Market Insight


Coming of Age or Ringing of the Bell?
Tuesday, October 25, 2016


For the first time, the Australian government has issued a 30 year bond. Many would argue that this is a coming of age for the domestic bond market.

For a long time, the government bond yield curve did not extend much beyond ten years. And indeed, if the then Federal Treasurer, Peter Costello, had his way, we would have had no government bond yield curve at all - from the early part of this century onwards.

The government was net debt free and Costello was keen to use surplus cash holdings to repay all outstanding government debt. However, the local financial market was in uproar at the proposal.

Without any risk free assets, how would the market function?

Firstly, there is the problem of how to price riskier debt obligations, when there is not a risk free benchmark to use. And secondly, what high quality bonds could be used for repo transactions with the Reserve Bank?

A then (and possibly still) nascent corporate bond market would have been stillborn.

Fortunately, Peter Costello was persuaded from taking the puritanical high road, and instead used the surplus cash to establish the Future Fund, which has been a great success. And for the government bond market, the decision has seen it go from strength to strength, aided of course, by a simultaneous ballooning in government debt since the GFC.

Longer term debt trend in post GFC
It is in the post-GFC years that most of a lengthening in the government bond yield curve has taken place. Bonds with terms to maturity of 15 years, 20 years and 25 years, have been progressively introduced - along with other maturities in between. Now we have a 30 year bond, which brings us into line with other large and developed economies around the world.

For governments, such long term debt instruments facilitate long term planning for economic development and ease the task of debt management on a year to year basis. For the economy as a whole, it has much the same benefits: Development of long term infrastructure is easier to price and to finance, and long term liabilities such as life insurance and annuities can be more effectively hedged.

Innovation in new long term debt products will inevitably follow. Imagine having a 30 year, fixed rate mortgage.

Of course, if we lived in some other countries, it wouldn’t be necessary to imagine. But fixing interest rates for 30 years can be an advantage or disadvantage depending on where we are in the interest rate cycle and whether you are a borrower or a lender.

Ringing of the Bell
This brings us to the ringing of the bell. Ringing the bell is a mythical event that occurs when a bull market reaches its peak and it is time to stop buying and start selling. In this case, does the introduction of a 30 year Australian government bond (coincidentally) coincide with the peak in a global bond market rally that has been going on for just as long?

Interest rates peaked in the late 80s and for the most part have been in decline since then. The declining trend accelerated after the tech wreck in the early part of this century and with the introduction of the Greenspan put.

This was followed by quantitative easing brought on by the GFC and the eurozone crises; and more recently, the move into negative interest rates by the European Central Bank, the Bank of Japan and others, as quantitative easing has failed to stimulate economic growth. But even as this move is aimed at currency depreciation to stimulate export growth, it has failed, as investment will not take place if positive returns cannot be generated.

There is a growing realisation that negative interest rates do not work and only succeed in destroying the profitability of banks and insurance companies.

Global bond markets are starting to acknowledge the likelihood that interest rates have gone as low as they will go and that the longer term direction is now upwards. The bell may well have been rung: yields globally have been rising for the last month or so.

But to underline the excesses of the peaking of the long global bond bull market, at the end of June this year, there was US$11.7 trillion of negative yielding sovereign debt on issue around the world, according to a global rating agency. It was in this environment that Ireland and Belgium were able to sell 100 year bonds at yields of just 2.35% and 2.3% per annum respectively, according to a recent report from ANZ.

Moreover, Italy, which may not be too far away from Greece, both geographically and economically, was able to sell €500 billion of 50 year bonds at a yield of 2.8% per annum, against an order book of €18.5 billion!

The bell may well have rung and for the Australian government selling $7.6 billion of 30 year bonds now, at a yield of 3.27% per annum may be the cheapest long term funding it will see for a very long time. But the buyers of the bonds may prefer to remain in blissful ignorance rather than consider just where the 10 year Australian government bond yields were 30 years ago - in the late 1980s.

Philip Bayley

 

Philip is the Principal of ADCM Services, publisher of The DCM Review an independent online commentary, analysis and data on Australia & New Zealand's debt capital markets. He is also a contributing editor to Banking Day and a director at Australia Ratings.

 


 

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