Is the Aussie bond safe haven a myth?

Like their foreign counterparts, Australian bonds seem to have gone from risk-free return to return-free risk. Matthew Drennan explains why bonds are not the safe haven, despite the stampede for the safety of this asset class.

We are familiar with the concept of return-free risk in foreign markets, but now Australian bonds too seem to have caught the disease.

Driven by a combination of renewed concern about countries exiting the Euro, an inability to agree on refinancing shaky European banks and capped off by vacillating concerns about the degree of slowdown in China and the continuing local circus masquerading as a Parliament, investors are stampeding for the "safety" of bonds.

While this has been one of the best-performing asset classes over the last 12 months, it is in my view difficult to see them as the safe haven many are claiming.

Let's look at these drivers in turn.

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Get your money for nothing and your risk for free

Australian 10-year yields touched a record low of 2.86 per cent recently following negative headlines from pretty much every major region in the world.

To put this in perspective, it means that after allowing for inflation, investors are prepared to lend to our minority government for no return.

You know people are really scared when they are prepared to lend you money for nothing.

Sadly, for overseas investors, this seems like a great deal compared to the risk they must take to lend to some peripheral European countries, or the negative returns on offer from stronger nations such Germany.

Another way of putting the enormity of this move into perspective is to look at the pace of change in the outlook.

As recently as March this year, our 10-year bonds were trading at a yield well above 4 per cent, and that oracle of economic forecasting the Reserve Bank of Australia (RBA) was warning of inflation risks. (Chalk up another great call for our policy makers. I bet some of them actually believe the official unemployment rate of 4.9 per cent too).

With the official cash rate at 3.75 per cent, the market is implying that the RBA will need to cut rates sharply in coming months.

The justification for the stampede to bonds is that at least your capital is safe and not being eroded by those nasty equity markets. Valuations are on the back burner as fear trumps greed.

Unless investors are planning on holding these bonds to maturity, there is a real risk of capital loss sometime in the future as the fear dissipates and the RBA moves to push interest rates back up to more normal levels.

If you were smart enough to buy bonds 12 months ago – great – but jumping in now is a whole different story. Why wouldn't you just buy overnight cash or 90-day bills? I don't get it.

What kind of a world do we live in where a bunch of second-tier European countries steal all the press?

The focus on contagion from Europe fascinates me. Apart from scary headlines, what is the real linkage with us?

Presumably this relates to the fact that it's a big export market for China and we, of course, supply the raw materials that fuel this production. The most recent concern stems from the fall in the Chinese Purchasing Managers Index to just 50.4. (anything below 50 signals a contraction in manufacturing activity).

This is not great news but, as I have often argued, China has the centralised control and financial firepower to ensure its gross domestic product growth remains around 8 per cent or higher.

Again the naysayers will argue that this is well shy of the 11 per cent figure generated last year.

True, but did you really think it would be allowed to stay at such unsustainable levels, and more importantly, did you base your investment decisions on that dubious assumption?

In addition, China is fast moving to a much more internally driven economy based on domestic consumption.

This will increasingly insulate it (and us) from the vagaries of the Eurozone dramas. Is the increasing likelihood of a Greek or even a Spanish exit really a cause for so much concern? The world seemed to muddle along reasonably well before the Euro Bloc formation.

Back to the Future IV?

I’ve lost count of how many false starts we have had in the Australian equity market recovery story. Suffice to say it would have long ago been disqualified from any Olympic sport.

After looking like it had broken out of the trading range and climbing higher, the Australian equity market is back on the mat (yet again) with the rest of the global stock markets.

This is despite the fact that we have not recovered to anywhere near the same extent of the US market, for example.

Much of this no doubt is attributable to the (until recently) high Aussie dollar.

If it continues to head south because our interest rate spread is less attractive and some of the steam comes out of the speculative bubble in resources as China slows and the supply response over the last five years begins to impact, then suddenly the landscape for investment returns alters dramatically.

Those long-suffering investors in global equities will start to recoup some of the losses brought about by the rising Aussie dollar, which more than offset attractive gains in foreign equity markets over recent years.

Foreigners will be attracted to Australia once more because prices appear more reasonable and the dividend yields remain extremely attractive.

Two mainstream examples. First Telstra, which is trading on an undemanding price-to-earnings (PE) ratio of under 13x and generating a dividend yield of 7.6 per cent.

The other is Westpac (yes, I know the banks have some issues, but “tell ‘em the price son”), which is on a PE of under 10x and is yielding 8 per cent.

Could we at long last see some upside in local equities over the next 12 months? Stranger things have happened.

One thing is becoming increasingly clear. When the bull market arrives, the bounce is likely to be extremely rapid, with interest rates so low and base money supply so plentiful.

Matt Drennan is a business and financial markets commentator.