High-Yielding AAA Aussie Bonds Lose Favor as Repo Costs Jump

  • Lower yield premium has sapped demand, while supply increases
  • Cost of providing repo likely to stay elevated: ANZ’s Whetton

Pedestrians walk past the Reserve Bank of Australia headquarters in Sydney.

Photographer: Brendon Thorne/Bloomberg

Time was, investors couldn’t get enough of Australian government bonds that offer the highest yields among top-rated sovereign debt. Not any more.

Demand for the sovereign securities has dropped to the lowest since at least 2013, based on Reserve Bank of Australia data on short-term borrowing spreads for repurchase agreements. Supply is surging as the Australian government’s debt pile climbs to almost A$500 billion ($383 billion), while demand at home and abroad is weakening as yield premiums shrink and stricter regulation deters banks from holding more debt than they absolutely must.

Repurchase agreements -- where bond investors borrow cash and offer their government notes as short-term security -- are a key money market transaction that can shed light on changes in liquidity and demand. The amount that holders of Australian government debt pay to counterparties to raise funds using their bonds as collateral rose to as much as 26 basis points more than the cash rate this month, the biggest gap on record in RBA data that stretches back to November 2013. In 2014 the spread averaged about 3 basis points.

“Banks have seen a reduction in the ability to warehouse risk,” said Martin Whetton, a Sydney-based interest-rate strategist at Australia & New Zealand Banking Group Ltd. “Increased issuance of Australian government bonds and a higher percentage of the market being held domestically have also contributed to a rationing of balance sheet.”

Spread Widening

Significant issues surrounding the spreads over cash that are referred to as repo rates have so far been rare in Australia, apart from some short-term squeezes in individual bonds. There are now signs of pressure though. Lower yields are spurring fund managers to tap the repo market in a bid to supercharge their returns, and that’s combined with increased sovereign issuance to jack up supply. Add to that diminished appetite from offshore buyers and circumscribed banks, and you have a recipe for wider spreads.

“Repo provision is becoming a scarcer commodity and the cost of providing repo is likely to remain elevated,” according to Whetton.

Stricter Rules

Repos allow investors to use bonds as collateral and receive cash in return. That money raised can used for liquidity, or to purchase other assets and allow investors to make use of the short-term arbitrage opportunity. The RBA is the major liquidity provider in the domestic repo market and conducts about A$2 billion per day in open market operations. While it hasn’t reduced the liquidity it provides, there’s nonetheless been an increase in repo rates due to other pressures.

Australia’s banks -- among the largest holders of the domestic government bonds -- are being curtailed by stricter global rules that limit their capital market activities. While the lenders still invest in these securities to meet liquidity requirements, they’re less active in trading them.

This decline in bank capacity has dovetailed with increased issuance as the government seeks to finance its ballooning budget deficit. The amount of sovereign debt outstanding is predicted to climb A$72 billion to $499 billion in the 12 months through June 30, and reach A$545 billion a year later, according to budget documents.

Foreign buying has struggled to keep pace with the increased amount of fundraising and the proportion of federal securities held by non-resident investors in the second quarter fell to just 59 percent, the least since 2009, according to official data. The average yield premium 10-year Aussie debt offers relative to eight other AAA sovereign markets reached a seven-year low of 1.36 percentage points in August. It was at 1.52 Tuesday, down from 1.78 at the end of 2015.

Non-resident holders of Australian government securities have also increased their use of repo funding, which has coincided with a rise in rates, the RBA said in its quarterly bulletin this month. Their borrowings in the repo market totaled more than A$60 billion as of June 2016 compared with about A$14 billion in June 2012, it said.

Investor activity at the government’s regular bond auctions has also weakened. Buyers at non-inflation linked bond auctions in 2016 have submitted bids to buy an average 2.9 times the amount of debt on offer at each sale, the lowest mean ratio since 2002, Australian Office of Financial Management data show. 

“Elevated repo rates are likely to become a more normal feature of the market landscape,” said Alex Stanley, an interest-rate strategist at National Australia Bank Ltd. in Sydney. “A large influx of cash bonds into the market amid a relative decrease in demand from global investors has contributed to the attractiveness of bond basket arbitrage trades and added pressure to repo rates.”

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