While the Reserve Bank of Australia (RBA) cut official interest rates to an all-time low at its May meeting and yields remain at depressed levels, at least by Australian standards, Franklin Templeton Investments says that Australian yields are comparatively generous, and Australia’s 10 year yield is among the highest in the developed world.
Andrew Canobi, Managing Director of Franklin Templeton’s Australian Fixed Income team, said, “The RBA has now, somewhat surprisingly, acted on its easing bias because while the Australian economy remains reasonably healthy, recent inflation data has clearly alarmed the Bank and prompted action.”
“Downside risks to the Australian economy including increasing spillover effects from a softer Chinese economy, and potentially weaker employment at home remain risks rather than our expectation. However, if the RBA is concerned that the spectre of global disinflationary forces is visiting our shores there is a clear prospect of further easing even if domestic growth indicators remain healthy” said Canobi.
Relatively higher yields have lured bond buyers to the Australian market, but Canobi believes it is important to remember that the Australian dollar historically has been a fairly volatile currency, and global investors have understandably looked for a premium to compensate them for this risk. This means there is a limit to the potential outperformance of Australian bonds relative to traditional safe havens such as US treasuries. Furthermore, all else equal global investors will require a weaker currency in order to be attracted to the bond market if yields decline. “Global forces from quantitative easing and negative interest rates have conspired to keep the Australian bond market at the higher end of valuations relative to what we think long-term value should be. If the global search for yield continues to lead investors to Australia, the country’s bonds could remain somewhat expensive.”
“Opportunities can still be found even in the current low-yield environment. We believe high-quality corporate bonds still offer good value, particularly in utilities, high-quality commercial real estate and some segments of the banking sector, which we consider to be strong defensive sectors that offer compelling yields above government bonds,” added Canobi.
On his longer term strategy, Canobi shared, “We also are looking at the attractiveness of some government bond yields in a relative sense to other government bond yields. Rather than just buying government bonds as a long-only strategy, we are looking at the relative difference between markets. We believe this is still a compelling opportunity, particularly in an environment where there is global divergence in monetary policies.”
On the risks investors should be aware of, Canobi said, “In our view, strategies that track an index may face considerable challenges in the period ahead. With interest rates at very low levels, and with the sensitivity of interest rates being at near-record high levels, there are risks to those strategies. If we move to a period where interest rates are moving higher, passive investors and those bond funds taking a more benchmark aware investment approach could incur significant capital losses.”
“Taking an absolute return approach to investing means we favor being very highly selective in the choice of securities. We also believe managing interest-rate risk is important and we focus carefully on yield securities that we believe can offer appropriate potential returns for the risk incurred.”
