Aussie govt high yields to limit bond indigestion

24 Feb 2009 Reuters

By Cecile Lefort

SYDNEY, Feb 24 (Reuters) - Australia's state-backed debt could triple in the next three years as governments and banks go on a borrowing binge, but the country has significant advantages over major sovereign issuers such as the United States to offset the risk of debt indigestion.

As many governments around the world are piling up huge amounts of debt to fund efforts to counter the global downturn, analysts expect the same of Australia.They estimate outstanding debt will be as high as A$500 billion ($322 billion) by 2012, triple current levels. That would equal half the country's annual economic output, a lot for investors to swallow when governments globally are competing for their cash.

"There probably will be some issues with digestion," said Sally Auld, a strategist at JPMorgan in Sydney. But she highlighted mitigating factors such as increasing investor demand for debt that carries a sovereign label. "Triple A rated supply is going to go up but also demand for that sort of paper will go up as lots of funds who liked credit now switch back to more vanilla products," she said. But that could apply to other countries as well. As elsewhere, Australia has launched a substantial stimulus package of A$42 billion to fight a looming recession.

But unlike many other sovereign issuers, Australia is starting from a position of strength thanks to years of budget surpluses and a strong banking sector that avoided investing in the U.S. subprime mortgages that triggered the global financial crisis. Australia's high bond returns and a weakening currency are also major pluses. "In a relative sense, yields in Australia are still quite high, they will help attract offshore investors," said Auld. Australia's 10-year bonds yield 4.11 percent, much higher than similar bonds in countries with the same AAA rating. U.S. 10-year bonds, for example, yield 2.78 percent and British 10-year bonds yield 3.46 percent.

Last week, the governor of the Reserve Bank of Australia said policy rates could still fall, but they were unlikely to fall as much as in the United States or Britain, suggesting yields will maintain a premium over debt in those countries.

For federal or regional governments, now is also the right time to borrow because bond yields are at 50-year lows. Moreover, Australian bonds may seem cheap to many punters. The Australian dollar has fallen over a third since July against the U.S. dollar, and is expected to fall further.

NO DEBT
Another key advantage for Australia's ambitious borrowing plan is it is starting almost from scratch with near zero debt outstanding, so its bonds have a scarcity value. In fact, Australia's is starting from a rare net asset position of 4 percent of GDP, based on the end of the financial year 2007/08 on June 30.

Even with net debt expected to reach 5 percent of GDP by 2011/12, it will still be well below net debt of about 20 percent of GDP in Canada, about 40 percent in Europe, Britain and the United States and about 80 percent in Japan, UBS says.

By keeping its debt outstanding steady at around A$50 billion for the past five years, the central government made its debt scarce when compared with other AAA-rated nations. Its debt level is a fraction of the US$10 trillion in outstanding debt of the United States or the 128 billion pounds ($185.8 billion) in Britain. "At least in the initial phase, new CGS (Commonwealth Government Securities) issuance is likely to be in demand," said Westpac Banking Group's chief interest rate strategist, Damien McColough.

Australia's recent bond auctions received good demand with bid-to-cover ratios above four times. This is almost double the level of demand seen in U.S. Treasury auctions, although they tend to offer much greater amounts of debt than in Australia. This week alone, the U.S. will borrow $94 billion - three times the total in Australian government bonds outstanding.

FEDERAL VERSUS STATES
But the government is not the only borrower. The country's state governments are looking to suck up almost as much money, if not more, to fund their own infrastructure plans. And the central government has inadvertently put the states at a disadvantage by guaranteeing wholesale borrowing by the country's banks, effectively lending them its AAA rating. The guarantee has been vital for banks to secure funds. They have raised A$58 billion already this year.

But it has also introduced a new competitor for the states and one that pays lenders a more attractive return -- as much as 100 basis points (bps) more than semi-government bonds. And after Standard & Poor's cut the rating on Friday of Queensland Treasury Corp, the largest state authority borrower in Australia, the gap will only increase further. "If there is going to be an (indigestion) tipping point, it's going to occur in the states before it occurs in the government. There will be less investors for state-debt in the near term than with the federal government," said Westpac's McColough.

Commonwealth Bank of Australia's head of debt research, Adam Donaldson, predicts the total amount of AAA-rated bonds, sold by the Treasury, the six local semi-governments and banks that now benefit from a sovereign guarantee, will balloon to nearly A$500 billion by 2012, triple the level of June 2008. "One can't help but fret the market is going to have difficulty absorbing that issuance," Donaldson said.

I can sense a long AUD trade looming at some stage!! KT