What are bond prices telling us?
When sources of income (most commonly tax receipts) are not sufficient to cover spending programs governments will issue bonds to raise the necessary funds. From time to time asset sales may also be used as a one-off solution to provide an injection of funds. In Australia the ten year government bond is the primary instrument for raising funds.
Running a budget deficit means that the government must keep issuing bonds to fund their expenditure. Conversely running a budget surplus allows the government to reduce debt.
The chart below shows the surplus or deficit over the last 25 years as a percentage of Gross Domestic Product (GDP).
Whilst a deficit of 3 or 4% is low compared to some other developed countries, many economists warn that we cannot afford to be complacent. With falling tax revenues, the projected budget deficit for 2104-15 is $40 billion, an increase of $10 billion on projections made just seven months ago.
Bonds and inflation
Bond investors expect that their capital will be repaid at maturity and that they will be paid interest during the term of the investment. The interest rate required by investors will therefore reflect the expected rate of inflation over the term and the likelihood that interest will be paid each year and the capital repaid at maturity.
This next chart shows the falling bond rate over the last 25 years against inflation. The post 2000 period is an anomaly because the introduction of the GST caused an inflationary spike. For the rest of the period there has been a reasonable margin between the bond rate and the inflation rate. Over the last few years this margin has narrowed and in January 2015 the bond rate was 2.45% and inflation was 1.7%, reflectiong a real return of just 0.75%!
Features of bonds
Government bonds are generally considered to be secure investments because it is assumed that a government controls the nation’s tax base and so should always be in a position to pay the interest due and return the capital at maturity. However we know this does not always happen. Defaults by Russia, Argentina and Greece being recent examples of note.
Fixed interest investors will typically hold a portfolio of bonds with different maturity dates and coupon (interest) rates. Further it is common for investors to buy and sell bonds to reposition portfolios in an attempt to profit from the prevailing and forecast economic conditions.
To illustrate this concept consider an investor who buys a ten year bond for $100,000 which pays 5% interest per annum. The investor will receive $5,000 in interest each year and the $100,000 capital back at maturity.
Assume after one year that the coupon rate on new bonds has fallen to 4%. The bond paying 5% per annum is more attractive and so the investor would be able to sell the bond for a profit based on the present value of the future income stream. The opposite applies if interest rates rise because the 5% bond becomes less attractive.
Bond markets are the secondary markets where bonds are traded. Prices are either bid up (which means yields decrease) or sold down (which means yields increase). In recent months investors have made healthy returns because the value of their bonds have increased. However such returns are ultimately not sustainable as bond yields cannot fall indefintely.
So to the message
It is argued that bond prices in Australia have largely been bid up by offshore investors chasing an attractive yield. Although our interest rates are hisorically low they are still high compared to other developed economies. This is the first time in our history that foreign investors have owned the bulk of the Australian government bonds on issue.
While lower bond yields are generally reflective of a subdued economic outlook and expected low inflation we should also consider current market conditions. As the predominant holders of Australian government bonds are foreign investors it is their assessment of value based on their inflationary outlook and expected real rate of return that matters. Currency movements during the term of their investment will also be a key factor for their consideration.
It is not inconceivable that foreign investors determine due to currency considerations alone that a superior real rate of return should be pursued elsewhere. With momentum that would lead to a reversal of the trend with falling bond prices and higher bond yields.