Credit magazine: the case for Aussie bonds

Credit Magazine, March 2010

In the red corner: a bond from an Australian bank. In the blue: a bond from an American or European. Which would you expect to be in better shape?

On the face of it, everything points towards the Australian being in ruder health. “Fundamentally, Australian banks are certainly stronger and the outlook is better,” says Mark Reade, credit strategist at Citi in Sydney.

Why? “First and foremost, Australian major banks didn’t have exposure to toxic structured assets that many US and European banks had exposure to,” says Reade. There was some exposure – National Australia Bank, for example, had some CDO holdings, and saw its share price hit as a consequence – but compared to peers elsewhere in the west it was extremely modest. “The bulk of the overall asset quality was much better.”

Australian banks do have a considerable level of exposure to housing, but that has proven to have very different consequences in Australia to elsewhere in the world. For a start, Australian housing markets are still going up in value and experienced very little weakness in prices through the financial crisis. Unemployment peaked at 5.8% and has fallen to 5.3%, a low level compared to western markets, and that helped too. “Unemployment is a leading indicator of the mortgage market,” says Duncan Beattie, executive director, debt capital markets at JP Morgan in Sydney. “If you’re getting paid, you can pay your mortgage.”

On top of that, while a form of sub-prime does exist in Australia – where it is known as lo-doc, for low documentation – it is very small compared to the US. “You can certainly point to isolated examples of dodgy lending practices, but it is a very small part of the overall pie and wasn’t as toxic as some of the products we saw in the US,” says Reade. So while Australian banks have in many cases had just as much housing exposure as counterparts in Europe and the US, it hasn’t translated into a fundamental credit concern.

There are a host of other things in Australia’s favour too: a strong economy, underpinned by emerging market (chiefly Chinese) demand for commodities; a strong Australian dollar; corresponding strength in Australian corporates, with relatively few defaults and bankruptcies; the government’s injection of stimulus into the Australian economy; a better national fiscal position than is common in developed markets; and a Reserve Bank that handled the downturn so well that it has been raising rates in order to normalise monetary policy while counterparts in the US, EU and Japan are barely even contemplating tightening policy. Where there were challenges, they were well predicted. “The Australian banking sector has a relatively high reliance on offshore funding,” says Gus Medeiros, credit strategist at Deutsche Bank in Sydney. But the government guaranteed wholesale issuance from Australian banks through the crisis. “That addressed this significant issue, and supported the banks’ ability to refinance and raise funds,” says Medeiros.

Compare this to US and European banks: in some cases still unveiling multi-billion dollar losses as they write down more and more problematic assets. They have been beaten out of shape in the last two years, in many cases gone broke or changed hands, and they still face extremely difficult circumstances in their key markets, be it sovereign debt in the EU, the uncertainty of the US recovery, worries about new taxes and regulations, or exposure to flagging commercial property markets. “Initially we saw some underperformance in Australia, but as people started to focus on fundamentals it became evident that the local banks are in very good shape comparatively,” says Luke Fay, head of credit trading for Australia at UBS. “You can see it in the change in the size of these banks on a world scale: the Australian banks have gone from outside the top 50 on the list to the top 10. Capital ratios are healthy, the macro picture supports the banks’ business models, and the government support has been very orderly compared to some markets.”

So we have a winner – or do we? Because the trading picture tells a quite different story. If Australian banks are so far ahead based on fundamentals, why is that, far from trading tighter than some obvious peers, they are much wider?

Beattie at JP Morgan looks to Canada as a similar market: five key commercial banks (Australia has four) in a stable and highly rated banking system. Bank of Nova Scotia, for example, has a five-year bond out with a January 2015 maturity; it is trading at 85 basis points over Treasuries. Compare that with five-year bonds from Australians with similar ratings. ANZ also has a five-year maturing in January 2015: it trades at 130 over. Westpac has a February 2015; it’s also at 130 over.

Beattie says: “The reason I was looking at Canadian banks is that some of them trade phenomenally tightly. I was thinking: why can’t the Australian majors trade like that?” And so, one assumes, are the treasurers of Australia’s banks.

So why should this be? One reason is this heavy reliance on wholesale funding, and this has its roots in the behaviour of Australian consumers. “Generally the Australian population has a low savings rate,” says Reade. “As a result, the banks don’t get the same level of deposit pools that Asian banks do. Consequently, loan to deposit ratios of Australian banks are high compared to those of US, European and Asian banks, which in turn means Australian banks are very reliant on wholesale term funding.” In fact, Commonwealth Bank of Australia and Westpac are among the most active financial services issuers worldwide over the last year or so in terms of straight debt, partly because of this lack of deposits and partly because the residential mortgage-backed securitization market, which traditionally has funded a large part of their book, has until recently been closed.

Correspondingly, there’s no shortage of supply. “Australian banks raised the equivalent of A$210 billion (US$186 billion) last year, and about 65% of that was raised offshore,” says Medeiros. He expects a lighter pipeline this year – banks have approximately A$90 billion equivalent of term debt maturing in 2010, have done about A$30 billion already and are likely to issue a full-year total of A$115 billion or so in order to support reasonable credit growth rates this year, he says. But even so, that is a wealth of paper hitting the market, and this perhaps partly explains the wider spreads on Australian bank paper since there is no scarcity.

“When there is a lot more debt to be issued, it can weigh on the spreads of existing debt,” says Reade. “Some investors don’t feel the need to bid up for it in the secondary market when they know there is more coming in the primary market.”

Beattie suggests that the strength of domestic sponsorship in other countries may also be a point of difference. To return to his Canada comparison, although the Canadian domestic asset management industry isn’t huge in its own right, many investing institutions cover it from their US desks, giving Canadian banks a vast amount of effectively domestic potential funding. Similarly French asset managers drive the relatively tight spreads on issues from French banks. “Naturally, investors are more comfortable with domestic banks,” says Beattie. And while Australia’s asset management industry is highly significant in its own right, it does not drive tighter spreads on Australian paper denominated in dollars or euros.

So what do investors think? Peter Dorrian is head of Australian retail at Pimco, the global debt asset manager; he tells clients in Australia they should diversify their portfolios to include international exposure, but from a local perspective the benefits of the domestic picture are very clear. “Australia has traditionally been a higher interest rate country than many around the world: the US cash rate is virtually zero and it doesn’t look like changing until early 2011,” he says. “Australia has come through [the financial crisis] in better shape and investment returns from the bond markets look pretty promising in the next 12 to 18 months.”

Greg Michel at ING Investment Management thinks there are good reasons to look at an overweight position to Australian bonds. As interest rates have risen in Australia over the last year, global bonds have outperformed in terms of capital returns. But as other central banks inevitably raise rates in future, that ought to reverse. “We believe there is some catch-up to do in global markets as central banks remove some of the crisis level cash rates implemented in 2008 to 2009,” he says. “This is likely to occur in the next 12 months so a short to medium term bias to Australian bonds relative to global bonds should work.”

Michel has a different take on the question of supply, although he considers it from the perspective of state and government rather than just bank debt. “Funnily enough, it feels like the Australian bond market may suffer from not enough supply rather than too much,” he says. “Strong offshore support, increasing demand from the banking system for proposed regulatory requirements, a general shift to fixed income product from the pension community and the likelihood of better than expected state and federal budget outcomes all point to ongoing support for highly rated government and state government debt.”

Nevertheless, he sees risks too. “While not a central case, banks could become a victim of their own success,” he says. “Historically they have been forced to fund themselves from offshore markets,” the more so in recent times. “The level of bank debt, both senior and government guaranteed, to be refinanced in 2011 and 2012 is massive. If there was to be some disruption to the willingness of global markets to fund the banks’ balance sheets, we could see a significant risk in their cost of funds.” But it is, he says, “a risk – a possibility, not a probability, but one worth watching.”

One final question is whether, even if we conclude Australian bank paper looks the best value, there’s any reason to assume that it will tighten to better reflect fundamentals. After all, that doesn’t automatically follow. “Treasurers feel they merit better pricing, and look to us to deliver that,” says Beattie. “We think that they can bridge the gap to a certain extent and there is a good case to be made for doing that based on credit fundamentals.”

THE RETURN OF THE CARRY TRADE

On October 6, the Reserve Bank of Australia raised interest rates by 25 basis points to 3.25%. More significantly, it became the first developed nation to start tightening monetary policy after the global financial crisis. It has since done so again, several times, and now stands at 4%.

In doing so, Australia has revived the carry trade. When world markets were booming, billions of dollars – maybe more – flowed from markets in which one could borrow at negligible rates, chiefly in Japan, to those where interest of rates were much higher, chiefly Australia, where risk-free bank account deposits could give you 7% as recently as 2007. The unwinding of that carry trade as interest rates began to fall was one of the many destabilising sub-plots of the financial crisis.

With Australian rates rising, the carry trade is back – and this time it’s not just about the yen. The US, Europe and Japan all offer miserably low rates of interest for investors, and for them, rising interest rates in stable Australia look attractive. 4% in Australia is 16 times better a return than 0.25% in the US. Evidence that funds are flowing in this direction comes from the Australian dollar. One US dollar bought you A$1.61 in late October 2008; at the time of writing it would get you only A$1.11. In January the two currencies flirted with parity.

What does this mean for bonds? Bankers tend to think that it’s part of the overall trend of capital flows into Australia but difficult to quantify. “I think there is an element of that,” says Medeiros. “It’s difficult to estimate precisely how much demand is being driven by carry trades, but there are certainly offshore investors willing to take currency risk and buy bonds in Australian dollars, funding them in US dollars, for instance.

“It could be a material amount,” he adds.  “I’m sure there are investors that would consider the bonds attractive given credit fundamentals, relatively high yields and from a currency point of view. You can align the three factors.”