It seems the perfect storm for the Australian bond market is continuing as offshore investors continue to sell Australian Commonwealth Government Bonds (ACGBs).
That’s because the rout in commodity markets is reinforcing notions among the globe’s bond fund managers that the Aussie dollar is heading lower.
That’s important because even though many of the foreign investors who buy Australian bonds are generally called “foreign currency bond managers”, meaning they invest their funds in the bonds of other nations, the reality is they are often really “foreign bond currency managers”.
That’s a subtle reordering of the words “bond” and “currency” but it’s more than a nuance. It’s fundamental to the operation of Australia’s bond market which is dominated by offshore investors.
Let me explain.
Bond or Currency Fund?
When you run a bond fund you are investing the money held in your portfolio in interest rate products, Government bonds, supranational bonds (think World Bank and so on), perhaps some corporate bonds (depending on your mandate), perhaps some interest rate swaps (again depending on mandate). But essentially you are investing in bond volatility which is supposed to be fairly benign and predictable.
But, when you are the manager of a bond fund that invests in bonds outside your home country you are not only buying bonds, you are also buying currency. Specifically, you are selling your home currency, say US dollars, yen, euro, sterling or yuan, and buying the currency the bond is denominated in, say Australian dollars.
That means you now have two areas of possible return, bond performance with an additional currency kicker (assuming you are unhedged). But forex volatility often – usually – overwhelms interest rate moves, volatility and returns. So the manager is not really running a fund that invests in foreign bonds; he or she is now managing a currency fund which invests in bonds.
This shift in the order of the words from “foreign currency bond managers” to “foreign bond currency managers” is fundamental to the appetite foreign investors have for the bonds of a country like Australia with its almost perfect free float.
The Perfect Storm
Back to the perfect storm of weak commodity prices and the Aussie dollar and demand has dried up for Australian bonds, Skye Masters, NAB’s Sydney-based head of interest rate strategy, said in a note this morning.
Masters said that “since the AUD has traded sub 0.85 offshore have predominantly been net sellers of ACGBS.”
That’s not going to change in a hurry, Masters says:
Weaker commodity markets should weigh on sentiment towards AUD and in turn continue to temper offshore demand for AU bonds. While the AUD is stronger overnight, falling commodity prices certainly isn’t supportive to the currency. While there has been some interest to put on AU-US yield compression trades following the recent widening, expectations of a lower currency are likely to continue to temper offshore demand for AU bonds.
No wonder Australian bonds are selling off even though the RBA has left the door open to another rate cut.
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