Bond market almost worth the wait

The amount of time it has taken bureaucrats to translate best intentions into actual ASX trading of Australian government bonds probably ensures that the new market will develop slowly. A huge bull market for Australian gilts occurred while they talked and talked and talked, and now it is drawing to a close: a fixed-interest bear market is on the horizon.

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