Fixed Interest
December 12, 2013
Exchange traded Government Bonds
Morgans Analyst
James LAWRENCE
T (61) 7 3334 4547
E [email protected]
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. 49 010 669 726) AFSL 235410 A PARTICIPANT OF ASX GROUP
Fixed Interest
December 12, 2013
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
SOURCES: MORGANS
Why invest in Government bonds?
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.
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Fixed Interest
December 12, 2013
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.
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Fixed Interest
December 12, 2013
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.
Figure 3: Break even analysis
Issue
CGL CIB
CGL
Maturity date Coupon
21/02/2022
1.25%
15/07/2022
4.50%
Break even inflation rate
Yield
0.62%
3.00%
2.38%
SOURCES: MORGANS
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.
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Fixed Interest
December 12, 2013
Figure 4: Exchange-traded Treasury Bonds
A S X c o de
M a t urit y D a t e
F a c e V a lue
C o upo n R a t e
GSB K14
15 Jun 14
$ 100.00
6.25%
GSB S14
21Oct 14
$ 100.00
4.50%
GSB G15
15 A pr 15
$ 100.00
6.25%
GSB S15
21Oct 15
$ 100.00
4.75%
GSB K16
15 Jun 16
$ 100.00
4.75%
GSB C17
15 Feb 17
$ 100.00
6.00%
GSB M 17
21Jul 17
$ 100.00
4.25%
GSB A 18
21Jan 18
$ 100.00
5.50%
GSB E19
15 M ar 19
$ 100.00
5.25%
GSB G20
15 A pr 20
$ 100.00
4.50%
GSB I21
15 M ay 21
$ 100.00
5.75%
GSB M 22
15 Jul 22
$ 100.00
5.75%
GSB G23
21A pr 23
$ 100.00
5.50%
GSB G24
21A pr 24
$ 100.00
2.75%
GSB G27
21A pr 27
$ 100.00
4.75%
GSB G29
21A pr 29
$ 100.00
3.25%
GSB G33
22 A pr 29
$ 100.00
4.50%
SOURCES: MORGANS; ASX
Figure 5: Exchange-traded Treasury Indexed Bonds
A S X c o de
M a t urit y D a t e
F a c e V a lue
C o upo n R a t e
GSIO15
20 A ug 15
$ 169.47
4.00%
GSIO20
20 A ug 20
$ 156.82
4.00%
GSIC22
21Feb 22
$ 103.89
1.25%
GSIQ25
20 Sep 25
$ 111.01
3.00%
GSIQ30
20 Sep 30
$ 108.32
2.50%
SOURCES: MORGANS; ASX
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Fixed Interest
December 12, 2013
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