Bond yields decline further making it hard for investors with cash to find a home

By Craig Simpson

For the month of April the ANZ Govt Bond Index provided investors with a 1.4% return for the month, making the annual return 6.3%.

Increased global demand for NZ Government Stock (NZGS) drove yields lower and subsequently capital values rose.

NZ Swap and Corporate Bond Indices on the other hand delivered positive returns but to a lesser degree. The yield on the ANZ Investment Grade Bond Index fell to its lowest level of 3.94% p.a. (a 27bps fall over April) and since the end of the month the yield on the index has fallen further to approximately 3.90% p.a.

One factor cited by a broker for the continued performance in bond markets has been strong demand for bonds from KiwiSaver providers and the sustained lack of new issuance.

It has also been widely reported there is a shortage of quality bonds on offer and the continued demand for our debt by offshore investors continues to compound the problem. The latest RBNZ data shows that approximately 70% of NZGS is now held offshore and this is a new 3½ year high and a record in dollar terms.

Over the next few weeks there are both BNZ and Mighty River Power bonds maturing so this money along with any other cash investors have in the bank will be trying to look for a home.

Investors will be finding it increasingly difficult to find good quality investment grade bonds (i.e. S&P rating of BBB- or above) that provide both an attractive yield to maturity and are trading at reasonable prices.

Many investors will be left resorting to pay a premium for bonds which meet their investment criteria.

The same issues are facing institutional investors and one broker we spoke to faces the issue of wanting to profit from some of their holdings but faces the problem of finding a home for the proceeds. In the meantime they would rather keep holding the position rather than have the money sit in cash.

One of the biggest factors adding to the supply / demand conundrum is the lack of new corporate issuance and in particular bank paper. One of the reasons for this has been that the Core Funding Ratios of the banks are in much better shape meaning the banks are not forced to raise capital.

There is an expectation of a shortage of bank issues in the immediate future according to BNZ. Other quality corporate issues are few and far between which leaves cashed up investors looking for a home for their cash.

Outside of bank bonds there has been little by way of corporates coming to the retail market to raise capital. Infratil are currently are looking to raise up to $100 mln and is offering an interest rate of 6.85%. The issue is not rated and matures in June 2022.

Interest rates tipped to rise

The latest bond market reviews indicate an expectation that swap rates will shift higher against the backdrop of reduced NZGS supply and continued offshore demand. The market continues to forecast a rise in the OCR by 25 bps in early 2014.

Roger Kerr in his latest weekly commentary sees increasing US bond yields over coming weeks which suggests that market participants (i.e. global fixed interest fund managers, hedge funds and US corporate borrowers) will be having more confidence about an earlier Fed withdrawal of stimulus.

Kerr believes the direction of US bond yields over coming weeks will have a greater impact on our wholesale swap interest rates from three years onwards than any local economic data, the May budget or investor/borrower activity in New Zealand.

NZGS demand could get heavier

Half way through April saw the NZ Debt Management Office (NZDMO) issue $2 bln of the new 2020 NZGS. The settlement of this bond coincided with the April maturity of an existing NZGS issue.

Needless to say there was plenty of funds coming available looking for a new home and the 2020 bond attracted strong bidding and was issued at an initial yield of 3.15%. Australasian investors took 63% of the 2020's and were immediately rewarded with yields falling 22 basis points (bps) to 2.93%.

A further $120 mln of Govt bonds maturing in 2023 were issued by the NZDMO in April with a bid-cover ratio of 4.4 times. Looking ahead, there are 3 more NZDMO issues for Govt bonds due in May through June totalling $360 mln ($120 mln each).

The bonds on offer are likely to include either the 2020 or 2023 maturities. Once we get through June, ANZ are expecting normal transmission to return with around $500 mln of new bonds issued monthly. ANZ notes the rising costs associated with the Canterbury rebuild (noting that the Government’s contribution has been lifted from $13 bln to $15 bln) suggests an increase in the borrowing requirement at some stage.

ANZ in their latest Credit Focus report expects the May 16 Budget will continue to flag reduced nominal NZGS issuance in favour of inflation-indexed bonds.

Also the same report notes NZ inflation-indexed bonds could be included in global indices later in 2013, while speculation has been mounting that New Zealand may be included in the Citigroup World Government Bonds Index (WGBI). The key criteria for inclusion in the WGBI is related to market size and there would be some pretty big hurdles to get over before we are included in the index. nominal bonds are unlikely to meet index inclusion criteria until next year at the earliest.

If our NZGS bonds (nominal and inflation indexed) are included in major global indices this will cause an even greater problem as more investors will be required to hold our bonds primarily because they are represented in the WGBI index.

ANZ believes that to meet all three foreign currency market size criteria by January 2014, the NZ$ would need to appreciate by at least 3.8% against the EUR, hold above 0.8450 again the US$ and be at least 84.7 against the Yen. If the target is not achieved by January 2014, then the most probable date to meet the WGBI criteria would be in early 2016.

Local Govt bonds offer better yields that NZGS

We have seen continued demand for the Local Government Finance Authority (LGFA) bonds with the latest issue being over-subscribed by nearly 4.8 times.

The yields on the LGFA securities are generally better than what can be achieved on NZGS but is lower than corporate bonds and attracts those investors looking for reasonably secure income and reduced credit risk.

To date and to the best of our knowledge no Local Authority that has issued bonds on our market has ever defaulted.

The LGFA's are not govt guaranteed but when you consider the issuers have the ability to increase rates in their respective districts the chance of default diminishes somewhat, but having said this there will always be some investment risk no matter how small.

At present the LGFA bonds are offering a yield pickup between 0.3% and 0.5% over swap rates and approximately 0.8% over equivalent NZGS. With this pickup available it would seem logical to expect some of the retail investors who traditionally only hold NZGS may need to look towards LGFA's to enhance the yield on their portfolio without sacrificing credit quality.

Examples of Credit Spreads over swap and NZGS

In general, one thing investors should be looking at is the relative spread over both swap rates and NZGS of a similar maturity.

We saw credit spreads contract just before the Global Financial Crisis and then blow out again as investors sought more secure forms of income.

One observation made during the heady times of 2007/2008 was investors were not being adequately rewarded for the risks they were taking.

Investors just saw the headline interest rate and did not care the lowly rated bond was trading at such a small margin over swap or NZGS.

Below are some examples of current spreads available for corporate and bank bonds with maturities in 2017. The data is from ANZ's Credit Focus report and some of the issues shown in the table below may not be available to retail investors or subject to minimum parcels of $100,000 or above. The spreads are subject to change with market movements.

From the table readers will immediately be able to spot that the Contact Energy Bond spread to both swap and NZGS is tighter than the Goodman bond which carries a higher credit rating.

The tighter spread margin could be due to increased demand for the Contact bond. There is a small difference in the maturity date too but this would not necessarily explain the 0.2% odd difference, we would have thought.