Sunday, 18 December 2011

Australian Bond Yields Hit Record Lows

The yield on a 10 year Australian government bond is trading at a record low around 3.73% this morning. There are several factors which go determine bond yields, but the most notable are inflation and risk.

Inflation matters because an investor would be unlikely to want to lend money to the government for 10 years (that is, buy a 10 year bond), if the return (annual interest rate) is eaten away by inflation. The higher the expected rate of inflation, the higher the yield needed to attract investors to buy and hold that bond.

The current record low yield on Australian bonds suggests investors are expecting inflation to be very low over an extended period of time. The near 20 year lows for board commodity pricesplus the massive amount of spare capacity in the global economy suggests this to be a well founded backdrop to the current record low yields.

A dominant issue at play now and in fact in recent years is the pricing of risk into bond yields. Again, think of an investor buying a 10 year bond. The greater the risk of default by the government, the higher the premium (interest rate) required by an investor to make that trade. With Greece clearly a high risk of default, it is no surprise that some of its bond yields hit 100%. What return would you insist on if you thought it likely the entity wouldn't pay you back? With risk of an Italian default rising, it is also no surprise its yields have skyrocketed.

With the risk of a US or German default on bonds very low (it seems), yields in those countries are around 1.85% - also near record lows. They are big enough to keep printing money to pay back investors - or at least that is the common perception at the moment.

For Australia, which is one of only 8 countries (at last count) that has AAA and stable ratings from all three major credit ratings agencies, sovereign risk is assessed to be one of the lowest in the world. The risk of the Australian government defaulting on a bond is as close to zero as you can get - hence the record low yields.

On balance, it seems likely that Australian bond yields can fall further. Some in the market are still spooked by inflation for some unknown reason and there is some hopelessly ill-informed chatter about sovereign risk in Australia. When these misunderstanding fade further into the back blocks with updated data on falling inflation and the return to Budget surplus in 2012-13, we should see yields continuing to meet new record lows.

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