Pimco Bets on Bonds After Worst Run Since 1994: Australia Credit

Australian bonds are attractive after their worst run of losses since 1994 because the central bank will need to lower interest rates as mining investment drops, Pacific Investment Management Co. said.

Pimco, which runs the world’s biggest bond fund, is favoring federal debt and taking positions in interest-rate swaps on expectations a U.S.-led run-up in global yields is at odds with the slowing Australian economy, said Adam Bowe, a Sydney-based money manager. Sovereign notes fell for a third quarter in the three months to June 30, matching the length of a more severe slump 19 years ago.

“We don’t think we’re at the end of the RBA’s easing cycle,” said Bowe. “The growth outlook over the next 18 months is quite challenging: first we get the leveling off in mining investment and then the level of investment will likely come down resulting in a potentially significant detraction from growth from that sector.”

Areas such as residential construction and commodity exports are unlikely to fill the gap left by declining mining investment, the biggest contributor to Australian growth last year, Bowe said. The extra yield the nation’s 10-year bonds offer over U.S. Treasuries is narrowing for a third year, heading for the longest stretch of annual declines since the early 1990s, when the smaller nation last experienced recession.

Sagging Growth

Australia, the fastest-growing major developed nation on average over the past five years, is struggling as a record mining boom peaks.

The Reserve Bank of Australia in May reiterated its forecast for “below trend” growth of 2.5 percent this year and predicted a 2014 expansion of between 2.5 percent and 3.5 percent. The median estimate among economists matches the RBA’s for this year and projects growth of 2.8 percent next year, according to Bloomberg surveys.

In a July 3 speech, RBA Governor Glenn Stevens said some industries are “well placed to expand once they have the confidence to do so.”

“That confidence seems pretty subdued right now,” he added.

Swaps traders are betting on 47 basis points of cuts to the nation’s 2.75 percent benchmark rate by December, according to Bloomberg calculations. The RBA is the only major central bank expected to substantially ease policy over the next 12 months, Credit Suisse Group AG indexes show.

Favoring Sovereigns

Those expectations didn’t prevent Australia’s benchmark 10-year yield from rising to a 14-month high of 4.04 percent on June 24, as signs that the Federal Reserve may pare back its bond-purchase program led to a sell-off in debt securities.

“We prefer to hold Aussie government bonds and high-quality spread assets like swap as we think interest rates will come down,” said Bowe. “The domestic outlook and the rise in global yields, due to the debate on whether the Fed will taper in the near-term, provide attractive valuations for Australian government bonds.”

The 10-year rate rose 47 basis points since Dec. 31 to 3.74 percent today, or 1.18 percentage points more than U.S. Treasuries of similar maturity. The three-year yield was at 2.62 percent.

Cautious on Corporates

Pimco said it is “fairly cautious” on corporate debt given concerns about the economy and is favoring high-quality issuers.

Prices of Australian sovereign bonds dropped 2.6 percent this year with total returns of 0.1 percent till July 26, according to Bank of America Merrill Lynch data. The nation’s corporate bonds declined 0.8 percent in price, with a 2.6 return once yields are included, the indexes show.

Australian businesses grew pessimistic in the second quarter about near-term prospects, while a lift in non-mining investment intentions is unlikely to be sufficient to fill the gap left by a slowdown in resources, a National Australia Bank Ltd. quarterly survey showed July 18.

“Even if mining investment remains at a high level and just goes sideways this year, that’s a 2 percent contribution to growth from last year that goes somewhere close to zero,” said Bowe. “There’s certainly signs of policy traction in the housing market but in terms of housing construction, you’re talking about a sector that might provide about a quarter percent to growth.”

Aussie’s Drop

The boost from the Aussie’s 10 percent drop over the past three months may be more muted than in previous periods as businesses that changed models to account for its strength will want assurance recent declines are likely to persist, he said.

The world’s fifth most-traded currency fetched 92.73 U.S. cents as of 12:30 p.m. in Sydney after remaining above $1 for a record 10 months till May 9. It will fall to 90 cents by Dec. 31, according to the median estimate of forecasts compiled by Bloomberg.

“We think the exchange rate remains too elevated relative to fundamentals and we think that lower interest rates and, or, a lower currency is required to help transition the country away from mining-assisted growth,” said Bowe. “Low policy rates will likely be required for some time yet. Eventually Australia will get an economic return from all this mining investment through stronger exports, but that’s not expected to kick in till 2015.”

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