Bonds send a growth message

The subdued outlook for global growth will put new emphasis on yields in investment portfolio returns.

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.

Clime offers individually managed account services to sophisticated investors with an emphasis on profitable and high-yielding businesses that pay fully-franked dividends to investors. Click here to find out more.

Alternatively, register for a free trial to MyClime, our online stock valuation & research platform.

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.