FIIG - The Fixed Income Experts

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AAA treat for investors

by Elizabeth Moran | Mar 03, 2015

This article was published in the Australian on Saturday. Australian government bond yields exceed, by far those of other AAA rated countries.

Australia is a privileged member of an elite club. It is one of only nine countries that have the highest AAA or equivalent credit rating from all three major credit rating agencies.

The credit rating relates to the perceived risk of investing in Australian Commonwealth Government Bonds. The higher the rating, the better. Having the highest rating with few other countries at this level, means global investors are attracted to investing in our Federal Government bonds.  

Importantly, it means that for Australia, the cost of borrowing is low. Downgrades to the rating would imply higher risk and mean it would cost more to borrow. So, achieving the highest rating and maintaining it is an important economic goal. 

Domestic interest rates, while low are relatively high on a global scale. Of the nine AAA rated countries, Australia still offers the highest returns for two year government bonds at 1.87 per cent, while four countries: Switerland, Denmark, Germany and Sweden show negative returns on their two year bonds. Switzerland has the lowest rate at    -0.82 per cent, making it profitable for the government to borrow money!

Australia is often compared to Canada yet Canadian two year bonds only return 0.47 per cent, while the closest AAA offering of 1.01 per cent, from Singapore, is still almost half the Australian rate. So, on a relative value basis Australian Commonwealth government bonds offer outstanding value.

Investors still buy bonds with negative returns as they are very defensive assets that will ensure capital is protected in the event of another GFC type event.  In fact, a severe event would see investors sell higher risk assets and invest in these bonds, pushing the price of the bonds higher. It would probably deliver a higher than expected gain on the bonds (over and above interest income) and cushion the impact of the event on the total portfolio.

For sophisticated investors that can access corporate credit ratings, they help qualify the riskiness of an investment. Reassuringly, the vast majority (by value) of Australian corporate bonds are assigned credit ratings and I would estimate that more than 98 per cent are investment grade. According to credit rating agency, Standard and Poor’s, the chance of an investment grade issuer not paying interest or principal is just 1.07 per cent over a five year term.

As the credit ratings decline from AAA down the scale, to AA, A, BBB, BB and so on, the investment is perceived as higher risk and so investors demand higher returns to invest.  For example, three corporate bonds all fixed rate and maturing in 2020, but in various credit rating brackets show a range of returns.  

Stockland, the highest rated bond in the sample has a low yield to maturity of 3.60 per cent. Moving down the scale, Lend Lease is higher risk than the Stockland bond but is still rated investment grade, that is higher than BBB-, and pays a higher return of 3.95 per cent to maturity. Qantas has a sub-investment grade bond and will return 5.00 per cent if held to maturity. These bonds show that as credit ratings decline, perceived risk increases, so do returns on offer. 

Risk increases markedly once investments drop below investment grade BBB, with the chance of a sub-investment grade issuer not paying interest or principal 16.03 per cent over the same five year term. It is at the fringes of just above or below the investment grade cut-off where good credit analysts and astute investors can maximise returns when investing in bonds.

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