In 2003 it looked like the days of the government bond market had come to an end. The federal government had reduced outstanding debt to almost zero. The plan was to eliminate the debt which would have meant the death of the government bond market. Voices within the finance industry lobbied the government to keep the bond market alive.

The two main arguments were: it provided a risk free benchmark off which all other securities were priced; if in the future the government needed to borrow funds again it would be very difficult to reconstitute the bond market from scratch.

In the end these voices prevailed. The government reduced net debt to zero but maintained about $50 billion in bonds, offset by a growing set of assets on its balance sheet.

Fast forward to 2009 and the world is facing a financial crisis of a magnitude not seen since the 1930s. The dominant economic voices are calling for a major Keynesian response. The basic Keynesian argument is that when private sector demand collapses the public sector needs to step in to make up the difference. Governments around the world have responded wholeheartedly with major stimulus packages having been announced in most developed nations as well as many developing ones.

The Australian government has embraced the doctrine and boosted spending programs including cash handouts and infrastructure building. This has resulted in the governments finances falling into deficit and the need to raise funds. This is further exacerbated by declining taxation receipts as the economy slows. The government has forecast a budget deficit of $53 billion for 2009/10 and government debt requirements are projected to reach $300 billion. The net result, a new lease of life for the government bond market.

Under the Howard government a cap was introduced on the level of bond issuance at $50 billion. This has now been raised by the Rudd government to $200 billion but that level is likely to be exceeded. According to the Australian Office of Financial Management (AOFM) government bonds on issue increased from $57.8 billion at 31 December 2008 to $92.0 billion by 31 May.

With this surge in the supply of bonds, both from major domestic issuance as well as foreign government raisings, the question is will there be sufficient demand to mop up the supply.

Throughout the 1990s bonds slipped out of favour as an investment destination. Equities seemed to be constantly outperforming so asset allocations drifted further that way. The meltdown in equity markets in 2008 has caused a rethink in asset allocation. While equity funds were plunging, bond funds performed well during 2008. Funds that focused on government securities delivered returns of 14 to 15 per cent.

The strong performance of 2008 resulted in bond yields descending to historically low levels. This led some commentators to worry that bonds may be overpriced or even in a bubble. Yields on 10 year government bonds have indeed started rising, from 4% at the start of the year to 5.5% by the end of June. All else being equal, increasing supply should lead to lower prices (higher yields).

Questions to consider

The question advisers must now consider is should they be moving their shell shocked clients away from the volatility of equities and into the calmer waters of bonds to bring balance to their portfolios and ease their nerves? Or is this precisely the wrong time to be shifting towards bonds with the market already being highly priced and increasing supply coming onto the market? What will be the impact of all this new debt issuance on yields? What other factors are likely to impact the level of bond yields over the coming 18 months?

Chris Batchelor is senior technical writer for Kaplan Professional.

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