Sales Surge Spurs Worst Yield Gap Since 2008: Australia Credit

Sales Surge Spurs Worst Yield Gap Since 2008
Australia’s economy has faltered after floods at the start of the year disrupted coal exports and the global financial turmoil spurred by Europe’s debt crisis undermined business and consumer confidence. Photographer: Jeremy Piper/Bloomberg News

Australian state bonds are set for the worst quarter relative to sovereign debt since 2008 as record borrowing needs spur regional authorities to increase their share of debt sales compared with corporate offerings.

The extra yield demanded to hold state securities instead of Australian sovereign notes rose 23 basis points since June 30 to 67 on Sept. 27, Bank of America Merrill Lynch indexes show, compared with a 44 basis-point gain in the fourth quarter of 2008. States issued 39 percent of Australian underwritten debt sales in the period, from 25 percent in the first half of 2011, Bloomberg data show. The spread to Treasuries for U.S. municipal borrowings fell 13 basis points to 56 since June 30.

Returns on Australian state debt are trailing sovereign bonds for the first time in five quarters as investors dump declining stocks and choose federal government assets above all else, spurring the securities to the developed world’s steepest annual climb. Global equities fell since June 30 by the most in more than 2 1/2 years and local stocks are headed for their first back-to-back annual decline since 1982. Queensland is the biggest debt seller this year as the state boosts spending to repair damage from its worst floods since the 1970s.

“We’ve seen a generalized flight to quality where sovereign bonds have outperformed pretty much everything including state debt,” David Plank, head of research at Deutsche Bank AG in Sydney, said yesterday. “There’s been an element specific to the states in the context of the need for Queensland, in particular, to issue and that’s put upward pressure on spreads given the lack of liquidity and the general risk-off environment.”

Fiscal Position

Australian states sold A$4.2 billion ($4.1 billion) of so-called semi-government securities in the third quarter out of A$10.7 billion in total issuance as most firms shunned credit markets amid widening spreads, Bloomberg data show. Queensland, the biggest regional government borrower, issued A$1.9 billion since June 30 and a total of A$10 billion this year.

The state’s funding arm signaled last month it will now issue debt only when dealers ask to buy the bonds amid volatile markets, according to an Aug. 31 research note from Nomura Holdings Inc. Sales of new benchmark securities will be based on investor demand, Richard Jackson, Brisbane-based general manager for funding and markets at Queensland Treasury Corp. said the same day.

Record Borrowings

Queensland has A$70.1 billion of debt outstanding followed by New South Wales with A$52.2 billion and Victoria with A$27 billion. Semi-government debt amounts to more than A$185 billion, including borrowings from Western Australia, South Australia, Tasmania, the Northern Territory and the Australian Capital Territory, data compiled by Bloomberg show. That’s the most on record, based on Reserve Bank of Australia figures.

“The fiscal side for the states is going to be under pressure for the rest of this decade really, and that will put pressure on debt levels and credit ratings for some of the states,” said Deutsche Bank’s Plank.

Fitch Ratings changed its outlook on Queensland’s debt, rated AA+, to negative on July 27, citing the state’s slow budgetary recovery in an environment that “largely remains challenging.” South Australia had its long-term credit rating outlook revised to negative, which may lead to a cut from AAA within the next two years, Standard & Poor’s said in a statement on Sept. 23.

Faltering Economy

Australia’s economy has faltered after floods at the start of the year disrupted coal exports and the global financial turmoil spurred by Europe’s debt crisis undermined business and consumer confidence.

The extra yield investors demand to hold Australian company bonds instead of government debt surged 53 basis points since June 30 to 230 yesterday, according to a Bank of America Merrill Lynch index. It reached 233 on Sept. 26, the highest since September 2009, the Australian Corporate and Collateralized Index shows.

Bonds sold by Australia’s six states and two territories returned 5 percent this quarter, including reinvested interest, the Merrill Lynch indexes show, compared with 5.8 percent for government debt.

Australian sovereign securities have generated an 11 percent return over the past 12 months, the biggest of any major market, Bloomberg/EFFAS Bond Indexes show. The MSCI World Index of shares slid 15 percent since June 30 and has fallen 11 percent since Dec. 31. The Australian All Ordinaries Index of stocks is 11 percent lower in the third quarter and down 13 percent this year.

The benchmark Australian government 10-year yield rose five basis points to 4.25 percent as of 2:26 p.m., poised for its highest closing level since Sept. 9. The rate’s premium over similar-dated Treasuries widened 7 basis points to 230. The Australian dollar, the world’s fifth-most traded currency, traded at 98.58 U.S. cents from 99.14.

Seeking Alternatives

Demand for Australian government bonds is being spurred by overseas investors seeking alternatives to holding the U.S. dollar and euro as those economies struggle to contain deficits. Offshore investors held 75 percent of Australian bonds as of June 30, up from 73 percent at the end of the previous quarter and 66 percent in the final quarter of 2007, according to data from the central bank and statistics bureau.

Yields on all Australian government securities, including the longest-dated bond maturing April 2023, have been lower than the Reserve Bank of Australia’s cash rate since Aug. 9. While state bonds have trailed that advance, yields on 2020 notes issued by New South Wales and Victoria also fell below the cash rate this quarter. Both states are rated AAA by S&P, matching the federal government’s grade.

Rate Expectations

“The sheer expensiveness of bonds relative to cash is something that took a heavy toll on semi-government bonds,” said Adam Donaldson, head of debt research at Commonwealth Bank of Australia in Sydney. “In recent weeks, views about the Reserve Bank have shifted and the idea that they could cut rates has generally become more accepted than it was a few months ago,” prompting investors to pare bets that yields will rise.

Cash-rate futures show traders are wagering that the RBA will reduce the developed world’s highest benchmark rate of 4.75 percent to 4.12 percent by December.

The yield on New South Wales’ May 2020 securities was 4.79 percent yesterday and rose to as much as 74 basis points more than the 10-year sovereign rate on Aug. 19, the most since April 2010. Victoria’s June 2020 note yielded 4.79 percent, with the spread over benchmark government bonds reaching 72 basis points on Aug. 19.

Queensland bonds maturing in February 2020 yielded 5.03 percent or 78 basis points more than the benchmark. The spread for South Australia’s longest-maturity notes due September 2017 was 80 basis points more than the six-year sovereign yield, after widening to as much as 87 on Aug. 22.

Fund Managers

Australian fixed-income fund managers increased their weightings of state government debt to more than 27 percent of portfolios on Sept. 26 for the first time since November 2005, from 26.8 percent on Sept. 12, according to a Deutsche Bank survey.

State bonds’ relative yields may be influenced by offshore buyers comparing the debt with Australian-dollar issuance from highly rated foreign borrowers such as the World Bank Group and the European Investment Bank, said Deutsche Bank’s Plank. As Europe’s debt crisis spurs global financial turmoil, an increase in the spreads for such supra-nationals may be transmitted to Australian state debt, he said.

“Spreads are being driven more by what’s happening in Europe than what’s happening in Australia,” said Plank.

Non-Sovereign Borrowers

An index that includes Australian-dollar denominated issuances by highly rated non-sovereign borrowers has returned 5.2 percent this quarter, Merrill Lynch data show. The extra yield demanded from such securities instead of sovereign notes rose 16 basis points this quarter to 72 on Sept. 27, the data show.

The spread between the interest Australian banks pay when borrowing from each other for three months and swaps tracking expectations for the RBA’s benchmark was little changed at 39 basis points. The gap, a gauge of banks’ difficulty in accessing funds, closed at 61 on Aug. 8, the highest since January 2009.

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