Why You Should Yield to Aussie Bonds -- Barron's Blog

        By WAYNE ARNOLD
        Everyone knows Australia is upside-down and so everything there is backwards. Summer is in winter, boab trees are upside-down in the ground, and water spins down the drain the way it ought not to (that's actually a myth but, quick, go flush the toilet and make sure).
        So it must make sense, now that investors are fleeing bonds in Europe, particularly German bunds, and U.S. Treasuries, that Australian government bonds, one of only nine sovereigns rated AAA, are falling, too. But does it also make sense that a government whose debt relative to GDP is one of the 10 lowest in the developed world should pay more to borrow than Thailand?
        It's true: Australian 10-year bonds, rated AAA by Standard & Poor's, are yielding roughly 3%, while Thailand's 10-year bonds, rated BBB+, yield just under 2.9%. Does that make Australian bonds a steal? Is it time to stock up on Aussie bonds or an ETF that specializes in them, like WisdomTree Australia & New Zealand Debt?
        Not just yet. While bonds are typically the misanthropic hedge to stocks, there are exceptions. Bonds of very risky, highly indebted companies, obviously, trade more like equity, as do the bonds of risky, heavily indebted countries.
        But now, in a world of rising global capital flows, international investment can swamp smaller, financially sound issuers and turn their bonds into weathervanes for risk, making them correlate with stock prices as if they were junk bonds.
        Quantitative easing has exacerbated this phenomenon. Investors starved for yield have poured funds into emerging Asia's stock and bond markets, suppressing yields everywhere. So while domestic investors may still play stocks versus bonds based on where domestic inflation is going, global investors often overrule them. This has become the bane of both central bankers who find that cutting interest rates can tighten monetary conditions by spooking foreign investors, and of fund managers who struggle to find stocks and bonds that don't bob up and down together.
        If and when the U.S. and European economies recover enough that the Federal Reserve can raise interest rates and the European Central Bank can stop printing money, sanity may be restored to global capital markets.
        In that world, Australian bonds look as fantastic. Australia's economy isn't doing so well for reasons that have little to do with Europe or the U.S. and everything to do with China's reduced demand for Australia's iron-rich dirt. Iron ore prices have sunk by two-thirds since 2011 and Goldman Sachs says they're headed lower. Australian exports are wilting - they fell 17% in the first quarter- as is industrial production. Mining investment has collapsed and is unlikely to recover to boom-time levels even if China's growth bounced back tomorrow. The International Monetary Fund last month cut its forecast for Australian GDP growth this year to 2.8% from 2.9%.
        Indeed, growth is so weak and inflation so low - just 1.3% -- that the Reserve Bank of Australia this month cut interest rates to a record low 2%. Nomura and Morgan Stanley predict it will cut again before year's end. The El Nino weather phenomenon is back, which is likely to hurt agricultural exports. Oh, and Australia's population is aging, meaning potential growth and long-term inflation should decline in the long run, too.
        But it isn't all ripper for bonds Down Under, though. Through careful study of Europe's disastrous experiment with austerity, Canberra has deduced that a government should not respond to weak growth by slashing spending to balance the budget. That was its wont in the past.
        The government is instead sheepishly allowing the deficit to grow. HSBC economist Paul Bloxham forecasts net government debt will rise to 15.3% in the current fiscal year, and as high as 19% in three years. That puts it in a tiny club alongside Switzerland, Lithuania and the Nordic nations of advanced economies that can boast net government debt below 25% of GDP.
        The bigger problem is that Australian bonds are owned primarily not by Australians, but by foreigners, who own just shy of two-thirds of them. That means Aussie bonds are likely to depend less on domestic inflation than on global interest rates and the Australian dollar.
        The Aussie dollar has fallen along with commodity prices by roughly 16% in the past year, so far in fact that like the commodity prices it fell with, it has been staging something a rebound. So, with global interest rates likely to stay low, notwithstanding the latest bobble in bond prices, and the Aussie dollar having found what looks like its bottom, Australian bonds will start looking very attractive once they start yielding about 3.2%. When that happens it should be safe to start buying them with your ears pinned back.
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        Comments? E-mail us at wayne.arnold@barrons.com
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        Comments? E-mail us at asiaeditors@barrons.com
        (END) Dow Jones Newswires

        May 12, 2015 23:34 ET (03:34 GMT)

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