The Australian Office of Financial Management, which manages the government’s debt programme, sold $200 million of inflation-linked bonds maturing in 2018 to 13 investors on Tuesday at a yield of -0.0763 per cent. It was the first time the government set the price of a new bond that implied a negative return for investors.
At Tuesday’s auction of 2018 bonds investors bid the bond price up so that the implied rate was slightly below zero. This meant investors were paying up because they expect the Reserve Bank of Australia to cut the current cash rate of 2.25 per cent to below inflation, which is currently at 1.7 per cent.
Investors pay a price to own the bonds and in return get a rate of 1 per cent plus a rate linked to the Consumer Price Index, which they receive when the bond matures in 2018. Excluding the gains tied to the inflation rate, they would get less back than their initial investment.
The “inflation-linked bonds” are distinct from more common nominal bonds and reflect expectations of ‘real’, or inflation-adjusted rates available in the market. These bonds, known as ‘linkers’ pay a fixed rate of interest, but subsequent rates, and the final amount due to investors on maturity is adjusted periodically to reflect moves in the consumer price index measure of inflation.
Westpac’s head of bond and inflation trading Andrew Barrelle said that the negative yields on inflation linked bonds are a reflection of “very low cash rates and easy monetary policy”.
“It’s a reflection that the market expects the cash rate will go to 2 per cent and possibly below. If you take the 2018 nominal bond yield of 1.80 per cent and an inflation expectation of 2 per cent – which is the bottom of the [Reserve Bank’s target] band, you will end up with a negative real yield of -20 basis points,” he said.
“If the RBA does ease rates to 2 per cent or below and inflation expectations went up you could get a situation where the real yield moves more negative.”
Tamar Hamlyn, principal of specialist inflation bond fund Ardea Investment Management said that with the market forecasting an inflation rate of 2 per cent and a Reserve Bank cash rate of around 2 per cent over five years, it summed to a ‘real’ rate of zero in the inflation linked bond market.
“The biggest factor that has changed has been the cash rate. When you look at the main contributor [to real rates], it’s not inflation, it’s just that rates across the economy have fallen,” he said.
The government has about $25 billion of inflation-linked bonds on issue compared with $330 billion in nominal bonds. Australia’s nominal bond rates are still in positive territory and even though they’re around all-time low rates, are substantially higher than yields of other highly rated governments, particularly shorter term rates which are close to zero or negative in Europe, the US and Japan.
”Australian real yields have been very high in comparison with the US and UK over recent years, but as the RBA lowers the cash rate, the yields are converging,” Mr Barrelle said.
“It’s not that unusual to have negative real yields, but you have to remember when you look at comparative yields, Australia is still a relatively high yielding market,” Mr Hamlyn of Ardea said.
“Australia’s growth is not good but we are not in recession so we shouldn’t expect to see [nominal rates] go negative. The fact we have real rates at zero is good,” he said.
Negative interest rates have become a common feature in global bond markets, at a time when growth is low, inflation expectations are suppressed and safe high quality assets are in strong demand. About $US3.6 trillion ($4.6 trillion) of government bonds, 16 per cent of the total outstanding, currently trade at negative rates.
The aggressive bond buying suppress has also contributed to negative interest rates. This week Germany’s 10-year bond rate fell to a further record low of 0.11 per cent this week.
While long-term bonds have traded at negative rates, Switzerland became the first government to issue new debt at a negative interest rate. Germany, Austria, Finland and Spain have issued shorter dated debt at negative rates.
“The behavioural impact of negative real yields is small if not non-existent. Germany has had negative real yields for some time and people have been indifferent. Negative outright yields, however, really gets peoples attention and changes behaviour. We’ve got a long way yo go before we get there,” Mr Hamlyn said.
Negative interest rates in the global bond market has also become a problem for the Reserve Bank of Australia’s staff that manage the bank’s foreign currency reserves.
With shorter-dated European bonds paying negative yields, the RBA has been forced to engage in currency swaps to keep returns on the $15 billion equivalent euro portfolio in positive territory.
Australian nominal bonds moved further away from negative rates on Thursday after stronger than expected unemployment numbers triggered a sell-off. The 10-year bond rate increased from 2.31 per cent to 2.37 per cent while the three-year bond increased from 1.75 per cent to 1.82 per cent. Meanwhile expectations on a May cut to the cash rate was pared back from about three in four to one in two on account of the better jobs numbers.