By Michelle Soesanto
The shock of COVID-19 on the Australian sovereign and corporate bond markets
Throughout February and mid-March, the Australian debt market was plagued by irrational investor behaviour following fears of economic stagnation. Many investors were spooked about the impending pandemic and its associated economic costs which caused a decrease in the value of risky assets and a boosted demand for risk-free assets such as government-issued bonds. As investors piled into safe-haven assets, Australian bond-yields declined to record lows.
However, in response to a pessimistic economic outlook and increased volatility, there were many investors who chose to sell their highly liquid government bonds to reduce leverage and meet their debts.
Following the US credit market seizure back in March, international travel bans and the US Federal Reserve’s aggressive stimulus, a frenzy of bond sales occurred in the Australian market. The sudden sales were not for the safety of sovereign bonds, but an ‘indiscriminate liquidation’, as investors were faced with redemption shocks. Multi-billion-dollar hedge funds and foreign central banks were liquidating their Australian sovereign bonds and with more bond sellers than buyers, bond prices fell and yields shot up. Similarly, in the corporate debt market, a massive sell-off occurred as hedge and pension funds prepared to offload their bonds to manage redemptions. This all-out scramble for cash caused Australian corporate debt yields to drastically increase.
The RBA’s monetary policies and its effects on the sovereign and corporate bond markets
In mid-March, the RBA announced some comprehensive monetary policies to control the volatility of the Australian bond market. Firstly, the central bank introduced the yield curve control policy which pinned the 3-year bond rate at 0.25 per cent. Secondly, to fund its fiscal stimulus, the government increased sovereign bond issuance. As a result, the RBA confirmed its quantitative easing policy in March to begin purchasing government bonds, ensuring that borrowing rates remained low to help stimulate the economy. As a result of these measures, the Australian sovereign bond-yield curve has steepened throughout the year, thus lowering bond prices.
With the RBA’s policy and anchored 3-year bond yield, corporate bond prices stabilised due to improved liquidity, thereby reducing the risk premium and lowering bond yields. The RBA’s monetary policies have eased the volatility of the corporate bond markets nevertheless yields still remained high due to increase credit risk, leading to a wider bond yield spread. This is especially true for ‘A’-rated and ‘BBB’- rated corporate bonds, where yields remained elevated. According to NAB, 3-year ‘BBB’ corporate bond spreads have more than doubled since February from 100 basis points (1 per cent) to 200 basis points (2 per cent), while ‘A’-rated bonds are up from below 80 basis points (0.8 per cent) to 160 basis points (1.6 per cent). As for the AU$50 billion Australian corporate bond market, it has remained largely stagnant. With increased uncertainty and credit risk, corporate bond investors are discouraged. The reluctance is not only due to market illiquidity, but also worries that these companies lack long-term corporate solvency and hence these bonds are not treated as a money good. Throughout the first quarter, the corporate debt industry has made calls for the Reserve Bank to imitate the Federal Reserve in buying private sector corporate bonds. However, these inquiries were mostly ignored. The RBA’s reluctance arises from regulators’ beliefs that the Australian corporate bond market is dominated by investment grade companies that can access financing from banks, which are in return, benefiting from the monetary support measures aimed to ensure lower borrowing costs. In contrast, the US corporate bond market sources a majority of their credit from the loan and bond markets.
Foreign sovereign bond deals financing the Australian economy
With steepening yields and reduced prices, there has been an increased demand in Australian sovereign bonds. In particular, Japanese investors have seized these opportunities within the Australian debt market. May data reveals that Japan has invested a total of AU$6.6 billion into the Australian bond markets, the highest since 2005. According to Akira Takei, a Tokyo-based global fixed-income money manager at Asset Management One, “[the Australian] yield curve control policy targeting short-term yields can steepen the curve from time to time and make the debt attractive”. Many foreign traders in Australia are implementing the “carry and roll” strategy, borrowing over a short time period at fairly low rates then investing the proceeds into longer-term, higher-yielding bonds.
In his July address, RBA Governor Phillip Lowe, declared that monetary financing of fiscal policy is not an option under consideration in Australia. This indicates that despite growing debt, the Australian government will not be funding budget spending with loans from their central bank. Lowe is confident that with strong sovereign debt demand, the Australian government is able to finance itself in the bond market. Furthermore, issuance should not be an issue, according to GFSM strategist Stephen Miller, as “Australia has a very low public debt-to-GDP ratio and a very high credit rating”.
Currently, Australia’s debt market is indeed a seller’s market, with numerous massive bond sales being recorded this year. The first was in May with the issuance of a new 10.5-year bond. The debt offer was finalised at an impressive AU$ 19 billion, the largest government bond sale in history, and at a yield of 1.03 per cent. The second mammoth sale was in mid-July, where the Australian Office of Financial Management finalised a 5-year bond deal at AU$ 17 billion and a yield to maturity of 0.50 per cent. On 29th July, the AOFM finalised the issuance of a 30-year bond that attracted bids of more than AU$20 billion. As of 30th July, the 30-year bond was sold for a whopping AU$15 billion at a yield of 1.94 per cent. Most recently, on 26th August, the AOFM is set to print AU$21 billion 11-year bond issue, which attracted AU$65.5 billion of bids by early Wednesday morning.
As a comparison, the existing August 2040 bond is trading at a yield of 1.46 per cent, whereas the yields for August 2030 bonds are currently at 0.84 per cent. This indicates that the current 20-10-year spread is at 0.62 per cent, whereas the 30-10-year spread is at 1.1 per cent. While those yields are historically low in Australia, they are high compared to current short and long-term rates of other developed markets where central banks have been more vigilant in intervening at longer maturities. For example, the yield spread between US 10-year and 30-year rate is just 0.65 per cent, while bonds of those maturities in Japan, Canada and Europe are narrower.
RBA lending stimulus for Australian corporate bonds
In May the RBA agreed to expand its monetary policies to include corporate bonds. The regulatory body have agreed to lend money against corporate bonds in the short-term money markets. Thus far, the central bank was only prepared to accept bonds issued by the government, regulated banks or AAA-rated asset backed securities as collateral when extending short-term funds to financial institutions. The change was aimed to improve trading conditions in the corporate debt market, meaning “narrower spreads, improved liquidity, and helping to open doors for issuers to come to market domestically”, according to Commonwealth Bank’s fixed income analysts. Following the RBA’s decision, Woolworths has hired four major banks to arrange fixed income meetings. In mid-May the grocery giant led a return of activity in the Australian corporate bond market by raising AU$1 billion through the sale of 5 and 10-year bonds. The AU$400 million in 5-year bonds yielded 1.85 per cent while the AU$600 million in 10-year bonds yielded 2.83 per cent.
The Australian iTraxx Index is a proxy for Australian corporate bond spread. This index is composed of five-year credit default swaps (CDS) for the twenty-five most liquid and highly traded investment grade Australian entities in the market. The index “rolls” every six months where the list of companies changes to reflect the market. The most recent roll, on March 2020 included firms like BHP, ANZ, Commonwealth Bank, Macquarie, NAB, Qantas, Rio Tinto, Telstra, Westfarmers and Woolworths to name a few. As seen in the ITraxx graph, corporate debt spreads have fallen from May onwards, signalling increased liquidity.
The funds raised from these Australian sovereign bond sales to foreign investors are expected to support government spending and cover fiscal debt. So far there is no indication that the bond markets will charge Australia a concession for these bond-deals. If these lucrative debt activities were to continue, the Australian government will be able to maintain a modest debt-to-GDP ratio of 45 per cent. Furthermore, the Australian corporate debt market remains a valuable source of income and spread diversification for firms. The Australian corporate credit market has benefitted from a strong fiscal stimulus and prudent corporate balance sheet management (i.e. delaying large capital projects, deferring or suspending dividend payment etc.). An efficient corporate bond market will allow Australian companies to replenish bank funding lines and shore up their balance sheets with long-term debt, thus protecting themselves from economic volatilities.
Sources: The Balance, AFR, RBA, investing.com, Bloomberg, theconversation
The authors of this publication are not qualified to provide financial or investment advice and as such the content provided should not be construed in this manner. All information is intended purely for educational purposes and is provided for the personal interest of UNIT members. The opinions expressed within the article do not reflect those of UNIT as an organisation, its partners or its sponsors.