Making sense of bond yields

PORTFOLIO POINT: The recent rally in domestic bond yields also underlines the potential for the Australian equity market to outperform offshore markets.

The world’s bond markets do not appear to make sense. Much has been written in recent weeks about the stunning rally in the yield of Australian bonds. If you think it is strange, then you might change your mind after reviewing the peer group that we have just joined.

Figure 1. The world’s lowest 10 year government yields

Maybe there is a case for buying Switzerland bonds through a Swiss bank account to avoid tax, but ultimately those bond investors will likely suffer massive capital losses.

The rally in Scandinavian bonds is probably just a mad freedom flight to Northern Europe away from Greece, Spain, Portugal and Ireland. Also, there is some semblance of economic growth in those countries. However, the bond yields in the United Kingdom and Belgium are purely perverse. Those economies are in disastrous shape. Therefore it is little wonder that Australian bonds have recently rallied hard to take our rightful place in the above table.

Indeed, based on relative comparisons of the quality of sovereign balance sheets, there is probably more relative outperformance to come for Australian bonds. For instance, how can Australian bonds be yielding 1.5% more than UK bonds, as that country slides in and out of recession as its fiscal deficit balloons, it prints currency and it risks a sustained devaluation?

Figure 2. Australian 10-year government bond yield

So while the rally in our 10-year bond seems belated (compared to offshore markets), it does underline the relative attractiveness of the Australian economy and the potential of our equity market to begin to outperform offshore markets. While we have not seen bond yields this low since the Great Depression, it does not mean that we are looking at a severe recession. Rather, we would suggest that bond yields are rallying because there has been too much liquidity created in the world from the massive quantitative easing programmes of the US, Europe, Japan and the United Kingdom. Further, Australia represents a growing economy with low inflationary expectations and a sound banking system.

The Income Portfolio

Start Value: $120,000.00
Current Value: $117,311.68

-Hybrids/Pseudo Debt Securities
Company	ASX	Market Price ($)	Margin over BBSW (%)	Running Yield (%)	Franking (%)	Total Return (%)
ANZ Note	ANZHA	99.78	2.75	6.31	0	-0.67
Multiplex SITES	MXUPA	71.61	3.90	10.40	0	-6.39
Australand ASSETS	AAZPB	88.90	4.80	9.39	0	-3.37
Macquarie Group Floating Rate Note	MBLHB	59.55	1.70	8.82	0	-11.12
NAB Floating Rate Note	NABHA	68.90	1.25	6.97	0	-6.49
Seven Group TELYS4	SVWPA	80.50	4.75	10.16	100	-4.07
Woolworths Notes II	WOWHC	104.10	3.25	6.53	0	0.89
Ramsay Health Care CARES	RHCPA	102.25	4.85	8.12	100	0.25

-High-Yielding Equities
Company	ASX	Market Price ($)	Dividend ($)	GUDY (%)	Franking (%)	Total Return (%)
Telstra Corp	TLS	3.66	10.93	11.33	100	4.27
Ardent Leisure Group	AAD	1.30	0.12	9.27	0	4.44
Commonwealth Bank	CBA	51.04	3.29	9.21	100	-1.20
Westpac Banking Corp	WBC	20.77	1.56	10.73	100	-4.76
			Average	8.90	Weighted	-2.24
			Yield		Portfolio Return

Readers may have noticed the negative price movement in recent weeks of various floating-rate securities. In particular, the prices of “perpetual” notes have declined and the question must be posed as to why this has occurred in a period where the Australian bond and bill markets have rallied?

The reason is that perpetual notes are valued by the market as equity-type securities. They are closer in the risk scale to equity then they are to fixed-income debt securities. Company shares are perpetual securities and they are the ultimate “junk bond” when you actually look at the entitlements that accrue to their owners. Shares do not carry the guarantee of dividends; they may become worthless at a future point, and they rank last in a wind up.

Perpetual floating notes, as their name suggests, have no defined termination date. This lack of a redemption date means that the holders’ return may only ever come from the interest payments coming from the security. However, whilst being unsecured, they do rank ahead of ordinary equity in a wind-up and the likelihood of them having no value is low. They therefore have less risk than pure equity and therefore a lower required return should be demanded by a purchaser.

The effect of lower bill yields on perpetual hybrids

In the last 60 days, the yield on 90-day bank bills has fallen from 4.3% to 3.5%, or about 80 basis points. The market for floating-rate perpetual securities is correctly adjusting the values of the following securities in our income portfolio:

• AAZPB yielding 4.8% over 90-day bills on $100 issue price;
• MXUPA yielding 3.8% over 90-day bills on $100 issue price;
• MBLHB yielding 1.7% over 90-day bills on $100 issue price;
• NABHA yielding 1.25% over 90-day bills on $100 issue price.

As the yields fall on these securities, and assuming the required return for owning them stays constant, then their value will decline. However, the question is by how much and at want point do they become attractive to buy?

Let’s quickly look at the new yields that would probably be set for these securities for the September quarter based on a 90-day bill yield of 3.5%. Then we can suggest the appropriate yields for us to be interested in acquiring these securities or our income portfolio. Please note that in doing so, we are assuming that 90-day bill rates are stable at current levels.

• AAZPB forecast yield $8.30 per annum. Security price $89.00 cum $2.25 interest paid in July gives an ex interest price of $86.75 and a new running yield of 9.6%. Our fair value is 10% yield or $83.00 ex interest.

• MXUPA forecast yield $7.30 per annum. Security price $72.20 cum $2.04 interest paid in July gives an ex interest price of $70.16 and a new running yield of 10.4%. Our fair value is 10.5% yield or $69.50 ex interest.

• MBLHB forecast yield of $5.20 per annum. Security price of $58.90 cum $1.47 interest paid in July gives an ex interest price of $57.43 and a new running yield of 9.05%. Our fair value is 8.5% yield or $61.20 ex interest.

• NABHA forecast yield of $4.75 per annum. Security price of $69.00 cum $1.26 interest paid in August gives an ex interest price of $67.74 and a new running yield of 7%. Our fair value is 7.5% yield or $63.00 ex interest.

Other points of interest

Readers may perceive that we rate Macquarie and National Bank securities more highly than the others. This is because the issuers are banks and regulated entities. We also note that these bank securities are both currently counted as Tier 1 capital. However, we must monitor developments for if they do not qualify in the future, then the issuers may well redeem them. If that were to happen, a windfall to holders could result. Currently, Macquarie Group is proposing a buyback of its ordinary share capital and the question needs to be posed as to why it does not buy back Macquarie Group notes (MBLHB) in preference to the Macquarie Group ordinary shares (MQG)?

Clime Investment Management is one of Australia’s top performing fund managers specialising in income and value growth portfolios for wholesale and sophisticated investors, particularly self-managed super funds.

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