Craig Simpson assesses recent changes in bond markets and notes many funds here and offshore no longer offer automatic price gains; yields start to rise

By Craig Simpson

May was dominated by a couple of key market events and the supply of quality NZ bonds remains in short supply.

Firstly, in a somewhat surprising move, the Reserve Bank of Australia (RBA) cut their cash rate further by 25bps to 2.75% at the beginning of the month.

The RBA said the inflation outlook would afford scope to ease further, should that be necessary to support demand. Market participants continue to price in further cuts in coming months.

Secondly, Federal Reserve Chairman Ben Bernanke surprised the market by indicating the Fed intended to taper back their QE program over the next few meetings.

Bernanke sent conflicting messages to the market. During his testimony he warned against a “premature tightening” of policy, however during questioning where he suggested the pace of QE could be reduced “in the next few meetings”. The market latched onto the question time response and the prospects of less accommodative policy saw US 10-year bond yields surge to their highest level in almost a year.

The month also saw an increase in volatility, something Christian Hawkesby from Harbour Asset Management notes in his latest research paper.

Hawkesby references US research firm Lipper who note US funds that invest in higher-rated bonds with average maturities of under 10 years lost an average 1.8% in May, their fourth worst monthly performance behind periods in 1994 and 2003.

In addition to this, the NZ government announced their fifth budget which sees the total borrowing programme scaled back by approximately NZ$3 billion from what was forecast in the 2012 Half-Year Economic and Fiscal Update (HYEFU).

key bond details of budget announcements are:

- 2012/13 issuance remains at a maximum of $14 billion

- 2013/14 issuance will be a maximum of $10 billion

- up to $5 billion of inflation-indexed bonds are expected to be issued in the 2013/14 fiscal year, subject to market conditions

- bond issuance over the forecast period is expected to be $2 billion lower than the HYEFU forecast, and

- Treasury bill outstandings are expected to average $4 billion over the forecast period.

Major bond indices down

Of the major bond indices only the NZX 90-day Bank Bill Index (+0.22%) and Citigroup WGBI in NZ$ (unhedged) (+3.88%) rose. The unhedged global bond index benefited from the falling NZ$.

Investors in NZ and global government bonds were the big losers in May, with both the NZX Government Bond and Citigroup WGBI in NZ$ (hedged) indices down 1.4%.

Despite the negative month, over the last 12-months fixed income investors have returned between +2% and +5%. The exception to this is those investors who have invested in unhedged global government bonds where the Citigroup WGBI in NZ$ (unhedged) is down over 9%.

On aggregate both domestic and global corporate bonds have performed better than sovereign issues over the last month, quarter and 12-month periods to the end of May.

At 2.8% all government revenues need to pay Japan’s interest bill

Japan saw heaving selling of their bonds as yields rose to 0.8% on the 10-year government bonds. BNZ in one of their daily commentaries wrote “if the Bank of Japan’s policies to stimulate inflation in the economy are successful, yields would be expected to rise a lot higher. Alternatively, if the market loses faith in the Government’s ability to service its already large, and expanding debt obligations, yields could also rise sharply.”

CNBC reported that Japan has enormous debt levels and can hardly afford the interest at the moment. They only have to reach 2.8%, when all government revenues will need to be used to pay that interest. The very last thing Japan needs is rising interest rates.

In a quarterly report by Standard & Poor’s Capital IQ, New Zealand is the ninth safest sovereign, sandwiched between Australia and Austria. The report focuses on changes in the risk profile of sovereign debt issuers, with the intention of identifying key trends and drivers of change.

New Zealand and Australia are new entrants in the top 10 least risky list replacing Britain and the Netherlands.

US set for possible credit downgrade

Rating agency Moody’s warned overnight that the US sovereign remains vulnerable to a rating downgrade, if policy makers do not address the projected rise in debt levels in the decade ahead.

This is despite a projected decline in the budget deficit to US$378 bln by 2015 from a peak of US$1.4 trillion in 2009. However, a downgrade would only align Moody's US rating with that of S&P.

New Issues

During the middle part of the month we saw investors piling into NZ bonds, with the first Debt Management Office (DMO) tender for three weeks attracting a 4x bid-cover ratio.

On the local government front, the Local Government Funding Agency (LGFA) issued three tranches totaling NZ$240 million. The 2021 maturity for NZ$215 million attracted interest of NZ$611 million with the weighted average accepted yield of 4.115%. The other two tranches although considerably smaller in size were both well supported attracting over 3.5x bid-cover ratios.

Examples of Credit Spreads over swap and NZGS

Below are some examples of current spreads available for corporate and bank bonds with maturities in 2018.

The has been collated from a variety of sources and some of the issues shown in the table below may not be available to retail investors, or may be subject to minimum parcels of $100,000 or above. The spreads are subject to change with market movements.

* As there is no 2018 NZGS currently on offer we have taken the mid-point between the yields on the 2017 and 2019 NZGS end of month quote as a proxy.

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