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Aussie bonds have room to improve

by Elizabeth Moran | Jun 17, 2014

Key points:

  1. Australian Commonwealth government represent good relative value compared to US treasuries and German bunds.
  2. The Australian iTraxx at 80bps still represents value compared to pre-GFC levels of 30bps and the European iTraxx at 58bps (100 basis points = 1 per cent).

Australian Commonwealth Government and corporate bonds have rallied in recent months prompting the question of whether they are now fully valued or have more gains to deliver to investors.

I would argue that while bond prices are high, they are not at record levels. Combined with very attractive rates of return compared to other developed countries, Australian bond prices have scope for further outperformance. 

First let us consider Australian Commonwealth government bonds. Yields for five and ten year bonds were 3.16 per cent and 3.78 per cent last Wednesday. This is much higher than German five year bunds at 0.43 per cent and ten year at 1.40 per cent, and higher than US treasuries offering 1.71 per cent and 2.64 per cent respectively.

All three countries are considered very low risk so the differential offers considerable upside for large international investors despite possible currency fluctuations.

Domestic corporate bonds are also attractive to global and domestic investors and there is further upside potential. One of the measures we use to determine value is the iTraxx index. In simple terms, it quantifies the perception of risk in the market. An increasing number means the market perception of risk is rising and investors are demanding a higher return to compensate for that risk. A decreasing number indicates the reverse meaning a lower yield is acceptable and bond prices will rise to reflect this.

The iTraxx only looks at the credit spread component that is overlayed or added to the base interest rate and is an important tool in assessing the movement and trends for the broader market.

Before the GFC, the Australian iTraxx traded around 30 basis points (bps) (100 basis points = 1 per cent) above the base interest rate. This figure blew out to 443bps at the height of the GFC reflecting greatly heightened fear in the market. Over the last three months the spread has been moving steadily lower from 106bps on 14 March 2014 to 80bps on 11 June, contracting by 25 per cent.

The current 80bps spread remains elevated compared to pre-GFC levels, demonstrating there is still room to move lower and for bond prices to improve further.

The Aussie iTraxx at 80bps, it is significantly higher than the European iTraxx at 58bps, which is another sign that our market represents good relative value. 

Interest rate expectations also influence bond prices. It’s not interest rate changes per se, rather differences between actual and expected interest rates that influence bond prices. Over the last six months, expectations of higher interest rates did not eventuate, resulting in higher than anticipated bond prices.

Markets are cyclical and interest rates at some point will rise but I expect interest rates will be lower for longer.

While I think a rise in US interest rates is inevitable, and this will eventually suppress bond prices, the timing is unknown and the US Federal Reserve seems cautious after a harsh winter. Interest rate rises should be gradual to minimise market disruption and allow the Fed time to evaluate their impact.

Bond spreads and overall yields continue to move lower. Investors need to prepare themselves for even lower yields as they compete against international investors for domestic bonds. A global search for yield and limited domestic supply should see bonds prices continue to appreciate.

The certainty and diversification offered by bonds make them essential in any portfolio.