By Roger J Kerr
With Government bond yields continuing at very low levels all around the world, the spread or risk premium that NZ bond yields trade above US bond yields become consequently more important in determining our bond and thus swap interest rates.
Over the last five years the NZ:US bond spread has steadily reduced from 2.75% in 2010 to just 1.20% today (US bonds = 2.04%, NZ bonds = 3.24%) – refer to the gold line in the chart below.
Over the last 15 years there has been a reasonable correlation between the NZ:US bond spread and the difference between the annual CPI inflation rates of the two economies. Right now the two inflation rates are very low at the 0.40% level due to lower fuel prices.
New Zealand’s annual inflation rate is forecast by the RBNZ to climb sharply to 2% by mid-2016 as the lower NZ dollar causes significant price increases on all imported goods. The inflation differential could easily increase to +1%, NZ above the US.
The correlation would suggest that the bond spread is at risk to increasing from the current 1.2% to over 2% i.e. reverse direction back upwards. On the basis that US 10-year bond yields increase from 2.04% to 2.5%/3% as US short-term interest rates increase with the Fed tightening policy over the next 12 months, NZ bond yields could move higher to somewhere nearer 4.75% over the same period.
The bond spread should reflect the higher credit risk (premium) for New Zealand as a sovereign borrower over the US.
A narrow based economy, lack of scale for many industries and a small/illiquid Government bond market justify NZ bonds trading somewhere between 1.5% to 2.5% above the US bonds. Investors into our bonds require this additional yield over US bonds to adequately compensate themselves for the associated NZ credit risk.
Currently, the bond spread of just 1.20% is clearly at the bottom end of its 15-year trading range and does not appear sustainable at these low levels.
What has been pushing the bond spread lower is the global demand by investors to get a relatively safe interest yield. New Zealand has offered that yield in a world of zero interest rates. Interestingly, the level of foreign holding of NZ Government bonds has not reduced over the last 12 months despite the Kiwi dollar depreciating 23 cents to 0.6500.
The expected increase in the NZ:US bond spread could be as large as the anticipated increase in US bond yields over the next 12 months. A potential double-whammy interest rate risk that both investors and borrowers should be aware of.
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Roger J Kerr is a partner at PwC. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com