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Australian bond yields and inflation

Australian government bonds are trading at extraordinary high prices and low yields. The only times yields were anywhere near this low were in the 1930s depression and in the 1890s depression, but in both of those depressions inflation rates were severely negative (deflation). Today, inflation is positive.

Unless you believe Australia is heading for another depression in the next 10 years, bonds appear over-priced at current levels. Yields may fall even further due to the weight of foreign money, but real returns for bond holders are likely to be very poor over the medium to long term from current levels.

Although the cash rate in Australia is at record lows, yields all across the curve up to 10 years are even lower, down to as low as 2% for 1 to 5 year terms. Even 20 year bonds are yielding less than 3%. Australian inflation-linked bonds are now trading at such high prices and such low yields that they imply inflation will average just 2% per year for the next 10 years. Again, these are depression-type levels. The most obvious conclusion is that the ‘safest of all assets’ in Australia – inflation-linked government bonds with very little risk of default – are in a speculative bubble like other ‘risky’ assets.

Thanks to the declining yields, recent returns from bonds have been good. However, even with yields at such low levels, they are still attractive to global investors. Foreign investors look at yields in countries like Canada, a similar market to Australia, and see yields on Australian bonds are more than 1% higher than on Canadian bonds. The only government bonds trading at higher spreads are in Greece, as it lurches toward another likely default. Unlike any era in the past, foreign investors now own the bulk of Australian bonds on issue and the flood of foreign yield-chasing funds is likely to continue to keep yields low for some time yet.

This cycle is usually halted only by a sudden currency collapse which turns the inward flood of speculative money into a rapid race for the exits. Sometimes these turnarounds are triggered by external crises, like the Russian default in 1998, and at other times triggered by domestic crises, like the current account crisis in 1986. This time the trigger for a sudden turnaround may be a Russian default once again, or it could be the worsening federal budget crisis (along with the Liberal party chaos and the volatile Senate), which is starting to seriously alarm many foreign investors.

In the current environment the catalyst for a sell-off in the AUD and bonds will most likely come from an external source, with many economies and geopolitical situations balancing on a knife-edge. Many investment markets are hovering at over-priced levels, supported only by central bank money-printing.

 

Ashley Owen is Joint CEO of Philo Capital Advisers and a director and adviser to the Third Link Growth Fund. This article is for general educational purposes and is not personal financial advice.

 

11 Comments
Warren Bird
February 20, 2015

No, it shows the point I was making in my previous comment about how new issues come at current coupon rates and are priced closer to par. The current benchmark bonds were issued in early February at coupon rates closer to where the market is now.

So the current 30 year bond is a 2.5% coupon that matures in 2045. It is priced at 95.2 to yield 2.7%.

The 30 year indicator bond a few weeks ago was a 2044 maturity with a coupon of 3.375% that at the time was indeed priced at a premium of about 16% to yield about 2.3%. It is currently yielding the same as the 2045 bond, 2.7%, so its price has fallen somewhat to just over 112.

So there you have it. Two bonds, maturing close in time to one another, one priced at 95 the other at 112. Is one overpriced and the other great value? Is one more risky than the other? Not at all - they both are priced to deliver a yield to maturity of 2.7% and that is what investors should mainly focus on when evaluating a long term bond investment.

ashley
February 20, 2015

When I wrote the story a couple of weeks ago at the start of February all US treasury bonds were trading at a premium - up to 16% for 30 years bonds. Just goes to show how volatile government bonds are, and that timing is everything!
Cheers
Ashley

Warren Bird
February 19, 2015

I understand the psychological point, Ashley, but that's not the same as this being a 'risk' feature of bonds. It is simply a characteristic that people either accept or they don't.

By the way, what usually happens when market yields decline and bond prices of current issue securities go above par is that the coupon rate on new issues to the market will be reduced. That's why, despite the so-called 30 year boom in bond prices, the price of the current ten year US Treasury bond is below par - it's price is 99.3. It has a coupon of 2% and a yield to maturity of 2.07%.

In fact all the benchmark maturity US treasury bonds across the curve right now are priced below par. So at least in the Treasury market this whole discussion is a furphy!

My point is that just because yields are low doesn't automatically mean that every bond in the market is trading at a premium to par. If buying at or below par really matters to you then you don't have to ignore the bond market. Just be selective about the securities you choose.

But ultimately, make your decision based on expected return - and in the bond market this is not the coupon rate, nor is it the purchase price minus the face value, but the combination of the two that is captured in the yield to maturity.

ashley
February 18, 2015

hi warren,
great comments. The issue of bonds being bought at a premium and therefore incurring a guaranteed capital loss at maturity is a fascinating study in rational logic versus investor behavioural beliefs.
Mathematically you are right of course - total return (including capital gain/loss plus income less fees and net of tax drag/benefits) is all that should matter to investors.
But in my experience the vast majority of individual investors regard capital and income in very different lights. When they receive less at sale or maturity than the purchase price they paid initially, that is seen as a "loss" and it hurts.

One example - a huge number of people bought BHP at more than $49 per share in April 2011 (that was the highest volume month in the past 5 years, and treble the monthly volume compared to recent years). Selling their shares for anything less than the purchase price is seen as a "loss". When I explain to them that the total return, including dividends and buybacks is significantly higher than that, it is rarely a satisfactory argument. A loss is a loss is a loss. Fancy "Dividend Indifference" theories and Modigliani models mean little to ordinary investors.

In the case of Commonwealth bonds - eg the 10 year (April 2025 series)
- sure investors are being recompensed in the form of a "higher" interest coupon. But the 3.25% coupon rate is hardly "high", and represents a running yield of just 3.06% (barely above inflation). So to most people, buying a bond for $106 (today's price) and getting only $100 back in 10 years time is indeed a capital loss.

It is as if I invested $100k in a bank TD paying 3.25%, if I asked the bank if they would repay my $100k capital at the end, and they said "Well no, you will only get $94k back at the end." To me and to most investors that amounts to capital loss. The interest income has long been spent on day to day living expenses, and is mentally accounted for separately.


cheers
ashley

Warren Bird
February 15, 2015

Well said, Andre.

First, there is still a failure among many analysts and commentators to realise that the reason bond yields are as low as they are is NOT QE by central banks. It is because the world economy is not generating a rate of return on capital that is high enough for real yields to be much more than zero in many countries, and negative in quite a few. QE is in place because central banks have recognised the dynamic.

Second, I eagerly await the day when people realise that you can't have bond bubbles. It isn't mathematically possible. If you buy a bond yielding you 0.5% per annum and bond yields then go up, your total return will end up being higher than 0.5% not lower. Bubbles end with permanent losses of capital, not with an increase in nominal returns!

Warren Bird
February 15, 2015

That is an amazingly jaundiced view, Ashley. Bond prices above par simply mean that the current yield they are trading at is below their regular coupon rate, which is a fixed percentage of their face value. So, yes, the capital does amortise to par over the remaining life of the bond, but this is 'offset' by the higher interest payments you receive, to produce the yield to maturity as the total return.

That in my view is not risk. It is a known mathematical outcome. You will receive the yield to maturity as your total return, with the par value at maturity.

Risk is about unpredictable things affecting the return on an investment so that it doesn't deliver what you expect. A bond yielding you 4%, say, will deliver you 4%. You could get it by buying a par bond that has a coupon of 4% and thus you get the total return as interest; or you could get it by buying a 5% coupon bond at a premium to par and you get the total return with higher on-going cash flows but the negative amortisation.

By all means people need to appreciate the maths of how bonds work because of this cash flow versus capital amortisation aspect, but it is not a 'risk' to your total return expectations.

I can feel a longer article coming on to explain bond maths 1.01.

ashley
February 13, 2015

Great comment Aaron,
But must disagree on your comment that "It is only ever risk-free to maturity".
If you define "risk" as price volatility (which academics do for some unknown reason), then the price of bonds changes every minute of every trading day so they are "risky".

But if you define 'risk' as the chance of losing part or all of your money (as most investors do), then almost all government bonds in the world today are still risky even if held to maturity, and even if they pay up at maturity (as most will).
Since almost all bonds in the world are trading above their 'par' value (including most Commonwealth Government bonds), if you buy just about any bond in the world today you are GUARANTEED to lose part of your capital - and that's before you take into account loss of real value through inflation.
Even if you hold it to maturity, and even if the government pays up at maturity, there is ZERO probability of making a profit and 100% probability of making a capital loss.

'Risk-free' indeed! It makes a mockery of the whole of corporate finance theory, which blindly assumes there is a magical "risk-free" asset as the starting point for their fanciful capital asset pricing models.

Phil Brady
February 13, 2015

Not sure why another Russian default is considered? According to the recent McKinsey report on country leverage, it is 43 out of 47 on the list - 1 from 47 being the worst is Japan with debt to GDP at 400% compared to Russia at 65%.

Andre Lavoipierre
February 13, 2015

I believe that an article titled "Unprecedented sovereign bond yields" written by Chris Cuffe on December 1, 2012 suggested a bond bubble back then.

I quote "It is equally appropriate to consider this a ‘bond market bubble’ as it is to worry about an ‘equity market bubble’ when company stock valuations are at extremes. Investors in long term bonds can suffer serious erosion of capital on a mark to market basis when bond rates rise".

Since then of course bond markets have continued to rally strongly, outperforming the equity markets last year in fact.

Will this new article look the same in a year or two when we see the cash rate at 1.50% and long bonds down a further 1%?

Unfortunately everything always looks rosy before the storm and usually storms are not that predictable, and the further the market rallies normally suggests a sell off could be very sudden and very sharp.

Perhaps, instead of worrying about what markets might do, the best option is to have a diversified investment portfolio, with the fixed rate bonds as direct investments instead of within managed funds so that, if we are happy with the issuer's capital strength and happy with the running yield and yield to maturity then we'll at least receive a good income and a return of our capital at maturity, even if we suffer paper losses in the interim!

Aaron Minney
February 13, 2015

Ashley,
As usual, a great discussion on the issue, but I think your final comment might be missing the real reason for low interest rates.
Central banks are not holding guns to the heads of 60-year olds who have money that they don't need to spend now, but don't want to lose either. Lower rates might make them scream about the falling income from their term deposits, but that won’t encourage them to spend now when they won’t have any income in the future.

There is also a need to be careful with the time horizon when calculating the risk-free rate. It is only ever risk-free to maturity. If you buy a 30 year bond, no matter the starting price, the return next month is going to be risky. People aren’t buying bonds speculating that prices will rise. What is happening is that demographics have delivered a boom in retirees with the peak lifetime wealth that the world hasn’t experienced yet. Far from speculating, retirees (just as they have always done) are investing some of their wealth to maintain it for later consumption. The weight of that money means that they have to accept lower interest rates. Despite the attraction of dividend yields from shares, these retirees do not want to put all their wealth in risky assets.

This is not to say that rates can’t go up or that 2% is the right level. Rates are set in a market after all. However, the unwind might need the demographics to ‘normalise’ and this will take a long time. Borrowing from TS Eliot, the low rates world might not end with a bang, but a whimper.

Jerome Lander
February 13, 2015

Bonds selling off need not be because of an unexpected source - although this could well be the case - but could simply arise when the US tries raising rates!

 

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