Bond market almost worth the wait
Tuesday's launch of trading on the ASX of "depositary interest" securities of $100 each that deliver beneficial ownership of medium to long-term Australian government bonds is more important than the first day's trading value of just $319,000 suggests.
Talk of launching retail government bond trading revved up during the financial crisis as the government issued more debt to fund stimulus, slowed when it became clear that wholesale demand for Australian bonds would be more than enough to soak up the expanded supply, and dragged on as the architecture of the trading system was debated. Better late than never.
Australian government bond returns are being beaten by shares this year and that will continue if the global recovery gathers pace and a rate rise cycle begins. The government also guarantees bank deposits up to $250,000, so that is an obvious first port of call.
With this change, buying and selling Australian government bonds directly becomes as easy as buying and selling shares on the ASX.
In time they should become a core component of investment portfolios, doing their most important work when shares are under pressure. The new ASX government bond market also has the potential to become a base and a benchmark for the corporate debt market here.
Retail investors were already able to buy Australian government bonds from the Reserve Bank, but it was a rudimentary system, an over-the counter transaction with an organisation that didn't have many counters, basically. Retail traffic through the window declined even as wholesale demand leapt post-crisis, and the window is closing now that ASX trading has arrived.
Investors who enter the new market must remember that they are building a counterweight to shares, which are less popular after the crisis. The ASX said on Tuesday they were directly owned by 34 per cent of Australians, down from 39 per cent in 2010 and a peak of 44 per cent in 2004.
Shares do best when economic growth is strong, and profits and dividends are rising. Interest rates also move higher as demand for money rises and regulators raise the cost of money to contain inflation - and existing, lower-rate fixed-interest securities become less attractive, and less valuable.
Existing debt securities offer a holder a yield that can run until the debt matures and is repaid. This "yield to maturity" is higher or lower than the "coupon" on the debt - the interest rate that is actually paid every six months - depending on whether the security has been acquired for more or less than 100¢ in the dollar, which means that bonds also generate paper capital losses and gains, depending on which way rates move. If the bonds are sold, the gains and losses materialise.
If rates on new debt securities are rising, existing lower-coupon debt needs to be sold at discount, to push the buyer's yield to maturity up to levels that are competitive with newer, higher rates on offer. If rates and yields are falling as they did during and after the global crisis, investors on the other hand will pay a premium for existing higher-yield securities, driving the yield to maturity down towards the new rate benchmark.
Numbers from Evans & Partners chief investment officer Mike Hawkins show how Australian government bonds act as a counterweight to shares.
In 2006 when the S&P/ASX 200 share index returned 25 per cent in a raging bull market, Australian government bonds tracked by UBS' government bond index returned just 2 per cent. But in 2008, when the ASX 200 was slumping 39 per cent, big investors were rushing into the safety of triple A-rated government debt, and the UBS bond index rose by 19 per cent. In 2011 as Europe's sovereign debt crisis expanded, the ASX 200 lost 11 per cent, and the UBS government bond index rose by 13 per cent, and last year the ASX 200 rose by 20 per cent, and the UBS index by 6 per cent.
Overall, the ASX 200 share index has returned just 7.6 per cent since June 30, 2007, and that includes a return of almost 33 per cent since June 30 last year. With average yields on Australian government debt down to about 2.9 per cent compared with 6.3 per cent in mid 2007, the UBS Australian government bond index has returned 51 per cent since mid 2007, and 63 per cent on maturities of between five and 10 years.
A small group of retail investors used the Reserve Bank's window or found funds that tracked the UBS index, but most missed that bonanza, and won't get a repeat if they buy on the ASX now. But over a full cycle they will have a valuable sharemarket hedge - and for safety Australian government bonds are the bee's knees.
mmaiden@fairfaxmedia.com.au
Frequently Asked Questions about this Article…
The ASX began listing $100 “depositary interest” securities that give beneficial ownership of medium-to-long-term Australian government bonds, making buying and selling government bonds as easy as trading shares. The move replaces the more rudimentary Reserve Bank over‑the‑counter window and aims to open the market to retail investors, even though first-day turnover was small (about $319,000).
Government bonds tend to perform well when shares are under pressure, providing diversification and capital preservation. Data cited by Evans & Partners’ Mike Hawkins shows examples: in 2006 the ASX200 rose 25% while a UBS government bond index returned 2%, but in 2008 the ASX200 fell 39% while the UBS bond index rose 19%. Bonds have repeatedly offset sharemarket losses in stressed years.
The article notes shares have outperformed bonds this year and likely will if global growth strengthens and interest rates rise. Bond yields are lower than in the past (average yields around 2.9% versus about 6.3% in mid‑2007), so potential returns are reduced. That said, government bonds remain a top safety asset and a useful hedge against sharemarket downturns—so they’re worth considering as part of a balanced portfolio rather than a full replacement for shares.
The coupon is the fixed interest a bond pays (usually semi‑annually). Yield to maturity is the effective return a buyer will get if they hold the bond to maturity and depends on the price paid relative to face value. If you buy below 100¢ in the dollar your yield to maturity is higher than the coupon; if you pay a premium your yield is lower. Changes in yields create paper capital gains or losses that only materialise if you sell the bond.
When new debt is issued at higher rates, existing lower‑coupon bonds must trade at a discount so the buyer’s yield to maturity matches current market rates. Conversely, if market rates fall, existing higher‑coupon bonds can trade at a premium. So rising rates generally push existing bond prices down; falling rates push existing bond prices up.
Since mid‑2007 the ASX200 share index returned about 7.6% (including a strong recent year), while the UBS Australian government bond index returned about 51% over the same period. For bonds maturing in five to ten years the UBS index returned about 63%. These figures illustrate how government bonds have delivered strong returns over that full cycle, especially when yields initially fell.
With ASX trading of depositary interest securities, retail investors can buy and sell Australian government bonds as easily as trading shares on the exchange. Previously retail investors could use the Reserve Bank’s over‑the‑counter window or funds tracking bond indices, but the ASX market is designed to broaden access and simplify transactions for everyday investors.
The new ASX government bond market could become a core component of investment portfolios, serving as a hedge when shares fall and offering a benchmark for pricing corporate debt. Over time it may provide a clearer reference rate for the corporate bond market and give investors an on‑exchange way to access high‑quality, triple‑A government debt.
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