Bonds send a growth message

PORTFOLIO POINT: Recent action in bond yields is largely due to central bank intervention and the dawning realisation that a sustained period of low economic growth has arrived.

Trying to gain an insight into the behaviour of markets can be challenging, but a good place to start is with the risk-free rate of return as presented by long-term bond yields. In recent weeks, long-term bond yields in the US and Germany have continued to rally from extremely low levels. In both nations, 10-year bonds have traded at yields well below 1.8% and are generating negative real returns (after current inflation) for their owners. Both bonds offer very low and limited investment returns but they do (hopefully) compensate their owners by having almost no risk of default and thus a return of their capital.

Figure 1: US, German & Japanese 10-year bond yields
Source: Thomson Reuters

The question must be posed as to why these yields remain consistently below historic levels? Further, why has the Australian bond market also rallied to historically low yields and what does this mean for my portfolio of listed income securities?

Figure 2: US dividend yield vs bond yield
Source: Thomson Reuters

Figure 3: Dividend yields, 10-year government bond yields and cash rates
Source: IBES, Datastream, Bloomberg, CIRA

The above chart shows an extraordinary development in markets. The striking feature is that for the first time in 50 years, we are witnessing the yield on bonds in major economies falling below the yield on shares. This is actually more striking in Australia because of franking credits. This feature can really only be explained by the following arguments:
1. Quantitative easing and central bank largesse across the world has generated a massive asset bubble in some bond markets. Those bond markets are identified by their large economy, high credit rating or liquidity; and/or
2. The bond markets are forecasting a massive worldwide recession, such that the current dividend yields are not sustainable and the observed relationship between the different asset yields is an aberration; and/or
3. There is a new market paradigm generated from the outlook of sustained low economic growth and equity yields will now have to be much higher to compensate owners of equities for low profit growth.

The following charts may help us come to the right conclusion on bond markets.

Figure 4: Foreign holdings of US Treasury
Source: US Treasury, Merk Investments

From the above chart, we can observe that Chinese holdings of US bonds have declined in the last six months, as US bonds rallied. However, as the Chinese withdrew from the market, the Japanese bought in. The Chinese are probably diverting capital towards higher European yields and the Japanese are likely foreseeing that the Yen will have to devalue sharply in coming years. I would suggest that the Chinese believe that quantitative easing is creating a false market in US bonds and they have already benefited through capital gain. Further, it could also signal that China will accelerate its revaluation at some point soon.

The chart below shows that foreign ownership of Australian bonds has increased dramatically in recent years, as the issuance of Australian bonds has increased. In total, Australian bonds on issue have increased by about $150 billion in the last three years, but the buyers of these bonds have not been Australian super funds or institutions. The rally in bonds appears to have caught our money managers by surprise. Overseas investors have been attracted by Australian bond yields and now by increased liquidity, as the Australian government issues more bonds to fund its deficits. Perversely, the greater supply of bonds attracts more inbound foreign investment.

Figure 5. Foreign ownership of Australian government bonds is worryingly high
Sources: Reserve Bank of Australia, Bloomberg, M&G Investments

Over in Europe, the ECB has commenced a change in strategy. During the first meltdown of Greece and other PIIGS, the ECB aggressively bought bonds and supported bond issuance. Now the tactic is to offer massive funding to European banks at 1% (three-year loans), thus funding the European bond markets. Remember that in quantitative easing, the central bank rarely buys in bond tenders, but prefers to fund market participants. However, it has the same effect of generally holding down bond yields and holding up bond prices.

Figure 6. ECB bond buying
Source: Thomson Reuters Datastream, ECB

Thus, my conclusion is that the rally in bond yields is primarily a function of central bank activities and the increasing market realisation that a sustained period of low economic growth is now upon us. I am discounting the fear of a worldwide recession, because I believe that all world central banks (including China) will act strenuously to stabilise economies.

This low economic growth outlook will stimulate the RBA to move interest rates lower over the balance of this year. Thus, looking at bank bills, we see that 180-day rates have fallen below 90-day rates. Therefore, bank term deposit rates will continue to fall over the balance of this year.

This suggests to us that yield will increase in importance in the total return of investment portfolios. Indeed, it is already important, because a quick review of sharemarket returns over the last two years in Australia produces the following returns (22 May 2010 to 22 May 2012):

• ASX All Ordinaries Price Index negative 3.25%
• All Ordinaries Accumulation Index positive 5.1%

The Income Portfolio
Start Value: $120,000.00
Current Value: $117,557.97

-Hybrids/Pseudo Debt Securities
Company	ASX	Market Price ($)	Margin over BBSW (%)	Running Yield (%)	Franking (%)	Total Return (%)
ANZ Note	ANZHA	100.74	2.75	6.16	0	-0.17
Multiplex SITES	MXUPA	75.95	3.90	9.69	0	-0.72
Australand ASSETS	AAZPB	92.50	4.80	8.93	0	0.54
Macquarie Group Floating Rate Note	MBLHB	63.00	1.70	8.19	0	-5.97
NAB Floating Rate Note	NABHA	68.95	1.25	6.83	0	-6.42
Seven Group TELYS4	SVWPA	81.70	4.75	9.89	100	-2.72
Woolworths Notes II	WOWHC	102.90	3.25	6.52	0	-0.25
Ramsay Health Care CARES	RHCPA	102.25	4.85	8.00	100	0.49

-High-Yielding Equities
Company	ASX	Market Price ($)	Dividend ($)	GUDY (%)	Franking (%)	Total Return (%)
Telstra Corp	TLS	3.53	0.28	11.33	100	0.57
Ardent Leisure Group	AAD	1.26	0.12	9.56	0	1.21
Commonwealth Bank	CBA	49.31	3.29	9.53	100	-4.55
Westpac Banking Corp	WBC	20.39	1.63	10.93	100	-6.44
			Average	8.80	Weighted	-2.04
			Yield		Portfolio Return

National Australia Bank Subordinated Debt issue (ASX code: NABHB)

National Australia Bank (NAB) recently announced a subordinated debt issue very similar to the ANZHA which was issued in March 2012. A brief summary, including relevant terms and conditions for these securities, is tabulated below and compared to ANZHA. Please refer to company releases and respective PDSs for more information.

Figure 7: Comparison of NABHB and ANZHA

-ASX Code	NABHB	ANZHA
Type	Subordinated Notes	Subordinated Notes
Indicative size	$500m	$500m
Size after book build	Upsize to over $1 billion	$1.5 billion
Margin over 90 day bill	0.0275	0.0275
Interest rate	90 day BBSW 275	90 day BBSW 275bp
Interest / dividend	Floating rate, paid quarterly	Floating rate, paid quarterly
Gross cash / franking	Gross cash / no franking	Gross cash/ no franking
Deferral of payment	NO unless insolvent	NO unless insolvent
First call to redeem	18.06.2017 (5 years)	14.06.2017 (5.25 years)
Maturity date redeem	18.06.2022	14.06.2022 (10.25years)
Ranking	Ranks above ordinary and all preference shares including the listed NABHA	Ranks above ordinary and all preference shares
Regulatory treatment	Tier 2 capital	Tier 2 capital
Step-up	None	None
*Spot 90 BBSW (23/05/12)	0.0345	0.0345

Clearly, the two issues are quite similar in structure and in my view, will both trade at a similar level. It is also likely that NABHB will be called back (redeemed) after five years (as will ANZHA) because these issues will lose 20% of their value towards capital in each of the last four years under current bank capital rules.

It is possible that NABHB may have a slight qualitative edge over ANZHA because NAB has not issued a similar instrument for more than 13 years. In any case, I would only consider these in an income-focused portfolio and they are relatively attractive given that term deposit rates continue to decline. At current yields, NABHB offers about 1.5% above the 90-day term deposits of major banks, with minimum increase in risk.

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Please note: Model portfolios only provides general information and does not take into account the investment objectives, financial situation and advisory needs of any particular person nor does the information provided constitute investment or personal advice. Under no circumstances should investments be based solely on the information herein as they are of a general nature.