Exchange traded Government Bonds

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1 Morgans Analyst James LAWRENCE T (61) E james.lawrence@morgans.com.au Exchange traded Government Bonds In an exciting development for investors, they will now be able to access exchange traded government bonds on ASX. These instruments afford investors with all the economic benefits of owning an Australian Government Bond (AGB). The following document should assist you in your understanding of them and bonds more generally. For more information please contact your adviser. What is a Government bond? It is a debt obligation of the issuing Government. When you invest in a Government bond you are effectively lending money to the issuing Government. A debt obligation requires that the issuer make all contracted payments. Bonds are wholesale debt securities traded by institutional investors and are not subject to a prospectus. Why are bonds issued? Bonds are issued by the Government as a means of funding long term infrastructure and other commitments. Notwithstanding that the Australian Government ran budget surpluses for an extended period and could have repaid its debt, it maintained an issuance program to ensure the continued orderly operation of Australian wholesale debt markets. This now means that the current issuance programs are easier to implement. What are exchange traded government bonds? Exchange-traded AGB holders gain beneficial ownership of an Australian Government Bond in the form of a CHESS Depositary Interest (CDI). Holders obtain all the economic benefits, including payments, attached to legal ownership of the Australian Government Bond over which the CDI has been issued. What are the types of exchange traded AGBs? There are two different types of Exchange-traded AGBs: Exchange-traded Treasury Bonds (TBs) are medium- to long-term debt securities with a fixed face value. They carry an annual rate of interest fixed over the life of the security, payable every six months. For further information on TBs please click here. Exchange-traded Treasury Indexed Bonds (TIBs) are medium- to long-term debt securities. They differ from Exchange-traded Treasury Bonds because their face value is adjusted for movements in the Consumer Price Index (CPI). Interest is paid quarterly, at a fixed rate, on the adjusted capital value. At maturity, investors receive the adjusted face value of the security adjusted for CPI movement over the life of the bond. For further information on TIBs please click here. For further details on the securities which are available, their coupon rates and maturity dates, please refer to Figures 4 and 5 (located on page 5). IMPORTANT DISCLOSURES REGARDING COMPANIES THAT ARE THE SUBJECT OF THIS REPORT AND AN EXPLANATION OF RECOMMENDATIONS AND VOLATILITY CAN BE FOUND AT THE END OF THIS DOCUMENT. MORGANS FINANCIAL LIMITED (A.B.N ) AFSL A PARTICIPANT OF ASX GROUP

2 Why are bond yields often lower than bank deposit rates? In simple terms, because Governments of developed economies have the ability to raise taxes to repay their debts, they can borrow more cheaply than any borrower including banks. This differential still exists despite the existence of a Government Guarantee on ADI deposits. How often do I receive interest payments? Interest payments are known as coupons and are paid half yearly in two equal amounts for TBs, while they are paid quarterly for TIBs. What is interest rate risk? Given that Government bonds are guaranteed by the issuer there is virtually no credit risk. However there is interest rate risk. This is where the value of the security will fall if interest rates rise, conversely its value will rise if interest rates fall. Simply explained, if you lock in an interest rate on an investment and rates subsequently fall, your investment at that higher rate becomes more attractive and therefore more valuable. This is reflected in the price of the security. Conversely, if you make an investment at a fixed interest rate and rates subsequently rise, your investment will become less attractive. This too will be reflected in the value of your bond and if you choose to sell it you may realise a loss. The longer the term to maturity, the more sensitive the bond s price to a change in interest rates. This means that longer dated bonds expose investors to a potentially higher level of price volatility. Some investors use this volatility to trade bonds based on their expectation of future movements in interest rates. Figure 1: Price and yield relationship Why invest in Government bonds? SOURCES: MORGANS There are three primary reasons for investing in bonds; they can form part of a diversified investment portfolio so as to reduce the overall level of risk in the portfolio. Secondly, in times of uncertainty and heightened risk in financial markets, they can be held as a safe haven asset. Lastly, notwithstanding lower yields they can be used as a low risk source of income. Government bond performance tends to have a low or negative correlation with the performance of other asset classes such as shares and property. In times of economic uncertainty these asset classes tend to perform poorly. However, this uncertainty tends to push investors into safe haven assets such as Government bonds. As demand for bonds increases, the price will rise, which will be reflected in a fall in bond yields. Post the GFC we saw a period when risk assets performed poorly, however bonds delivered strong returns to investors. 2

3 Figure 2: 5 year asset class performance Diversified Portfolio composition: 50% ASX-200 Accumulation Index, 50% UBS Government Bond All Maturities Index SOURCES: MORGANS; ASX How do I invest? You can buy or sell Exchange-traded AGBs on ASX the same way you buy or sell shares, but with both prices and yields quoted. You cannot sell a security which you do not already own. Settlement of the trade takes place three business days after the transaction (T+3) and you will receive a CHESS statement recording your holding, just as you do when you buy shares on-market. Exchange-traded AGBs cannot be taken out of the CHESS registry system. Please refer to the following page for a full list of the securities which are available. Can I sell my bond prior to maturity? Yes, but you need to be aware that the value of your investment may have changed resulting in you receiving more or less than you initially invested (see Interest Rate Risk). To sell, you will need to contact your adviser who will obtain a price for the sale and execute on the ASX on your behalf. Are bond yields linked to the RBA Official Cash Rate? Not directly. Bond yields more generally reflect the outlook for inflation over the longer term, that is, investors generally expect to earn a return equal to the inflation rate plus a real margin over inflation. The actual yield for each bond is determined through the trading of these securities by institutional investors and traders. How can I assess whether bond yields are likely to rise or fall? RBS Morgans Chief Economist and Strategist Michael Knox forecasts a fair value yield for the Australian ten year bond which may be an indicator of the future direction of longer term bond yields. He also forecasts a fair value yield for the 90 day bank bill rate which may be an indicator of the direction of shorter dated bond yields. You might consider asking your adviser for this information. It should be noted though that there are numerous factors that impact on the direction of both short and long term interest rates and you should consider their potential impact on the value of your investment should you need to realise your investment before maturity. 3

4 Figure 3: Break even analysis Issue Maturity date Coupon Yield CGL CIB 21/02/ % 0.62% CGL 15/07/ % 3.00% Break even inflation rate 2.38% SOURCES: MORGANS Why is the quoted yield to maturity different to the coupon rate? The coupon is the percentage interest rate paid each year; it is divided into 2 equal half yearly payments. The yield is the return if the security is held to maturity and takes into account the difference between the purchase (capital) price and the face value repayable at maturity as well as future coupons. The yield is calculated using the RBA bond formula which is available on the RBA website. What are Treasury Indexed Bonds? When investors think of Government bonds they traditionally think of what are known as nominal bonds. That is, bonds that pay a fixed semi-annual coupon irrespective of movements in inflation. In periods of higher inflation though, the real return from these bonds will be eroded. Below we look at an alternative. One type of Government bond not commonly considered by retail investors is inflation linked bonds or linkers. Linkers compensate investors for movements in inflation unlike nominal bonds. Treasury Indexed Bonds (TIBs) are the most commonly traded type of inflation linked bond and are issued by the Commonwealth Government. The Principal (or Capital) amount which is to be returned to investors at maturity is adjusted on a quarterly basis. This adjustment, known as the indexation factor, is based on the Australian Bureau of Statistics consumer price index (CPI). As the security is indexed over time, the total amount of Principal payable to the investor at maturity also changes in line with the cumulative change to the CPI over the life of the bond. From an income perspective, TIBs pay investors a fixed coupon rate; historically this was set at 4.00% p. a. however the more recent issues have seen numbers below this. This coupon rate is payable quarterly on the outstanding Principal amount which as noted above adjusts in line with the quarterly inflation rate. Therefore as the Principal amount of the bond increases, the income payable will also increase. When the CPI falls, the Principal value and therefore the income payable also falls. Importantly though, in Australia the maturity value cannot be below the original Principal value of $100. Using the simple example (Figure 3), if inflation were to be under 2.380% for the period to 2022, nominal bonds would be the better investment over that time frame, however if inflation were above this level, the CIB bond would outperform. When assessing whether to buy nominal bonds, or inflation linked bonds, it comes down to an investor s view of inflation. If, after having conducted the break even analysis, an investor believes inflation will be above this rate for that period, they should purchase the TIB; below this level invest in nominal bonds. For investors simply looking for investment diversity, TIB s may be a useful addition. Summary Exchange traded bonds provide investors with an opportunity to diversify their investment portfolio into an asset class that performer counter cyclically with property and shares. In periods of declining interest rates there may be opportunities for capital gains. However, remember that when rates rise, the capital value of bonds will fall. TIBs provide a mechanism through which to protect against future increases in inflation. You should ensure you understand both the advantages and risks before investing. 4

5 Figure 4: Exchange-traded Treasury Bonds A SX co de M aturity D ate F ace Value C o upo n R ate GSBK14 15 Jun 14 $ % GSBS14 21 Oct 14 $ % GSBG15 15 Apr 15 $ % GSBS15 21 Oct 15 $ % GSBK16 15 Jun 16 $ % GSBC17 15 Feb 17 $ % GSBM Jul 17 $ % GSBA18 21 Jan 18 $ % GSBE19 15 M ar 19 $ % GSBG20 15 Apr 20 $ % GSBI21 15 M ay 21 $ % GSBM Jul 22 $ % GSBG23 21 Apr 23 $ % GSBG24 21 Apr 24 $ % GSBG27 21 Apr 27 $ % GSBG29 21 Apr 29 $ % GSBG33 22 Apr 29 $ % SOURCES: MORGANS; ASX Figure 5: Exchange-traded Treasury Indexed Bonds A SX co de M aturity D ate F ace Value C o upo n R ate GSIO15 20 Aug 15 $ % GSIO20 20 Aug 20 $ % GSIC22 21 Feb 22 $ % GSIQ25 20 Sep 25 $ % GSIQ30 20 Sep 30 $ % SOURCES: MORGANS; ASX 5

6 QUEENSLAND PORT MACQUARIE (02) BRISBANE (07) SCONE (02) BUNDABERG (07) SYDNEY LEVEL 9 (02) CAIRNS (07) SYDNEY LEVEL 33 (02) CALOUNDRA (07) SYDNEY MACQUARIE STREET (02) CHERMSIDE (07) SYDNEY MACQUARIE STREET (Parramatta) (02) EDWARD STREET (07) SYDNEY REYNOLDS EQUITIES (02) EMERALD (07) WOLLONGONG (02) GLADSTONE (07) GOLD COAST (07) ACT IPSWICH/SPRINGFIELD (07) CANBERRA (02) MACKAY (07) MILTON (07) VICTORIA MT GRAVATT/CAPALABA (07) MELBOURNE (03) NOOSA (07) BRIGHTON (03) REDCLIFFE (07) CAMBERWELL (03) ROCKHAMPTON (07) CARLTON (03) SPRING HILL (07) FARRER HOUSE (03) SUNSHINE COAST (07) GEELONG (03) TOOWOOMBA (07) RICHMOND (03) TOWNSVILLE (07) SOUTH YARRA (03) YEPPOON (07) TRARALGON (03) WARRNAMBOOL (03) NEW SOUTH WALES SYDNEY (02) WESTERN AUSTRALIA ARMIDALE (02) PERTH (08) BALLINA (02) BALMAIN (02) SOUTH AUSTRALIA CHATSWOOD (02) ADELAIDE (08) COFFS HARBOUR (02) NORWOOD (08) GOSFORD (02) HURSTVILLE (02) NORTHERN TERRITORY MERIMBULA (02) DARWIN (08) NEUTRAL BAY (02) NEWCASTLE (02) TASMANIA NEWPORT (02) HOBART (03) ORANGE (02) DISCLAIMER The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual s relevant personal circumstances. 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