How long will this unique investment environment last?

The prospect of rising US interest rates…

President-elect Donald Trump’s bullish fiscal stimulus plan has seen US real interest rates rise, relative to other G10 countries.

While fiscal expansion is obviously negative for long bond yields, it also raises the prospect of a more hawkish US Federal Reserve.

This has resulted in higher US bond yields, relative to other countries, and a strong US dollar.
 

Chart 1: Rising US dollar and relative 10-year bond yields

…has driven the US dollar and inflation pricing higher…

Fiscal expansion, at a time when the US economy seems to have reduced much of its slack, has seen markets pricing in a rise in inflation. This has driven up real and nominal bond rates.

Interestingly, the pricing of expected five-year inflation in five years’ time has separated from its long-term relationship with the US dollar.

Does this mean bond rates have gone too far?
 

Chart 2: US dollar and US inflation are no longer linked

…with commodities rising around the world…

Although it has happened previously, there remains a question as to whether commodity prices can rise against a higher US dollar, even if the higher US dollar is due to a more hawkish US Federal Reserve.

In the past, a stronger US dollar signals tighter financial conditions which has caused commodity prices to fall.

This has hurt emerging market countries and those companies with large borrowing requirements, especially if these are in US dollars.

The rise in commodity prices this time around, especially metals, reflects optimism around US election promises for increased infrastructure spending.

The question is, can this optimism outweigh tighter US dollar conditions?
 

Chart 3: Commodities are rising, despite a strong US dollar

…especially metals in Australia…

A rise in the US dollar has kept Australia’s Trade Weighted Index steady, despite a massive jump in Australian commodity prices, especially coal and iron ore.

This should allow the Reserve Bank to keep interest rates on hold.

This is a reversal from the situation in 2012, which saw the Australian economy badly hurt by an Australian dollar that was too strong, and only belatedly reacted to falling commodity prices.

If commodities, especially metals, continue to not react to a stronger US dollar, then concerns that inflation may be rising should remain.
 

Chart 4: Australian commodity prices continue to rise

…as inflation starts to rise again in China.

A rise in Chinese inflation, as measured by its Producer Price Index, could suggest that the recent deflationary scare may have passed.

Could the threat of deflation even return, given we now have a stronger US dollar and a more aggressive US Federal Reserve?

Are investors and the bond market turning too quickly, thinking that rising inflation in China is about to return?

Or can commodities keep going?
 

Chart 5: Strong Chinese demand for Australian commodities

What this means for investors

Commodity prices (especially metals) are rising strongly in an environment where, previously, they would be stable, or even falling.

The change in several historical price relationships (such as the US dollar and commodities) has created a unique investment environment.

Is optimism around the US President-elect’s fiscal expansion masking the true deflationary picture?

We would suggest it has, and will continue to monitor the situation closely.

By Roger Bridges, Global Rates & Currencies Strategist

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Disclaimer: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material 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, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any economic or market forecasts are not guaranteed. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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Weakness in the economy has seen the Reserve Bank of Australia (RBA) slash interest rates over the past few years, leading to a plunge in term deposit rates. Although this has also had the effect of dragging down bond yields and thus making bonds more expensive, we believe they are still likely to outperform cash, particularly if the cash rate keeps falling. Given the current economic environment both globally and domestically, the cash rate is likely to remain lower for longer. As a result, Australian investors may want to reassess their low exposure to fixed income.

Bond yields historically low and likely to remain so for a while

The cash rate fell to 1.75% in May, down from 2.5% in 2014. Australian bonds have followed the cash rate down and are currently sitting just above historical lows in yields. However, as chart 1 shows, despite the fall in bond yields, the Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) and the 10-year government bond are currently providing a yield of around 50 basis points (bps) above cash. This looks fair value in historical terms; in contrast, the 2015 rate cuts reduced the spread of bond yields over cash down to zero.

One factor that many investors have been wary of over recent years is the US Federal Reserve (Fed). Many believe that if the Fed tightens rates, as they did in December 2015, it could lead to a rise in global bond rates – and Australia would not be immune. However, negative interest rate policies and quantitative easing (QE) in Europe and Japan are driving global bond markets at the moment more than the Fed. Japanese and German savers are searching for yield in bond markets outside of their home countries and particularly in the US (see chart 2). This is keeping a lid on US and global bond rates and raises the question of whether the Fed still has the same control as it once did over the US Treasury market.

What will happen to the Australian cash rate?

The rate cut in May was largely due to a surprise fall in inflation, particularly in the non-tradable components of the index, which reflects domestically created inflation and is not subject to the vagaries of currency movements (see chart 3). Domestic inflation is mainly driven by wages and we are seeing historically low growth rates, implying that we could see further falls in inflation from domestic sources. This was compounded by the fact that the Australian dollar had strengthened prior to the rate cut due to a speculative rebound in the iron ore price and the fact a more dovish Fed had led to a weaker US dollar.

Since the May cut, iron ore prices have fallen and the Fed’s more hawkish rhetoric has fuelled the US dollar, allowing the Australian dollar to depreciate. This may relieve some of the pressure on the RBA to cut again quickly and we expect that the bank will wait until August when they will get the next read on the inflation picture and to see if the Fed further assists a decline in the US dollar by raising rates in the interim. Even so, it is unlikely the RBA will remove its easing bias and we don’t expect the market to stop pricing in further rate cuts. With rising concerns around settlement issues on multi-unit developments and the fall in total hours worked, we believe another rate cut is likely even if the Fed tightens and/or non-tradable CPI growth stabilises.

Bonds may be expensive, but are still likely to outperform cash

Australian bond rates are currently quite low, but so is the cash rate and bonds are providing a historically fair value for investors compared with cash investments. There is a risk of another ‘Bund tantrum’, when German Bunds sold off for no apparent reason in 2015, or the US Treasury market could react negatively to the Fed if it raises rates. However, these are likely to be short-term events that could actually provide investors with a good opportunity to buy bonds at higher rates. The fact is that Australian bonds remain well priced to cash and since we believe that the official cash rate is highly likely to move lower, this provides an extra incentive to consider a fixed income allocation over a cash allocation.

By Roger Bridges, Global Rates & Currencies Strategist, Nikko AM

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Important Information: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material 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, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any economic or market forecasts are not guaranteed. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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Dark days ahead for Greece.

In Sunday’s referendum, the Greek populace overwhelming voted to reject the terms of the programme for reform and fiscal adjustment put forward by the European Commission, European Central Bank (ECB) and the International Monetary Fund (IMF). Greece now risks a banking collapse and a potential exit from the Euro.

Although the current situation is causing some market volatility, it is not as much as the amount of media attention might suggest. It is worth noting that Greece is a small economy, representing only 1.3% of GDP in the European Union. In our view, although whatever happens will be painful for the Greek people, it is unlikely to have a severe longer-term impact on Europe or global markets.

Greece – more pain to come

The Greeks may feel that they have made their point by rejecting the European notion of austerity, but this is likely to be at a significant cost. This is most likely to be felt though a continuation of capital controls and a closed banking system as the ECB feels less able to provide assistance and emergency liquidity assistance (ELA) remains frozen. In fact, the ECB could request additional collateral from Greek banks to cover the risk of losses on the emergency lending it’s already provided, which the banks are in no position to do.

If capital controls remain, it will seriously threaten the whole economy, including Greece’s most important industry – tourism. In addition, it will increase the number of nonperforming loans from individuals and businesses, further damaging Greece’s banks and financial system. In order to remove capital controls, depositors need to feel that the Greek banking system is safe enough to start returning their deposits. However, that would require depositors to be confident that ‘Grexit’ was a remote possibility. Unfortunately, the weekend’s ‘No’ vote makes ‘Grexit’ much more likely and perhaps even unavoidable. If nothing else, result will harden the negotiating stance of both sides, potentially rendering any attempt at a deal impossible as the level of trust on both sides disappears. One thing that does seem certain is that Greece has further hardship to come.

Europe – threat of contagion much lower than in 2011/2012

Financial contagion in Europe has been mitigated by three main factors since the ‘Grexit’ threat of 2011/2012. Greek debt is now in public rather than private hands (mostly European sovereign creditors), so financial contagion via the banking system is a low probability. The ECB’s quantitative easing programme is helping to support European markets and avoid the deflationary forces that have been plaguing the Eurozone. US and European economies are in better shape than they were in 2011 so a ‘Grexit’ and default is now likely to be more contained than before.

One of the biggest threats to Europe is if this vote encourages anti-austerity and Eurosceptic parties in other nations, such as Italy, Spain, France and Portugal. In the short term, the European economy and budget deficits are improving and the need for increased austerity is declining, which should weaken anti-austerity parties. However, if Greece leaves the Euro, it means that any country could potentially leave a single currency that was intended to be permanent and unbreakable. As a result, it is likely to have a destabilising effect – when any member country is in economic distress in future, it will raise speculation about a possible Euro exit.

Global markets should prove resilient to Greek crisis

Unsurprisingly, the initial market reaction to the ‘No’ vote was for the ‘risk-off’ trade to return. There is likely to be some volatility over the coming weeks while Greece’s future remains uncertain. However, unlike in 2011/2012, markets have proven to be fairly resilient to negative news from Greece in recent weeks and we expect this to continue.

In terms of the US, the economy is on a more sustainable path than it was in 2011/2012 and the risk of contagion is much reduced. As a result, we still envisage the US Federal Reserve starting to lift rates in September although this will very much depend on how the US dollar behaves. If the Greek crisis causes the US dollar to strengthen significantly, then this could slow down the pace of rate tightening, which would support the US bond market.

 By Roger Bridges, Global Rates & Currencies Strategist

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Disclaimer: This material is issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (Nikko AM Australia). The information contained in this material 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, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. The graphs, figures, etc., contained in this material include either past or backdated data, and make no promise of future investment returns, etc. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.

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Roger Bridges, based in Sydney, has been named Global Rates and Currencies Strategist; Andre Severino, based in London, has been named Head of Fixed Income for the U.S. and Europe, and John Vail, currently Chief Global Strategist, will be leading the company’s global investment committee process and thought leadership effort after relocating to New York from Tokyo in November.

“In response to the growing needs of our clients, building out our global investment capability has been a priority for us over the past year,” said Yu-Ming Wang, Global Head of Investment of the Tokyo-based asset manager. “We have brought on highly talented individuals and teams from outside the firm, and now we areappointing some of our most experienced individuals to lead areas that will be increasingly important to us going forward.”

Roger Bridges joined the firm in 1998 and has most recently been responsible for providing macroeconomic research and strategic direction to the Nikko Asset Management Australia fixed income team. In his new role, Roger will be the chief global strategist for interest rates and currencies, working closely with the Global Investment Committee on macro and market target views. He will be the main spokesperson for rates and currencies at the company.

Andre Severino joined Nikko Asset Management in New York in 2007, and most recently has been serving as Acting CIO for Europe. In addition, he is Senior Portfolio Manager of the firm’s multi-billion-dollar sovereign fixed income series.  Andre’s position has been expanded to include heading the firm’s fixed income teams in Europe and the U.S., and he will also join the team managing global macro strategies.

John Vail has been with Nikko Asset Management since 2006, and serves as Chief Global Strategist, in addition to leading the Global Investment Committee and several investment forums within the company. Nikko Asset Management is taking steps to deliver its strategic insights within a single, global thought-leadership solution, and John will lead this effort upon relocating to New York from Tokyo in November.

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However, the returns on fixed income have actually been superior to the returns on term deposits over the past 10 years. Given the current economic environment both globally and domestically, cash rates are likely to remain lower for longer, which should keep bond prices higher and term deposit rates lower. As a result, Australian investors may want to reassess their low exposure to fixed income. 

Q: Is Australia unusual in its preference for cash vs fixed income?

A: The simple answer is yes. Historically, Australian investors have preferred cash rather than fixed income as the default position for the defensive asset holding in their investment portfolios. Although US investors have held around the same amount of equities as an Australian investor, instead of cash they held more of their portfolios in fixed income.

Pension Fund Asset Allocation in Selected OECD Countries, 2012

 Source: OECD Global Pension Statistics

The “Other” category includes loans, land and buildings, unallocated insurance contracts, hedge funds, private equity funds, structured products, other mutual funds (i.e. not invested in cash, bills and bonds, shares or land and buildings) and other investments.

For Australia, Source: Australian Bureau of Statistics. The high value for the “Other” category is driven mainly by net equity of pension life office reserves (14% of total investment).
For Canada, the high value for the “Other” category is driven mainly by other investments of mutual funds (15% of total investment).
For Japan, Source: Bank of Japan. The high value for the “Other” category is driven mainly by accounts payable and receivable (22% of total investment) and outward investments in securities (21% of total investment).

For Germany, the high value for the “Other” category is driven mainly by loans (18% of total investment) and other investments of mutual funds (17% of total investment).

 Q: What are the reasons for this disparity?

A: It is partly due to a lack of familiarity with fixed income in the Australian market and partly because historically Australian cash rates were high, leaving very little premium between the cash rate and the yield on the 10-year bond. By contrast, US investors historically have been paid to hold 10-year bonds and so have been incentivised to hold long duration assets.

Q: What was the effect on Australian investors of holding cash rather than fixed income?

A: Given the high yields available on Australian term deposits, the decision to hold them rather than bonds may be seen as rational and appropriate in a high inflation environment. However, such  investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. This particularly came to light in the GFC when equity prices collapsed and many Australian investors had no fixed income exposure to offset the negative returns from equities. In fact, as cash rates fell to help stabilise the economy, cash holdings performed poorly compared with fixed income.

Q: What’s the difference in long-term returns between fixed income and term deposits?

A: The returns on fixed income have surpassed term deposits over the longer term despite the fact the Australian yield curve has been so flat over the past 10 years.  Although investors in cash believed they were investing in an asset class which was offering higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds. When choosing where to allocate funds, it seems that investors are more concerned about ex ante returns than the returns they would have got from an asset class they don’t own.

Bonds outperform term deposits over the long term

Source: Mercer Insight; RBA (data reference: FRDIRBTD10KAR)

Dividends and distributions are reinvested. Returns are gross (pre fees, pre tax) and assume reinvestment of distributions.
*Term deposit return is the average rate on $10,000 term deposits across all terms at the five largest banks, including their advertised ‘specials’ and regular rates (using the monthly effective rate)

Q: Will we see domestic investors looking more closely at fixed income for their liquid or defensive asset class holdings?

In our view, they should but the problem is that investors are still scared off by the fact that bond markets have had a 20-year rally and rates must return to their normal levels from the current historically low yields.

Bond markets have had a 20-year rally in Australia and this has been due to the fact the neutral rate for cash has fallen as inflation has fallen. The Reserve Bank of Australia (RBA) has an inflation target of 2-3%. The success of the RBA in achieving its target has resulted in the financial market viewing it as credible. Since longer-term bonds use this as a realistic inflation level, it has lowered the risk premium around future inflation levels helping to lower bond yields and raise prices.

Q: Bond yields are historically low: is this likely to continue?

A: Central banks globally have intervened to lower bond rates. They could not cut cash rates below zero and so embarked on unconventional policies, such as quantitative easing (QE) to help repair their economies. QE has depressed real rates and term premiums globally. Many of these programmes have stopped or are being tapered. In 2013, US rates rose by 100 bps on the back of the Federal Reserve’s tapering of QE. However, the Fed still holds a vast quantity of fixed income securities on its balance sheet. This is not just holding up bond prices (therefore keeping yields low) but also bolstering all risky assets, including equities.  While QE persists, bond yields will remain depressed.

As we have stated previously, Tyndall views the new neutral rate for cash as being around 4.0%, which would imply a normal rate for the 10-year bond yield of around 5.0% (100 bps above its current level of 4.0%).  With the cash rate at 2.5%, even the current low bond yields are still providing a better return than cash.

Q: What will be the impact on Australia of lower rates for longer?

Australia’s household debt to disposable income is at record highs at around 148%[1]. With the decline in the terms of trade, low wages and low returns, income growth will remain low. As a result, monetary policy will have a stronger impact on the economy and won’t require large increases in interest rates to have the desired effect on the economy as we have seen in previous cycles. With cash rates low and likely to remain low and term deposit rates falling, Australian investors may start considering increasing their exposure to fixed income.

The risk of being so underinvested is a major one that is often ignored and leaves investors exposed not only to a potential fall in the cash rate but also the current low interest rate environment.  Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of low inflation and the inability of central banks to adequately deal with it also warrants an allocation to bonds, in our opinion.

[1] Source: Reserve Bank of Australia, table E2, http://www.rba.gov.au/statistics/tables/index.html.

By Roger Bridges, Head of Fixed Income Strategy, Tyndall AM

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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.

The Tyndall Australian Bond Fund (ARSN 098 736 255) is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL 229664, a related entity of Tyndall AM.  Potential investors should obtain their own independent advice and consider the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.

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Assessing risk is one of the key factors in the investment process since every investment involves some level of risk. Most investors consider medium to high probability risks when making their investment choices. Low probability risks tend, perhaps understandably, to garner less attention. However, in our view, considering the impact of a variety of risks is crucial for effective risk management. It is important not only to consider high probability risks, but also low probability ones, especially where they would have a serious negative impact. This is a lesson that many investors learned when the GFC occurred and they were taken unawares.

Bonds have started to fall out of favour as investors are worrying about the end of the bond rally and rising interest rates in the medium term. However, were a low probability, high impact risk to occur, then it’s important to maintain an allocation to bonds in a diversified portfolio. If investors had had a higher allocation to traditional defensive Australian fixed income funds during the GFC, their portfolios may have been better protected. Fixed income provides superior volatility-adjusted returns (return per unit of risk) than equities, which has benefited fixed income investors during economic downturns.

In this paper, we discuss three low probability, high impact risks that Tyndall AM has been factoring into its thinking about the global macroeconomic landscape. We emphasise that we believe these events are unlikely to occur, but that the fallout if they did could be extremely severe. In such a situation, the portion of an investor’s portfolio allocated to bonds could help cushion the overall portfolio losses on the equity portion.

Is there a Canadian housing bubble and what would happen if it pops?

Interest rates across the world are at record lows and major central banks are indulging in huge quantitative easing (QE) policies. This has created a large amount of money that needs to be deployed. Following the GFC, banks globally have been reluctant to lend, particularly to small and medium-sized businesses. However, in some countries that came through the GFC relatively unscathed, banks have been willing to lend to individuals, in particular to invest in real estate.

In Canada, the household debt to GDP ratio has been steadily rising, such that it now stands at almost 100% of GDP (see chart 1). According to the World Bank, the increase in this ratio since 2006 has been faster in Canada than any other country.

This phenomenon seems to be driven heavily by mortgage borrowing, which would explain the hefty rise in house prices over the same period (see chart 2).

Countries that suffered severe housing market over-pricing in the lead up to the GFC, such as the US and Ireland, saw a strong correction and haven’t recovered much since then. As a result, those countries are now slightly undervalued. Countries that weathered the GFC more successfully are now the ones facing potential housing bubbles. As chart 3 shows, Canada was second only to Norway in that list as of the end of 2012 and Canada’s house prices are more than 60% higher than their long-term average. The Organisation for Economic Co-operation and Development (OECD) has ranked Canada as one of the countries most at risk of a price correction, especially if borrowing costs increase or income growth slows.

Due to its well-regulated financial system and fairly solid banks, Canada has been seen as a relative safe-haven following the GFC, attracting significant foreign capital inflows. Former Governor of the Bank of Canada (now Governor of the Bank of England), Mark Carney sounded the warning bell over using these foreign capital inflows to inflate the housing market rather than putting it towards business initiatives. He said that it was like a film that has “just played in a major cinema just south of here, over and over and over again, and it would be the height of folly to repeat those mistakes.” 1

Construction projects are booming in response to demand from investors and home buyers taking advantage of record low interest rates. But analysts are warning that Canada’s housing market is due for a correction due to this overbuilding, as well as overvaluation and excessive household debt. The Bank of Canada recently noted: “The elevated level of household debt and stretched valuations in some segments of the housing market remain an important downside risk to the Canadian economy.” 2

The immediate impact of a major housing market correction would be on the Canadian banking system. However,

Canada’s banks remain relatively strong and although a slump in the housing market could create difficulties for the smaller banks, it is unlikely to have the same deadly impact in Canada as the slump in Irish property had on banks in Ireland. In addition, although Canadian banks extend globally, especially into Latin America and Asia, they are still minor players compared with major US or European banks so the knock-on effects would be more muted.

For Australian banks, the direct impact would likely be limited given that their exposure to Canadian banks is relatively low. However, the similarities between Canada and Australia could cause a severe weakening of sentiment towards Australian banks if their Canadian counterparts were to stumble. In such a case, the Australian banks’ dependency on offshore funding for a substantial part of their balance sheet could become a pressure point and the cost of funding could become elevated. Although it’s unlikely that this alone would be sufficient to cause major disruption in the Australian banking system, it could affect the credit spreads on the banks’ bonds and lead them to underperform for some time.

What are the downside risks for China?

China’s economy is no longer seeing the stellar growth that it had become accustomed to. The consensus view is that the country is unlikely to suffer a hard landing. While this is the most likely scenario, there are several issues about China that concern us: its shadow banking system, the extent and size of which is staggering; property prices in the major urban centres, which are displaying bubble-like conditions; and local government debt levels.

Shadow banks issue liabilities and hold assets, much like normal banks. However, unlike banks they lack an official lender of last resort. The International Monetary Fund (IMF) has pointed out that “a fast-growing share of credit is flowing through the less-well-supervised parts of the financial system.” 3   In fact, JP Morgan Chase & Co. estimates that from 2010 to 2012, shadow lending doubled to an estimated 36 trillion yuan or about 69% of China’s GDP. 4 The vast proportion of shadow banks’ business involves wealth management products (WMPs), which raise money from investors in large increments and for short periods. The problem with WMPs is that they have a potentially risky duration mismatch with the long-term underlying illiquid assets (such as property) they are secured against. The other issue is that those assets are not usually disclosed to investors so that they have no idea what they’re investing in. Often the banks repay maturing WMPs using money raised from new WMPs, which creates huge risk if the underlying assets were to perform poorly or default.

Another concern with shadow banks is that they are deeply intertwined with the commercial banks, which means there could be a knock-on effect if any of them fail. Shadow banks have sprung up because of the official policy of financial repression, where interest rates have been held at artificially low levels for a very long period to enable banks to keep lending to enterprises and governments, especially those engaged in building infrastructure. This drives Chinese households into WMPs in search of yield above the sub-inflation rates they are offered on bank deposits. The problem is that if enough of the riskier WMPs fail, investors might stop buying new products. Given the short-term nature of the WMPs vs. the long-term nature of the underlying assets, it could lead to a credit crunch on otherwise solvent projects.

The housing bubble issue is related to that same search for yield. China has very few investment vehicles on offer and real estate is one of those few. Prices continue to rise as a result, particularly in the larger cities, such as Shanghai, Shenzhen and Beijing. However, the pace of building may be starting to outstrip sales, particularly outside the larger cities where there is a growing stock of completed but unsold homes. The government has tried to curb this appetite for real estate, but with economic growth weakening it can’t risk leaning on the housing market too hard while it remains an engine for growth. Another concern is how indebted the property developers are, which makes them vulnerable to any downturn.

In December 2013, China announced the results of a debt audit on local governments, which included contingent liabilities and debt guarantees. The audit revealed that liabilities of local governments totalled 17.9 trillion yuan as of the end of June, compared with 10.7 trillion yuan as of the end of 2010, a 67% increase.5 Local authorities have been using debt to fuel growth, channelling money into infrastructure projects, some which may not have been particularly viable. However, given that the debt is almost all denominated in the domestic currency (yuan) and owned domestically, the central bank can prevent a crisis by deploying its unlimited liquidity supply.

The Chinese government realises that growth via such an investment-based economy is unsustainable. As a result, it is attempting to shift growth away from fixed asset investment towards domestic consumption, but this rebalancing is a delicate task. 2013 has seen repeated bouts of stress in China’s money markets as the government has attempted to tighten monetary conditions and reduce the economy’s reliance on cheap capital. By raising short-term rates and making them more volatile, the government is encouraging banks to stop relying on short-term liabilities in the interbank market to finance risky longer-term assets. Although the government doesn’t want to see a severe cash crunch, a miscalculation is possible if it doesn’t correctly predict the supply of and demand for cash when conducting monetary tightening. China needs to reform its financial sector, rein in government debt and increase consumer spending all at the same time – not an easy task.

Given how much control authorities have over the economy, for a crisis in China to emerge, it would likely be an accident, the result of an underestimation by authorities of the magnitude of one of these three issues and letting it get out of control.  Any resulting slowdown would threaten stable growth in other economies. Australia in particular would be hit extremely hard by a crisis in China, so although such an occurrence might be extremely unlikely, it must be a factor in Australian investors’ thinking.

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Investors looking at their medium-term and long-term investments are currently asking themselves: what is in store for bonds when rates normalise? As central banks’ bold experiment in monetary policy comes to an end and they begin to normalise cash rates, many investors fear possible negative returns on bonds, such as we had in 1994, which is notorious as the year of the great bond rout. Either we will see an orderly bond selloff (with a slow, steady rise in yields) as the central banks successfully manage to exit quantitative easing (QE) without causing market panic, or we may experience a disorderly one if central banks lose control of the process. Another possibility is that there is a selloff caused by inflationary fears. Whichever scenario one subscribes to, the outlook for bonds does look risky.

Obviously with any asset class, investors must ask the question: does the cost of holding bonds outweigh the benefits of holding bonds? In our view, the answer is no. Bonds remain an important component of a portfolio: even in a rising cash rate environment, diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns, diversify risk and reduce overall volatility. The approach should not be to avoid or sell out of bonds, but to look at the types of bonds in a portfolio and to adopt a flexible, active approach that helps cushion the bond portfolio against rising rates.

Bonds are the only truly defensive asset

Over the past few decades, Australian investors have largely ignored fixed income investments, preferring cash or term deposits as the defensive assets in their portfolios. Although they believed they were investing in asset classes which were getting higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds.

In addition, these investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. Although bonds don’t generally deliver the high returns that equities do, holding them in addition

to equities should decrease the risk in a portfolio. In market environments when equities are performing poorly, the bond holding can help to offset losses on the equity portion. So it’s possible to construct an efficient portfolio that maximises potential returns while helping to minimise risk. This cannot be done with other defensive asset classes, such as cash or term deposits, because their correlation to equities is zero and can even verge on positive in the long term since falls in equity markets can lead to cash rate cuts by central banks.

Bonds tend to perform relatively better in market downturns and when, due to very low inflation or deflation, prices are falling. Although bonds may perform well during times of low inflation or deflation, such an environment is bad for most other asset classes, particularly equities. Central banks around the world have strived for low inflation, but the risk from any cyclical fall in inflation can lead to a deflationary scare in financial markets, such as we saw in 2001 and 2009.

The reason why we have seen such a bold QE experiment by central banks is that they have learnt how to deal with inflation and have the tools to do so. However, most have not had to deal with deflation and don’t necessarily have the tools to handle such a scenario. Japan in the 1990s and the US in the 1930s are examples of the risk of deflation and the difficulty it takes to get out of such a situation once in it. With low world inflation and the weakening of conventional monetary and fiscal policies, deflation is still a potential risk for investors to consider, just as inflation was in the 1970s and 1980s. Maintaining an allocation to bonds would help to offset this risk given their superior performance in such an environment. Cash and term deposits would not offset the risk of deflation because the RBA would cut the cash rate to very low levels in order to try to jump-start the economy in that scenario.

Assessing risk for bond portfolios

The short-term risk of higher rates is compounded by the current relatively low yields and the fact that duration has increased for bonds and the typical benchmarks. The lower a bond’s duration, the lower its price volatility and the less sensitive it will be to interest rate changes. The duration of the UBS Composite Bond Index 0+YR (the benchmark for most Australian bond funds) is currently around four years compared with three years prior to the GFC1. The major reason for this is that government issuance since the GFC has tended to be longer in nature. For example, Australia issued a 20-year government bond in November, the longest maturity bond to be issued since the 1960s.

Apart from duration, it’s important to consider what will happen to bond yields when assessing what a rise in rates will do to bonds. The most important consideration is when and how orderly, or disorderly, the bond selloff is. If rates were to rise and bond yields rose in an orderly and steady manner, they wouldn’t suffer large losses. However, in a disorderly selloff or market panic, it’s possible that we could see negative returns, as in 1994. The big risk to bonds isn’t so much rising rates, it’s rapidly rising rates. A fact that might surprise some investors is that in the past 20 years, Australian bonds have only experienced negative returns twice, in 1994 and 1999. Although 1994 saw a very disorderly selloff in the bond market, it only delivered a negative return of  4.66%, with -1.22% for 1999 . The most common returns over the whole 20-year period have been between +5% and +15%.

In addition, unlike capital losses experienced on equities, capital losses on bonds are recovered over subsequent periods until maturity. This is called the ‘pull-to-par’ effect: As a bond approaches maturity, its market value gets closer and closer to its face value based on an assumption by the market that the bond will be repaid in full and on time. Even if rates do rise and prices fall, as long as the issuer remains solvent, investors will receive repayment of their full capital investment at the bond’s maturity. So, if you hold a bond until it matures, you won’t lose your principal. The potential for capital loss thus only comes when selling a bond before it matures or if the issuer defaults.

New natural rate of interest is around 4%

Quantitative easing from global central banks has depressed real rates and term premiums. The chart below shows how we believe the new natural interest rate (NRI) has changed from being around 5-5.5% from the start of the century until the GFC, to around 4-4.5% since then. In our view, the reasons for the drop are pressure on the government to rein in spending and that since the Reserve Bank of Australia (RBA) started cutting the official cash rate, Australia’s banks have retained around 100 bps of those cuts and not passed them on.

Source: Bloomberg

If rates were to normalise, we should expect the cash rate to head toward this new NRI, so potentially the extent of the rise over time would be around 150-200 basis points (bps). Obviously, the NRI can change temporarily, but this means the extent of the selloff shouldn’t equate to 1994.

In our view, the concept of duration should be rethought, particularly as it applies to individual bonds. As a measurement of risk in a portfolio, duration is still highly relevant since it measures the portfolio’s sensitivity to interest rates. However, that does not mean that long duration bonds are necessarily more risky – as the chart above shows, 10-year bonds are currently within the 4-4.5% band of this new NRI. If long-term rates don’t move or don’t move by too much, then longer duration bonds shouldn’t be particularly affected. If we saw the cash rate rise to 4.0%, then it would be the yield on the shorter maturity bonds which would react the most and despite their shorter durations, they would suffer worse losses than higher duration bonds. Longer duration bonds are more vulnerable to central banks decreasing their purchases or decreased foreign investment in Australian bonds as the supply increases. However, a normalisation of cash rates would not hurt all maturities of bonds equally.

Because a bond portfolio comprises a variety of bonds with different interest rate levels and maturities, it should have a steady stream of maturities which can be invested at the higher yields if cash rates/yields are rising. By owning bonds of different maturities, fund managers ensure that they are not tying up money for too long. If and when interest rates go up, maturing assets offer the opportunity to reinvest that capital into more recently issued, higher yielding bonds. As such, the effect of any return erosion is constantly being reduced and so any capital losses on bonds should be recovered over time. It’s important to remember that not all bonds are the same: a diverse portfolio containing different bond types and maturities helps to minimise any potential losses.

Conclusion: Bonds remain a good long-term investment

Bonds remain a viable asset class despite the risk of higher rates in the short term. Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of deflation and the impotence of central banks to deal with it also warrants an allocation to bonds. The question is which bonds to invest in and at what level. Good value can still be found in various areas of the bond market, such as semi-government, bank and some corporate bonds, as well as by using duration and yield curve strategies. Opportunities remain to add value through bonds via active management using a variety of different strategies in combination to produce a diversified, well performing portfolio.

By Roger Bridges

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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 future of fixed income.

Roger Bridges, Head of Fixed Income and Anita Daum, Head of Portfolio Management and the portfolio manager for the Tyndall Australian Bond Fund have provided their answers to AdviserVoice on fixed income and the future for bonds.

Roger has 30 years’ experience in the fixed income market, and has overall responsibility for managing and implementing the strategy for Tyndall’s fixed income portfolios. Anita has 11 years’ experience in the fixed income market and has been managing the Tyndall Australian Bond Fund for four years.

Why did bonds take such a hammering in June?

Roger:  The June reaction of bonds was due to the market’s expectation for the reversal of quantitative easing or QE in the US. Bonds prices surged to record highs in recent years, in part due to central banks such as the US Federal Reserve and Bank of England buying them under QE programmes. The intention – and the effect – was to push down bond yields, which move in the opposite direction to prices.

Low bond yields tend to cause interest rates to fall. This helps to reduce the cost of borrowing for consumers and governments and boost the prices of other assets such as shares. These effects can help pull a country out of recession and assist economic recovery.

But as the recovery gathers momentum, central banks try to curtail and then reverse QE, sending the previous trends into reverse. Announcements by the Fed in June that it planned to scale back its QE programme sparked fear among investors, sending bond prices in the US sharply lower and yields higher. Our bond market is strongly affected by the movement of US bonds, particularly longer-dated bonds such as the 10-years. As a result, we also saw a sell-off here with yields rising and bond prices falling below fair value.

Following this upset, the Fed was forced into a partial retreat and tried to calm market fears over QE tapering, which caused bond yields to fall back to more normal levels. In fact, July saw Australian bond market indices post modest positive returns as bond yields fell.

Can we expect more volatility in the short term?

Roger:  In our view, September seems to be a likely start date for the US Fed’s tapering of its bond-buying programme. The Fed indicated back in June that it may start tapering next month and recent strong economic data makes this all the more likely. In the past week or two, we’ve seen strong US employment and consumer price data.

Given the strong correlation between the movement of US government bonds and Australian government bonds, bond market volatility remains a strong possibility as the market tries to work out what the effects of tapering QE will be.

As growth improves in the US and this tapering of QE comes into effect, how likely is it that we will see another 1994 with bonds experiencing negative returns?

Roger:  It is possible, though unusual, for bonds to deliver negative returns. In general, this only occurs when either the cash rate unexpectedly increases by a large amount or the bond market tries to price in unexpectedly large rate increases and adjusts these expectations quickly. If these market expectations are slowly priced in, then the market value of bonds may fall but they don’t experience negative returns, only lower returns.

This is what happened in 1994: The Fed and its chairman Alan Greenspan were worried about inflation following the 70s and 80s and so decided to take swift action to avoid a spike in inflation. The market was surprised by the sharp rate hikes that the Fed introduced and US bonds didn’t respond until the rate hikes occurred since they were not well telegraphed in advance. The market then panicked and bond yields jumped, while prices fell. 2004-2006 also saw rate hikes in the US but because the Fed was more transparent and took action more slowly, the market had time to react to avoid bond losses.

The current situation is likely to be a repeat of 2004-2006. The Fed is telegraphing its moves in advance so the market shouldn’t be taken by surprise, although there might be brief periods of panic, like in June. But in the longer term, QE unwinding and rate hikes will be slow, measured and telegraphed in advance which shouldn’t lead to bond losses even though the trend will be for yields to rise.

Focusing back on the domestic economy, what’s the likely impact on our bond market of the upcoming Federal election?

Roger:  There is unlikely to be much of a reaction. In general, investor confidence should improve if there is a clear-cut outcome, with one party obtaining a decent majority. A hung parliament will be a negative for confidence and add to uncertainty.

Whichever party wins, if they intend to achieve a fiscal surplus, then obviously that will have an effect on bonds due to the reduction in bond issuance. If there are fewer bonds on issue, it should help to support pricing and keep yields lower.

With prices surging to record highs in recent years, is it fair to say that Australian bonds have had their day?

Roger:  Given historically high prices and low yields, investors have been questioning whether bonds have had their day. I don’t think this is the case.

Australian 10-year bonds have fallen from around 15% in 1982 to record lows below 3%.  The decline in bond yields has been largely the result of a structural decline in global inflation expectations, partly due to QE from central banks around the world and partly to slowing population growth and an aging population.

But in the shorter term, there are three main reasons why Australian bonds should remain attractive.

1)     Foreign investment. Even though this has started to drop off, it is still historically very high. Before the GFC approximately 20-30% of our bonds were held offshore, but by this year, it had jumped to just under 80%. This is largely due to other central banks wanting to diversify away from currencies such as the US dollar.

2)     QE globally. For Australia, this artificial suppression by other central banks means that there is increased demand for our higher yielding assets. Although interest rates are at record lows, our cash rate of 2.5% is still much higher than the zero or close to zero rates seen in Europe, the UK and the US.

3)     Our AAA rating. Australia is one of only 8 countries that has a AAA rating with a stable outlook from all 3 major rating agencies (Standard & Poor’s, Fitch, Moody’s).

So, in a world with a still highly volatile macroeconomic backdrop, the combination of very loose monetary policy in other countries and foreign demand for our debt due to its yield advantage should help to support the bond market in the medium term. We don’t envisage many catalysts that would suddenly push bond yields upwards for a sustained period.

Anita, why should an investor maintain a bond allocation in their portfolio?

Anita: Australians have traditionally invested in shares rather than bonds. But bonds are a valuable component in a diversified portfolio. Bonds tend to perform relatively better in market downturns and when deflation is a major risk. Diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns and reduce overall risk.

Although equities can offer the potential for greater returns more quickly, they involve considerable volatility and the potential for capital losses. Fixed income, on the other hand, offers regular, predictable income with a greater likelihood of capital protection and much more stable returns over the long term. It’s the non-correlation to equities that’s important – bonds should outperform when equities are underperforming and vice versa. So it’s important to have some of a portfolio invested in bonds.

What do you think an investor should look for when choosing a bond fund to invest in?

Anita:  If an investor wants a core bond holding to diversify their portfolio, then they should look for a traditional “true-to-label” bond fund to offset the volatility of other market sectors and provide that non-correlation to equities risk.

A fixed income fund should perform well in market downturns, providing the consistency of performance and regular income that investors expect. However, it’s important to note that not all bond funds are the same. For example, some funds are able to allocate large portions of their portfolio to credit. This gave investors in some of those funds a nasty shock during the GFC. Instead of the fixed income portion of their portfolio doing its job and being the outperformer during that time, funds that were very overweight credit actually performed badly and in some cases actually delivered negative returns during that period.

Our flagship bond fund did very well during the GFC because it is a true-to-label fund that is highly risk-aware and designed to deliver consistent performance even through serious market dislocations, when equities are doing badly.

So, it’s important to consider what an investor wants from fixed income and choose a fund accordingly. If it’s a non-core holding and the investor is looking for a higher return and is prepared to take on extra risk, then a fund that is able to invest in riskier securities could be appropriate. But if the investor is looking for a core holding, then they want a conservative true-to-label fund that won’t give them any nasty surprises at a time they can least afford them.

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Disclaimer

This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“TIML”). The information contained in this document is of a general nature only and does not constitute personal advice. 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 Tyndall Australian Bond Fund ARSN 098 736 255 is issued by Tyndall Asset Management Limited ABN 34 002 542 038 AFSL No: 229664 (“TAML”).  Investors should consult a financial adviser and the information contained in the current Product Disclosure Statement available at www.tyndall.com.au before deciding to invest.  TIML and TAML are wholly-owned subsidiaries of Nikko Asset Management Co., Ltd.

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“In my view, as long as global uncertainty and problems in Europe and, to an extent, the US persist, the behaviour of the Australian dollar (AUD) is unlikely to change significantly.

“I also believe that the domestic economy is on a slower growth path as it continues to adjust to a high AUD and the RBA is setting monetary policy to accommodate this period of adjustment.

“In the short term we will experience lower official interest rates as the rest of the world continues to de-lever and the continuation of foreign quantitative easing (QE) programs keep the AUD strong.

“The currency will most likely continue to remain strong in the near term, which should restrain inflation, allowing the RBA to keep interest rates at these lower levels.

“However, in the longer term, as the AUD stabilises and the economy continues to adjust to accommodate it, the effect of the AUD on containing inflation will wear off (as it began to in the December quarter of 2012).

“For interest rates to remain low, inflation (and the outlook for it) needs to remain stable. This either requires domestic inflation to fall or the AUD to not depreciate. If the strength in the AUD is a direct result of overseas QE programs, we could see the official cash rate rising as these programs reverse and the upward pressure they are exerting on the AUD starts to dissipate,” Mr Bridges said.

He said that for the time being, the main drivers of the strong AUD show no sign of disappearing. These drivers include:

• Australia remains one of the few remaining countries with a stable AAA rating.  Even the US has lost its coveted AAA status, with many other major economies on a negative outlook. This creates demand for Australia’s relatively ‘safe’ assets.
• By running deficits during the GFC, the Australian government has effectively re-established a large and deep government bond market.  This extra supply may have created its own demand as more central banks look to the AUD as a currency to diversify into, while they reduce their weights in the US dollar (USD) and Euro.
• The effect of the mining capital expenditure boom is another factor in the AUD’s strength.  A recent research paper from the RBA highlights that net foreign investment into the resources sector increased from 0.5 percent of GDP in 2007 to 3 percent in 2012. This foreign direct investment in the mining sector to fund new projects has exerted upward pressure on the AUD.
• Many of the world’s central banks have used QE to stimulate their country’s weak economy, hoping to push investors into equities and riskier assets than government bonds as they search for greater yield. Essentially, this means that the bank increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity. Another objective of this policy is to weaken the home country’s currency.  For a country like Australia that has a floating currency and is not itself engaging in QE, the result is that its currency appreciates as these policies unfold.

“The easier monetary policy from the US, and now Japan, is essentially being imported into Australia’s economy, pushing up our currency.

“Although Australia has an independent monetary system, the rising currency can still result in easier monetary policy here.  Exchange rate sensitive sectors are suffering as the currency remains strong, making them less competitive than peers in countries with a weaker currency.

“In addition, the stronger dollar helps to keep top-line inflation subdued, which has allowed the RBA to cut official interest rates over the last year or so.  While domestic inflation has not fallen, international or tradeables inflation has plunged due to the strong currency, dragging down the headline inflation figure and keeping inflation within the RBA’s target band.

“In fact, domestic inflation is still very high, being above the RBA’s two to three percent inflation target. 

“Furthermore, the effect of the stronger dollar on tradeable inflation is starting to wane and there has been a marked pick up over the past six months. This may be due to improvements in domestic productivity as the economy adjusts to the ‘new normal’ rate of the AUD.

“However, domestic consumer and business confidence levels are at historical low levels and, in some cases, are worse than in countries experiencing much greater economic problems.

“Some of this can be explained by the bad news from overseas and the fact the Australian economy is going through a structural rebalancing, which is causing uncertainty.

“Much of the structural change is due to the strong AUD forcing businesses to readjust to accommodate it and improve productivity,” Mr Bridges said.

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Not a bond bubble

Investors should not be worried about a bubble in the bond market, as the current high prices and low yields in bonds are not driven by the same factors as a classic bubble, says Roger Bridges, head of fixed income at Tyndall AM. 

“The definition of a bubble is a price level that is much higher than is warranted by the fundamentals and by what rational expectations would dictate. 

“In essence, bubbles occur when prices continue to rise because enough investors believe that they can buy securities at the current price and then sell them at even higher prices. 

“However, the key drivers for the current bond market prices and yields are not the same ones that create a bubble situation, and investors should rest assured that the current market environment will remain supportive of bonds,” Mr Bridges said. 

He said there are three main reasons why these assets should remain attractive for the foreseeable future. 

“Firstly, the flow of money into the bond market is not being fuelled by greed, as is the case in a classic bubble scenario, but by flight-to-safety. 

“You could say that in the current environment investors are worrying more about the return of their capital than on their capital. 

“In addition, foreign investment is playing a huge role in the price of Australian bonds. Before the global financial crisis (GFC), approximately 20-30% of Australian government bonds were held offshore. By 2012, this number had jumped to around 80%. 

“With countries previously viewed as safe havens experiencing extreme turmoil, Australian dollar-denominated assets are benefiting from central banks’ impetus for diversification away from currencies such as the US dollar, and this is helping drive bond prices higher. 

“Secondly, loose monetary policy in other developed economies is driving demand for our bonds. 

“Central banks around the world (the main three being the US, Japan, and the UK) are attempting to boost growth in their nations and accelerate economic recovery by using quantitative easing (QE). 

“The aim is to increase the central banks’ excess reserves, raise the prices of the financial assets they are buying, and thus lower their yields. 

“For Australia, this artificial suppression by other central banks means that there is increased demand for our higher yielding assets. Given that QE is likely to continue for some time as these countries’ economies recover, it is difficult to see the attractiveness of Australian bonds diminishing in the near future. 

“And thirdly, investors are not looking to sell their bond investments any time soon. 

“Although at Tyndall we think that yields on Commonwealth government bonds are currently below fair value, investors on the whole are not buying these bonds in order to sell them at a higher price.

“Despite recent rate cuts, Australia’s government bonds remain the highest-yielding AAA rated assets in the world.   Prices for our Commonwealth government bonds may be historically high and yields historically low, but compared with the rest of the developed world they remain attractive.

 “This yield differential has quite a bit further to contract before it starts becoming unattractive to offshore investors. 

“In the near to medium term, Australian bonds will remain attractive. With the US and France losing their AAA status and several of the remaining AAA rated countries looking shaky, Australia’s position is stronger than ever,” Mr Bridges said.

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