Gillard Surplus Amid BHP Slump Cuts Bond Risk: Australia Credit

Australian Prime Minister Julia Gillard’s determination to carry out record spending cuts even as a mining boom falters is winning over credit markets.

The gap between the cost of contracts to insure Australian debt and U.S. Treasuries shrank 3.5 basis points this month to 21.6 basis points yesterday, set for a second-straight monthly drop. Credit-default swaps for the South Pacific nation, which gauge bond risk perceptions, cost 15 basis points more than for the U.S. on Oct. 4, the smallest difference since August 2011.

Gillard, slammed by opposition leader Tony Abbott for endangering growth with taxes on mining and carbon emissions, plans to return the budget to surplus even as BHP Billiton Ltd. delays projects on sliding commodity prices. She’s trying to recover from the worst popularity ratings in almost 20 years to win elections in 2013. Australia’s fiscal discipline is luring Daiwa Investments Ltd. and Pacific Investment Management Co. to the nation’s bonds as they pull back from Treasuries.

“Australia has a very good budget situation and a firm AAA rating,” said Kei Katayama, who buys U.S. and Australian debt in Tokyo for Daiwa SB Investments Ltd., which manages the equivalent of $63.1 billion. “That’s positive for the currency and the bonds, and makes it easier to invest.”

Favoring Aussie Bonds

Daiwa SB holds more Australian dollar-denominated assets than the percentage in the benchmarks it uses to gauge performance, and less U.S. assets than indicated, Katayama said.

Buyers of U.S. Treasuries should avoid 30-year securities as the Federal Reserve’s monetary stimulus risks stoking increases in asset prices, Tomoya Masanao, head of portfolio management for Japan at Pimco, which runs the world’s biggest bond fund, told a conference in Tokyo on Oct 10.

Pimco, which oversees $1.82 trillion in assets worldwide, is favoring Australian 5- and 10-year government notes, according to Scott Mather, head of global portfolio management at the Newport Beach, California-based company. The Australian dollar’s resilience may spur the Reserve Bank of Australia to cut its benchmark rate to a record 2 percent over time, Mather said in remarks reported in the Wall Street Journal.

CDS Dropping

Australian five-year sovereign credit-default swaps have fallen 27 basis points this year to 56 basis points as of yesterday, according to data provider CMA, which is owned by McGraw-Hill Cos. The cost for similar-maturity contracts on U.S. notes declined 14 basis points in the same period to 35. The Markit iTraxx Australia index of corporate CDS was little changed at 137.8 basis points as of 12:39 p.m. in Sydney, according to Markit Group Ltd.

The South Pacific nation’s underlying cash surplus will be at A$1.54 billion ($1.6 billion) this fiscal year, Treasurer Wayne Swan said when he presented the budget in May. This will lead net bond sales to drop to A$9 billion in the 12 months ending June 30 from A$44 billion the prior fiscal year, according to official data.

The expected scarcity in supply has prompted overseas buyers to acquire a near-record 78.1 percent of outstanding government debt, according to central bank data. Demand at debt auctions since the start of July has climbed to average 4.05 times the notes offered, heading for the strongest level since the fiscal year that ended June 30, 2007, according to official data.

Demand at today’s sale of April 2023 securities was the strongest for a benchmark 10-year bond since at least 2009, when the government started ramping up borrowings as it boosted spending to counter the impact of the global financial crisis that occurred after Lehman Brothers Holdings Inc. collapsed. Investors bid for 5.02 times the A$500 million of the 5.5 percent notes auctioned, official figures show.

Biggest Drop

Ten-year yields were at 3.14 percent as of 12:44 p.m. in Sydney and have fallen 133 basis points in the past year, the biggest drop among 24 developed markets tracked by Bloomberg outside of Ireland, Portugal and Greece -- who have all accepted international bailouts -- and Belgium. The notes offer almost double the average yield for top-rated peers.

Australian sovereign securities returned 6.3 percent this year, set for a third annual gain and the strongest performance among the 11 markets that retain AAA scores from all three major ratings companies. That compares with a 1.9 percent advance in Treasuries, the least since they lost 3.8 percent in 2009, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies.

Moody’s Investors Service said Sept. 11 it may join Standard & Poor’s in downgrading the U.S.’s credit rating unless Congress next year reduces debt relative to gross domestic product during budget negotiations.

Currency Strength

Investor appetite for Australia’s bonds has also helped drive the local dollar’s 46 percent climb over the past four years, the biggest surge among more than 150 currencies tracked by Bloomberg. The Australian dollar has remained above parity with the greenback for all but 28 days this year.

The so-called Aussie bought $1.0314 as of 12:49 p.m. in Sydney and has risen 7.6 percent from its 2012 trough of 95.82 U.S. cents reached on June 1.

Central bank Governor Glenn Stevens decreased the overnight cash rate target by a quarter-percentage point to 3.25 percent on Oct. 2. Minutes of that meeting released yesterday showed officials concerned over mining companies paring investment.

BHP, the world’s biggest miner, has delayed projects estimated at $68 billion by Deutsche Bank AG after sliding commodity prices led to a 35 percent slump in profit during the 12 months ended June 30.

Bearish Commodities

“Australia has a very sound fiscal situation, but that’s already priced into the market,” said Park Sungjin, head of asset management in Seoul at Meritz Securities Co., which oversees the equivalent of $46.5 billion in bonds. “If commodities continue to be bearish, the CDS level won’t fall. There’s not much more room for spreads to tighten.”

Park has been selling Australian CDS for several months and is pausing after recent price declines. By Dec. 31, benchmark may resume its decline to 50 as a recovery in the global economy supports Australia’s credit standing, he said.

Interest-rate swaps data compiled by Bloomberg show traders see a 68 percent chance the RBA will reduce its key rate to 2.75 percent by February, which would be the least in the central bank’s 53-year history. “On monetary policy, we have ammunition,” as inflation is OK, Stevens said Oct. 12 in Tokyo.

Australia’s benchmark borrowing cost is the highest among advanced economies and compares with a record-low 0.75 percent rate for the euro area and near-zero rates in the U.S. and Japan. Room for the RBA to bolster the economy through rate cuts may allow the Gillard government to end four years of deficits.

Ending Deficits

Australia’s budget shortfall was A$43.7 billion in the fiscal year ended June 30, 2012, equal to 3 percent of gross domestic product, budget papers show.

Gillard has been promoting her government’s economic credentials to boost the Labor Party’s electoral chances. Her minority government’s hold on power has been threatened by sex and embezzlement scandals involving politicians it relied on to pass legislation.

Her approval rating fell to 23 percent in September, 2011, the lowest since 1993 in surveys conducted by Newspoll for the Australian newspaper, and stood at 36 percent this month. The government trails Abbott’s Liberal-National Party coalition by 8 percentage points, according to the latest Newspoll.

Australia’s deficit last fiscal year compares with shortfalls in the U.S. exceeding $1 trillion in each of the past four years, according to data compiled by Bloomberg. The gap was equivalent to 8.6 percent of output in the world’s biggest economy for the fiscal year ended Sept. 30, 2011.

“Australia is in a comparatively strong fiscal position because of the government balance sheet,” said Ben Byrne, a credit markets analyst in Sydney at Citigroup Inc. “In addition, the higher interest rates provide the country with monetary policy flexibility.”

To contact the reporters on this story: Kristine Aquino in Singapore at kaquino1@bloomberg.net; Wes Goodman in Singapore at wgoodman@bloomberg.net

To contact the editor responsible for this story: Rocky Swift at rswift5@bloomberg.net

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