Bloomberg News

Best-in-World Bonds Spurred by Recession Risks: Australia Credit

September 25, 2011

Sept. 26 (Bloomberg) -- Australian government bond yields are dropping for a ninth month, the longest stretch since at least 1978, as the securities generate the biggest returns of any other major market amid concern the global economy will slide back into recession.

The benchmark 10-year note’s yield fell 32 basis points this month to 4.06 percent at 10:09 a.m. in Sydney, from 5.55 percent on Dec. 31. Ten-year Treasuries tumbled 38 this month to 1.84 percent while German bunds fell 47 to 1.75 percent.

Europe’s inability to cope with its debts has pushed the world to the brink of a financial crisis, Mohamed El-Erian, the chief executive officer of Pacific Investment Management Co., which runs the world’s biggest bond fund, said Sept. 22. Global stocks entered a bear market last week as the U.S. Federal Reserve warned of “downside risks” to growth. Investors betting Australia’s central bank will cut the developed world’s highest benchmark rate sent yields on its two-year debt toward the least relative to the U.S. this year.

“There’s almost a crisis of confidence in political leadership in the U.S. and Europe,” said Stephen Miller, a managing director in Sydney at BlackRock Inc., which oversees about $3.7 trillion. “There are knock-on effects for us and the thing about Australia is that the Reserve Bank here has the capacity to cut rates and cut them a long way should that be required.”

Australian bonds returned 10.6 percent over the past 12 months, the most of 26 markets tracked by Bloomberg/EFFAS Bond Indexes. Treasuries have gained 7 percent.

Rate-Cut Bets

Cash-rate futures show investors are betting Reserve Bank of Australia Governor Glenn Stevens will cut the key rate to 4.03 percent by December from 4.75 percent currently. The RBA slashed the benchmark to 3 percent from 7.25 percent between September 2008 and April 2009 to counter the global credit freeze that followed the collapse of Lehman Brothers Holdings Inc. in 2008.

Australia’s two-year yield slid 21 basis points this month to 3.54 percent, or 332 basis points more than similar-maturity Treasuries. The 10-year rate fell below 4 percent on Sept. 23 for the first time since January 2009, the same month it reached a record low 3.84 percent.

Yields on all Australian government securities, including the longest-dated bond maturing April 2023, have been lower than the cash rate since Aug. 9.

Equities Bear Market

The MSCI All-Country World Index entered a bear market last week for the first time in more than two years, retreating 20 percent since July 22. It fell after Standard & Poor’s cut the U.S.’s credit rating in August following a debate over raising the nation’s borrowing limit and as speculation intensified this month that Greece will default, raising borrowing costs for Spain and Italy.

Stock markets pared some declines after Group of 20 finance chiefs pledged Sept. 22 to provide a “strong and coordinated” response to rising risks to the global economy and pushed Europe to contain its sovereign debt crisis. Many urged Europe to implement a July promise to expand the powers of a rescue fund, Japanese Finance Minister Jun Azumi said.

Euro-area countries will do whatever is necessary to end the crisis and ensure the financial stability of the entire euro area and its members, the International Monetary Fund said in a Sept. 24 statement after holding meetings in Washington. The fund’s $384 billion lending chest may not be enough to meet all loan requests if the global economy worsens, Managing Director Christine Lagarde said in an “action plan” distributed to the IMF steering committee the same day.

The IMF cut its forecasts for global growth Sept. 20 and predicted “severe” repercussions if Europe fails to contain its crisis or U.S. politicians deadlock over a fiscal plan.

‘Less Vulnerable’

The world economy will expand 4 percent this year and next, the IMF said, compared with June forecasts of 4.3 percent in 2011 and of 4.5 percent in 2012. The U.S. growth projection for 2011 was lowered to 1.5 percent from 2.5 percent in June.

Strategists predict Australia will grow 1.84 percent this year and 4.25 percent in 2012 compared with 9.3 percent and 8.7 percent for China, Australia’s largest trading partner. The U.S. economy will expand 1.6 percent this year and 2.2 percent next year, separate Bloomberg News surveys show.

“Domestic yields in the front end still look very overpriced,” said Martin Whetton, an interest-rate strategist at Nomura Holdings Inc. in Sydney. “As a base case, we do not see the RBA cutting rates and so we see the front end under pressure in any risk-on environment.”

Australia’s AAA long-term sovereign credit rating was affirmed with a “stable” outlook, Standard & Poor’s said Sept. 23 in a statement.

Policy Flexibility

The rating reflects “the country’s ample fiscal and monetary policy flexibility, economic resilience, public policy stability, and its sound financial sector,” said Melbourne- based Kyran Curry, a credit analyst at S&P. “We believe these factors demonstrate Australia’s strong ability to absorb large economic and financial shocks.”

Australia has become “less vulnerable” to slowdowns in the U.S. over the past 15 years, RBA Deputy Governor Ric Battellino said Sept. 21. “There are reasonable grounds for optimism,” he said.

Futures traders had bet Aug. 9 on a 92 percent chance the Australian central bank would reduce its key rate to 4.25 percent at the Sept. 6 meeting. Policy makers left it unchanged and said in minutes released Sept. 20 that they are well positioned to respond to global and domestic economic risks or the threat of an acceleration of inflation.

Corporate Spreads

Bond yields may advance if by “some miracle” policy makers are able to revive market confidence, said Miller, who holds the same proportion of Australian government debt in his portfolios as the benchmarks they track.

The gap between yields on Australian government bonds and inflation-indexed notes shows investors estimate consumer-price gains to average 2.46 percent for the next five years, near to the lowest in more than a year and down from 2011’s peak of 3.14 percent on May 6.

The spread between the interest Australian banks pay when borrowing from each other for three months and swaps tracking expectations for the RBA’s benchmark fell two basis points today to 36 basis points. The gap, a gauge of banks’ difficulty in accessing funds, closed at 61 on Aug. 8, the highest since January 2009.

Default-Swaps Climb

The perceived riskiness of Australian corporate bonds soared to the highest since July 2009, according to traders of credit-default swaps.

The Markit iTraxx Australia index rose 40 basis points last week to 213, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The gauge closed at 217 on Sept. 22, the highest since July 13, 2009, the CMA prices show.

The extra yield investors demand to hold Australian company bonds instead of government debt surged 14 basis points last week to 229, matching the highest since November 2009, Bank of America Merrill Lynch’s Australian Corporate and Collateralized Index shows.

“There might be some tinkering at the edges by central banks and politicians but the fundamentals remain high unemployment in the U.S. and Europe, and Asian growth slowing,” said Mat McCrum, the investment director at Melbourne-based Omega Global Investors Pty, which manages A$1.1 billion. “There is no engine for world growth.”

--Editors: Garfield Reynolds, Edward Johnson

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To contact the reporter on this story: Sarah McDonald in Sydney at smcdonald23@bloomberg.net.

To contact the editor responsible for this story: Shelley Smith at ssmith118@bloomberg.net.


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