Performance and relative value

Strategists say Australian bond outperformance may not be able to continue throughout 2020. But they also do not expect a dramatic spread reversal to emerge.

DAVISON We have talked for years about whether bond yields can keep tightening, yet the Australian sovereign and semi-government market continued to perform in 2019. What is the outlook for 2020?

STANLEY We are bullish on semi-government and government bonds. The starting point for yields is a lot lower in 2020 than it was a year ago so the level of returns probably won’t be what it was. We see global growth stabilising at a slower pace, rather than rebounding significantly. Global yields will, therefore, mostly be range-bound. In contrast, we see the Reserve Bank of Australia (RBA) cutting rates more than is currently priced so we expect the drivers of performance to be more domestic than global, relative to last year.

We think semi-governments spreads will grind tighter. Low rates are supportive, the market is familiar with the infrastructure-driven nature of increased bond supply and we don’t foresee ratings issues.

WHETTON I agree that we likely won’t see the same returns as in 2019, which came about largely from global factors. We are probably a little more circumspect around the semis. They have a substantial borrowing task, although there is plenty of demand and they have conducted extensive prefunding.

One I’d highlight in particular is Western Australia (WA). The state enjoyed a big revenue pickup from iron ore in 2019 as well as an improved GST [goods and services tax] outcome. GST is more permanent, but we don’t expect the same benefit from iron ore. We don’t think WATC [Western Australian Treasury Corporation] will see the same return it did in 2019, though we think it will stay reasonably tightly priced.

At the moment, we don’t expect the eastern states to have to borrow any more as a consequence of the bushfires. This depends, to some extent, how much the federal government is prepared to step in to fund recovery. The prime minister has already announced a A$2 billion (US$1.4 billion) relief package.

PLANK The states could direct some of their prefunding in this direction.

WHETTON Exactly. As of mid-January, the states have only about A$14 billion of issuance left to do in the year to the end of June.

MCCOLOUGH That is now 55-60 per cent complete.

PLANK Our outlook overall is a little different. We think US yields will go up – not by much, but above 2 per cent – because we don’t expect the US Federal Reserve to cut. This would normally drag Australian bond yields up, but the RBA cuts’ impact will offset this.

As a result, the US-Australian 10-year yield spread is hitting minus-100 basis points, allowing a sideways move in the absolute level of the 10-year Australian Commonwealth government bond (ACGB).

In the semi-government space, we think the outperformance of WA has largely played out for the time being. We are broadly neutral on double-A versus triple-A, but we expect the sector overall to tighten somewhat. I very seldom worry about supply – I think a supply increase has to be enormous or based on a shock to have a real impact. In fact, I tend to think greater supply promotes greater demand.

MCCOLOUGH I tend to agree. I believe we have seen one budget round – in 2017, when New South Wales (NSW)became a net issuer again – that spurred a small supply-driven impact in the market. But even this was short lived, and as soon as the new supply started coming it was readily absorbed.

Our overall picture on yield is not that different, even though we have a more bearish outlook for the US. We see lower 10-year yields in the US and this will inevitably have feed-through effects, so we don’t anticipate as much outperformance for Australia. On the other hand, if QE does come into effect, it should trigger quite strong outperformance.

We have US 10-year yield getting down towards 1.15-1.20 per cent. Australian 10-year yield would go to about 1.75 per cent in this scenario – and we forecast QE to follow.

My sense is that a 45 basis point spread for triple-A semi-government 10-year notes to ACGBs is fair. But I think that spread will get tighter in the year ahead. With QE, I can imagine it getting down to 25-30 basis points.

DAVISON Any more thoughts on specific relative value between the states?

WHETTON Overall, we probably still marginally favour the double-A rated states – especially Queensland. In the triple-A space, Victoria seems to be able to do its incremental spending on infrastructure in smaller amounts – which gives more flexibility.

NSW’s infrastructure plans are things like big tunnels, which it can’t just abandon. Victoria has a lot of smaller projects and can slow down if necessary. It also has the benefit of a reasonably strong economy.

STANLEY Relative spreads between issuers are so tight that it is difficult to see the big opportunity purely on a valuation basis.

From a fiscal metrics perspective, the one that really stands out is WA. Iron-ore prices need to fall by plenty to be below state forecasts, which are for a return to the long-run average. WA has also improved its fiscal credibility by establishing a greater track record of limiting expense growth, while its net issuance task is likely to stay quite low.

MCCOLOUGH There is less idiosyncratic risk in the state sector than there has been for some time – whether it be the drivers of individual state economies or states’ financial management capabilities. Looking at WA as an example, achieving an operating surplus in the general-government sector and 1.3 per cent expenditure growth is remarkable considering the state’s previous track record.

I don’t see much reason for a triple-A to double-A spread to open – assuming that any QE package is not discriminatory. I don’t see specific double-A outperformance, in other words, in the absence of a credit uplift.

This latter outcome isn’t impossible: I was surprised by how quickly S&P Global Ratings was prepared to move on South Australia and WA, given its track record. On the other hand, I think some positive credit direction is already priced into spreads.

I think it is a little easier to see triple-A outperformance, if we get two rate cuts and a consequent positive impact on housing-market revenue for NSW and Victoria. But it’s marginal, to be quite honest.