and cash). Some superannuation funds adopt a “life stages” approach where the proportion of shares declines with a member’s age. However, many members may not be in a system that offers this so unless they receive advice they may not adjust their growth allocation as they get older.

What is appropriate?
There is no easy answer as to what is the appropriate allocation to shares and bonds. It is essentially a function of age (the younger the member the higher the share allocation), wealth (the wealthier the investor the easier it is for an investor to accept short term volatility so a higher share allocation may be appropriate) and risk tolerance.

There is a case for superannuation funds to invest more in alternatives such as property, infrastructure, private equity and distressed assets to provide some diversification away from a reliance on shares, though it should be recognised that such assets are usually less liquid and more expensive to manage limiting any asset allocation to them.

There is also a strong argument that a better way to manage superannuation funds, particularly for older members with less wealth, may be with a particular return (or outcome) objective over time rather than to manage to a particular benchmark allocation to shares, bonds and other assets.

For these reasons, along with My Super reforms, the ageing population and hopefully the growth of the local corporate bond market it is likely that over time the share allocation in the Australian superannuation system may decline a bit.

Not the best timing
The trouble is that now is not a good time to undertake a structural reweighting from shares towards bonds. Shares have already had several tough years resulting in very poor returns. And at the same time bond yields have plunged to record lows in the US and generational lows in Australia and elsewhere, making it very hard for the strong bond returns of recent years to be repeated. The next chart shows the gap between the grossed up for franking credits dividend yield on Australian shares (ie the annual cash flow investors receive from shares) relative to the 10 year bond yield. The dividend yield has risen relative to the bond yield, with the latter pushing down to levels not seen since the early 1950s.

Putting the period through the GFC aside, the gap between the two has blown out to levels not seen since the 1950s when the post war share boom was getting underway.

With shares offering a 2% or so yield pick up over bonds, they only require modest capital growth to deliver a total return sufficient to cover the extra risk of owning them. At the same time the generational lows in bond yields are at risk of reversing resulting in capital losses for investors in bonds.

Corporate bonds offer a higher yield than government bonds, but their yield advantage over shares has receded. For example, since 1997 A rated Australian corporate debt has yielded an average 1.4% pa more than shares, but yields are now in line. See the next chart.

While average share market returns are likely to remain constrained in the years ahead, relatively low bond yields are likely to mean that shares will provide a relatively better return on a 5 to ten year horizon. So now may not be the best time to undertake a structural shift away from shares to bonds in superannuation funds.

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Over the last year global bonds returned 11.1% and Australian bonds returned 11.4%. Over the last two years they have returned 10% per annum and 8.7% pa respectively. With such strong returns it is worth asking whether they are in a bubble. Our answer is no, but they could certainly be considered poor value and there are much better return opportunities elsewhere.

Generational lows
Despite seeing their sovereign rating downgraded from AAA last year, US 10 year bond yields have fallen to their lowest level on record (based on data dating back to the 1850s). 
 

Australian bond yields are at their lowest level since 1951. 

 
Bond yields in the UK, Japan and Germany are also running around generational lows, if not record lows.

What has driven bond yields so low?
The sharp decline in bond yields from the early 1980s can be largely explained by the shift from a high inflation to a low inflation world. The more recent fall to extreme lows reflects a combination of factors, flowing from the Global Financial Crisis and its aftermath.

• First, sub-par economic growth and benign inflation have further lowered equilibrium levels for bond yields.
• Second, and related to this, market expectations for short term interest rates have been continuously revised down over the last few years. Several central banks have been cutting interest rates again since late last year (eg, the ECB, the RBA and central banks in emerging countries) while the US Federal Reserve, the Bank of England and the Bank of Japan have left interest rates near zero. Furthermore the Fed has indicated that rates are likely to stay near zero at least out to late 2014, after previously indicating out to mid 2013. The historical experience tells us that the longer short term rates stay low, the more likely it is that long term bond yields will converge on them as expectations of future short term rates are revised down. This is exactly what has happened in Japan over the last two decades, particularly during the 1996-98 period. The US, UK and Germany appear to be going through something similar

• Third, the US Federal Reserve and the Bank of England have been actively buying government bonds as part of their quantitative easing programs, which are designed to keep private sector borrowing rates as low as possible and encourage banks to lend. This, and the expectation of more to come following recent comments from the US Federal Reserve, has had the effect of keeping bond yields lower than might otherwise have been the case.
• Fourth, the US Federal Reserve introduced “Operation Twist” which involved selling short term bonds and buying long term bonds in September last year in order to further keep down long term bond yields and hence private sector borrowing costs.
• Finally, safe haven demand for bonds from investors has been boosted in response to the worries last year about another global economic downturn, partly resulting from the intensification of the debt crisis in peripheral European countries. In this regard it’s worth noting that sovereign bonds in perceived core countries have been the best safe haven through recent bouts of share market turmoil. As such they have been in strong demand as a diversifier.

What about Australian bond yields?
Australian long term bond yields are a function of the level of bond yields globally and particularly in the US, expectations regarding short term interest rates as set by the RBA and perceptions regarding the riskiness of Australian government bonds. All of these have been pointing lower recently.

• Global and US bond yields have been falling for the reasons noted above.
• The Reserve Bank started to cut interest rates late last year and is expected to cut further.
• Australia is one of a diminishing group of 11 countries to still have a safe AAA sovereign credit rating. This has resulted in safe haven demand for Australian bonds, subsequently benefiting the Australian dollar.

Not a bubble, but not good value
Given the sound fundamental reasons for bond yields being so low it’s hard to agree they are in a bubble. Similarly, it’s unlikely we will see a big change in many of the fundamental factors that have pushed bond yields down any time soon. The global economic recovery is likely to remain anaemic and fragile for a while yet, global inflation is likely to fall further on the back of high levels of spare capacity, short term interest rates are expected to either remain low or fall further depending on the country, and further quantitative easing is likely in the US, UK and probably Europe. In Australia, the RBA has further easing ahead of it and safe haven demand for Australian bonds may have further to go as more countries are at risk of losing their AAA rating. Given this, it’s hard to get particularly bearish on bonds.

Against this though, bond yields at generational or record lows are poor value. (In the same way shares would be, for example, if dividend yields and earnings yields were at record lows.) Over the long term there is a rough relationship between bond yields and long term nominal economic growth (inflation plus real economic growth). The following table looks at current ten year bond yields relative to our assessment of their long term value based on each countries’ potential long term nominal GDP growth. On this basis, bond yields are well below long term sustainable levels.

Furthermore when bond yields are low, strong returns can only be had if yields fall further. This is what happened last year in Australia, for example, where the 10 year bond yield fell from 5.6% at the start of the year to 3.7% at the end, resulting in roughly 8% of capital growth for investors who held such bonds. Now with Australian bond yields much lower and sub 2% elsewhere, it’s now very hard to see this being repeated, unless there is a complete meltdown in Europe resulting in a return to global recession.

If bond yields track sideways, returns will be no more than current yields, eg, 1.8% in the case of US 10 year bonds and 3.7% in the case of Australian 10 year bonds. Alternatively, if bond yields back up by say just 1%, which will still leave them well below long term fair value measures, investors will suffer roughly a 4% capital loss taking returns negative.

What does this all mean for investors?
Global central banks want to keep bond yields low until a sustainable recovery is clearly underway. This might take some time so it would be premature to bet on a bear market in bonds. Similarly, sovereign bonds are a good diversifier in times of worries about the growth outlook so a core exposure should still be retained given that event risk still remains high regarding the European debt crisis.

However, against this, now is not the time to be boosting core country sovereign bond exposures. They have already rallied hard and the scope for further falls in yields, which would be necessary to provide decent capital growth and hence returns, is limited. By contrast, better medium term return opportunities exist elsewhere for investors:

• Investment grade corporate bonds in Australia are yielding around 6.5% on average.
• Australian listed real estate trusts are yielding around 6.2%.
• Australian shares are yielding 6.3% once franking credits are added in.

With the global growth outlook improving and tail risks associated with a blow up in Europe receding somewhat, the prospects for these assets has improved compared to sovereign bonds in core countries which now have very low yields and hence more constrained return prospects.
Within fixed interest, Australian bonds with their higher yields probably make them better value than global bonds.

So overall, while there is still a strong case to include sovereign bonds in a multi asset portfolio as a diversifier, it makes sense to lighten exposures in favour of assets providing better yields and return prospects.

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Omega has timed the release to capitalise on a renewed interest from institutional investors looking for a high quality investment grade bond portfolio with a stable return profile.  The fund will predominately invest in a combination of Australian government and corporate bonds.

 “Australia is in an enviable fiscal position compared to many other developed nations and Australian government bonds provide an attractive yield, especially on a risk adjusted basis. Australian corporate bonds also compare very favourably to their European and US counterparts, especially in the current market. This gives investors access to increased diversification and higher yields,” said Mathew McCrum, Omega’s Director of Investments. “All in all they carry much lower downside risk than those in almost any other developed country.”

The fund’s diversified portfolio invests in a range of quality Australian corporate, government, semi-government and mortgage backed security bonds, enabling access to issuers such as Rio Tinto, Woodside, BHP, Stockland and ANZ. 

While the domestic bond market is generally dominated by government issued bonds, Mr McCrum stresses the importance of a proactive approach to purchasing securities to avoid the pitfalls of following the herd. 

“It’s important to remember that there are still risks associated with bonds, so simply following the benchmark is inefficient.  At Omega we use a risk-controlled approach specifically controlling return volatility and we undertake a stringent screening process to identify high quality securities for our clients,” said Mr McCrum.

According to Mr McCrum, Australian bonds represent a great opportunity but are currently underrepresented in portfolios.  McCrum says Australians tend to have a total asset allocation to bonds of approximately 13 per cent compared to 50 per cent allocation to shares.  In other developed markets such as the G20 nations, the allocation is around 20-30 per cent.   

With market volatility and demographics of superannuation members migrating from accumulation to retirement phase, investment strategies have shifted focus to defensive assets.  Mr McCrum believes the Australian Bond Fund enables investors to tailor their asset allocation to best suit their investment strategies.

The Australian Bond Fund will be open from 9th September and will start with a $200 million FUM with a view to gradually increase its portfolio size.  The $200m investment into the Australian Bond Fund brings Omega’s total FUM to over $1 billion.

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“For investors, particularly self managed super fund investors holding unallocated cash from super contributions made at financial year end, investing in an actively managed Australian bond fund might be a sensible option for generating income and reducing portfolio volatility,” Mr Dorrian said. “Actively managed bond funds are also flexible compared to term deposits because they can move in and out of debt securities to gain the best returns and there are no break fees.”

PIMCO’s Australian Bond Fund returned 7.48% per annum in the 10 years to June 30, compared to 7.21% per annum for Australian shares (as measured by the S&P/ASX 200 Accumulation Index, which includes dividends).

“The outperformance of the Australian Bond Fund compared to Australian shares is a significant achievement when you consider that bond investors have had a much smoother ride in financial markets than investors in Australian shares,” said Mr Dorrian.

The Australian Bond Fund, and the wider Australian bond market, as measured by the UBS Composite Bond Index, also outperformed Australian shares over five year and three year periods. In the five years to June 30, Australian bonds returned 6.50% per annum versus 2.38% per annum for Australian shares. Over three years, the returns were 8.06% per annum for Australian bonds versus 0.32% per annum for Australian shares.

Regarding global bonds, the pattern was similar, with PIMCO’s Global Bond Fund returning 9.23% per annum over a ten-year period versus -0.14% per annum for global shares (as measured by the MSCI World Accumulation Index, unhedged), with less volatility.

“What is important is that PIMCO’s actively managed bond funds have outperformed share markets and their own benchmarks over the long-term. Bonds diversify portfolios and can provide a differentiated stream of returns in times of market uncertainty and volatility,” Mr Dorrian said.

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