Daiwa Shuns Sovereigns as Loss Worst Since ’10: Australia Credit

Japan’s biggest investors are favoring higher-yielding debt over government bonds in Australia as improving economic prospects drive the worst losses for sovereign notes in two years.

Daiwa SB Investments Ltd., which manages Asia’s biggest debt fund dedicated to the nation, is bullish on Kangaroo bonds, Aussie-dollar securities issued by foreign borrowers. Mizuho Asset Management Co. and Mitsubishi UFJ Asset Management Co., overseeing more than $100 billion between them, are attracted to state government bonds. Federal debt dropped the past week after falling 0.6 percent last quarter, the most since the final three months of 2010, Bank of America Merrill Lynch data show.

A rebound in iron ore prices and a pickup in manufacturing in China, Australia’s largest trading partner, is buoying investor confidence and curbing demand for safer assets in one of only seven stable AAA sovereign markets. Kangaroo and state debt gained 9 percent on average in 2012, versus 5.5 percent for federal notes, according to Bank of America indexes. Japanese fund gains were amplified by the Australian dollar’s 15 percent rally against the yen.

“People are searching for more yield,” said Yoshisada Ishide, who manages the $11 billion Daiwa SB Short-Term Australian Dollar Bond Open Fund, which is also Asia’s second-biggest mutual fund. “Investors are still willing to take credit risk.”

Buying KFW

Daiwa SB bought Kangaroo notes in November, said Ishide, whose holdings include debt sold by German development lender KFW and the European Investment Bank. He said he is “underweight” federal notes.

Returns on an index of local-currency debt from foreign issuers and Australia’s six states and two territories beat sovereign notes last year by the most since 2009, led by a 21 percent advance for bonds of the European Bank for Reconstruction and Development and a 14 percent gain for EIB.

The gauge, compiled by Bank of America, returned 24 percent to Japanese investors after accounting for a tumble in the yen, which slid 13 percent versus the Australian dollar last year. It fetched 91.56 per so-called Aussie as of 12:26 p.m. in Sydney after reaching 92.85 on Jan. 7, the weakest since September 2008.

Demand for Australian assets will persist as confidence recovers, which may push the Aussie-yen rate toward 100, said Ishide. He holds fewer government securities than would be indicated by the gauges the fund uses to judge performance.

Yields Rising

Australia’s benchmark 10-year yield has increased after a decline last year, rising to as high as 3.47 percent on Jan. 7, the most since August. The rate was at 3.39 percent today, 152 basis points more than for similar-dated Treasuries.

The average discount on federal notes to Kangaroo and state debt shrank to 69 basis points yesterday, matching the narrowest since October 2011.

“This is a good time to start gradually switching back to government bonds,” said Hideya Kubo, a senior money manager in Tokyo at DIAM Co., which oversees the equivalent of $118 billion. “The spread between government bonds and other credit products has become expensive.”

DIAM has been adding to government holdings in the past six months and is aiming to reduce investments in Kangaroo bonds and state government notes before the second half of 2013, he said.

Iron Ore

Prices for iron ore, Australia’s biggest commodity export, climbed yesterday to the highest since October 2011. Government figures last week showed Chinese manufacturing expanded for a third-straight period in December and matched the fastest pace in seven months.

Australia’s statistics bureau said today retail sales unexpectedly declined in November after stalling the previous month. A bigger-than-expected trade deficit and slumping consumer confidence, amid a looming peak in resources investment, are also supporting the case for lower borrowing costs in the South Pacific nation.

Interest-rate swaps data compiled by Bloomberg show traders show an 84 percent chance Reserve Bank Governor Glenn Stevens will cut the overnight cash rate target to 2.75 percent or less by June, which would take it to the lowest level in the central bank’s 53-year history.

“There’s still a lot of yield pickup in state bonds,” said Hideo Shimomura, who helps oversee the equivalent of $69 billion as Tokyo-based chief fund investor at Mitsubishi UFJ, a unit of Japan’s largest publicly-traded bank. Government bonds may benefit from rate cuts later in the year, he said.

Queensland Gains

Bonds by Queensland, the biggest issuer with about A$78 billion of outstanding debt, returned 9.4 percent last year compared with an average 8.5 percent for a Bank of America gauge tracking so-called semi-government notes. The state’s bonds shrugged off a downgrade by Fitch Ratings to AA in September.

The spread between Queensland’s July 2023 security and comparable sovereign bonds shrank to 107 basis points today from 124 on Nov. 29, according to prices from Australia & New Zealand Banking Group Ltd.

Hiromasa Nakamura, a senior investor for Tokyo-based Mizuho Asset, which oversees the equivalent of $38 billion and is part of Japan’s third-biggest bank, said he is optimistic on state bonds and so-called supranational notes issued by borrowers that are backed by more than one government.

“Spreads are stable or gradually shrinking,” said Nakamura, who counts notes by EIB and Queensland among his favorites in the South Pacific nation. “The credit situation is improving.”