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Aug 02

Australian Government Bond Yield Curve…slight increase but risks remain

Source:RBA

The above chart shows that over the last few weeks there has been an increase of around 10-25bps across the yield curve which is also in line with the marginally stronger equity markets. As I’ve stated numerous times before, the European situation is what is currently driving most major market moves and the partial bailing out of the Spanish banks has calmed markets for the time being and this has resulted in a slight increase in market confidence.

The other interesting outcome the above chart shows is that over the past 12 months the yield curve has dropped by around 150-170bps. Given the Australian fixed interest market (i.e. UBS Composite Index) has a duration of just short of 4, that indicates that most conservative bond funds should have provided a capital return on top of interest of at least 6% (4*150 = 600bps). The index did actually return 10.97% in the year to the end of July so assuming an average coupon of around 5% that adds up. Unfortunately it appears that more managers chose to have shorter duration than the index over the past 12 months and most managers appear to have underperformed.

Moving forward there is no doubt, the European situation will dominate. There is still limited evidence that the problem of the Euro will be resolved any time soon and that a Greek exit will happen so there is to be more volatility in all markets. The other big issue which will be resolved one way or the other is the US Fiscal cliff, which should be a hit to US GDP of around 3-4%, which comes next January. It’ll be resolved one way or the other following the elections, but this uncertainty is bound to also contribute to market volatility. Finally, the China slowdown is increasingly evident with poorer numbers out of China….this is hardly a good sign for the Australian economy whose success has largely been on the back of the Chine-led resources boom…but we all knew that was coming anyway…the question is how low can China go???

Whilst I know I get a bit of criticism for this view, the best bang for your buck in Australia continues to be term deposits where the premium above government bonds continues to be attractive and they continue to carry the same risk for investments less than $250K. Whilst many believe that a term deposit has failed to receive the short term capital gains that bonds have received, my response is that capital gains are irrelevant for all fixed income securities if held to maturity which is typically the purpose of choosing a specific term. As the professional bond managers have shown, playing the yield curve or duration, is a very tough game.

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