The Royal Bank of Scotland (RBS) has Aa3/A+ rated short term Australian dollar denominated bonds that, at the current yield of about 6.75%, offer more than 2.7x’s the 2.5% yield of their similar maturity US RBS denominated bonds. This 32 month, investment grade, superior yield bond provides sound diversification away from a heavily debt burdened US economy into one of the World’s more fiscally conservative countries, Australia, which is why we have selected it as this week’s best bond.
Current US Debt woes
As Senator McConell’s “back-up plan” slowly gains traction towards raising the debt ceiling, Moody’s analyst Steven Hess continues to breath threats against our nation’s coveted AAA ratings. The reasoning? “The numbers that are being discussed in terms of any possible deficit reduction coming out of this plan don’t seem to be very large,” according to Hess in an interview with Reuters. There certainly are large numbers in the plan, as it would authorize the President to raise the debt limit a total of $ 2.5 trillion (in three increments,) without any mandatory spending cuts. So while the plan plainly provides for the avoidance of a technical default, Hess surmises that it would not eliminate the periodic uncertainty related to the debt ceiling.
This persistent and nagging environment of uncertainly continues to frustrate fixed income investors, even as ten year government bond yields remain stuck near record lows in front of a rising stock market. Unemployment may not be restricted in it’s application to merely the general populace of our country. It appears there may also be sidelined money that’s cautiously looking to be put to work. Consequently, investors may want to consider investing in foreign fixed income for the following reasons:
- Foreign debt issues offer a way to diversify away from the US Dollar denominated debt.
- Many global corporations pay higher yields in their foreign denominated bonds than they do in their similar US dollar based counterparts.
- Alternate global currencies have the potential to substantially appreciate or depreciate against the US Dollar, significantly increasing or decreasing actual returns. Used as part of a broader diversification strategy, this may actually serve to reduce overall portfolio risk by hedging against the US dollar’s loss of buying power and it’s depreciation relative to other increasingly popular “commodity currencies.”
Australia’s abundant and diverse natural resources include extensive reserves of coal, iron ore, copper, gold, natural gas, uranium, and renewable energy sources. It also has a large services sector and is a significant exporter of natural resources, energy, and food. Key tenets of Australia’s trade policy include support for open trade and the successful culmination of the Doha Round of multilateral trade negotiations, particularly for agriculture and services.
The Australian economy grew for 17 consecutive years prior to the global financial crisis. Subsequently, the Rudd government introduced a fiscal stimulus package worth over US$50 billion to offset the effect of the slowing world economy, while the Reserve Bank of Australia cut interest rates to historic lows. These policies – and continued demand for commodities, especially from China – helped the Australian economy rebound after just one quarter of negative growth. The economy grew by 1.2% during 2009 – the best performance in the OECD – and by 3.3% in 2010. Unemployment peaked at 5.7% in late 2009 and fell to 5.1% in 2010. As a result of an improved economy, the budget deficit is expected to peak below 4.2% of GDP and the government could return to budget surpluses as early as 2015.
Although Australia has experienced persistent deficits since World War II, the estimated 2010 deficit of $30.4 billion, a mere 2.46% of GDP, bringing the total outstanding public debt to 22.4 % of GDP (2010 est.) The 2010 inflation rate stood at 2.9%, with current unemployment rates about 5.1%. Exports exceeded imports to the tune of 10.3 billion, with partners China, Japan, South Korea, and India all listed ahead of the US. The longer term outlook remains good as Australia’s terms of trade appear to have reached record peaks with prices for key export commodities staying high thanks to voracious demand from China and the rest of Asia.
Public debt to GDP
A$ 20.3 billion
|100.0 %||US$ 1.294 Trillion|
Stanford University has rated the Australian economy number #1 on its global Sovereign Fiscal Responsibility Index. This recognition helped highlight how much stronger Australia’s financial condition is compared to #28 ranked (out of 34) United States, which came in only four points above a defaulted Iceland.
Australian dollars (AUD) per US dollar –
The Royal Bank of Scotland (RBS)
After forming a strategic partnership with the Bank of China in 2005, and two years later leading a consortium to acquire the Dutch bank ABN AMRO, the crisis in global financial markets and deteriorating economic conditions across the world weakened many financial services organizations, and RBS was no exception. In February 2009, RBS set out on a five-year Strategic Plan to guide the restructuring of RBS to make it safer, stronger and more efficient for customers. The plan was built around strengthening their Core businesses while winding down and exiting the businesses they decided not to retain long term (Non-Core). In March of 2011, Standard & Poor’s attributed an upward revision of standalone credit ratings to the good progress made in executing RBS’s restructuring program, citing a significant reduction in non-core assets and an improved balance sheet, which have strengthened its funding and liquidity position and contributed to improvements in its risk profile and earnings.
RBS reported a £1.9 billion pretax operating profit in 2010, which was a material improvement from its £6.1 billion loss in 2009. According to RBS’ May 6 Q1 report, their Non-Core division is on track to reduce its funded assets to less than 10% of the Group total by the end of 2011 and the Group’s Core Tier 1 capital ratio improving to 11.2%. Further progress in expected for 2011 as non-core impairments continue to decline. In absolute terms, however, RBS’ earnings remain a rating weakness, and it has some way to go to achieve its target of a 15% return on equity from its core businesses in 2013. Their current credit ratings are Aa3 from Moody’s, A+ from Standard & Poor’s, and AA- from Fitch.
Worth noting is the U.K. government’s 83% ownership of RBS they will likely retain as a result of ongoing regulatory uncertainty as well as the broader euro-zone debt crisis. The government’s capital injections and the insurance it provides under the Asset Protection Scheme (APS) underpin RBS’ capitalization through the restructuring period.
The default risk is RBS’s ability to perform. Although RBS is owned 83% by the U.K. government and passed the recent “stress test” for banks likely to be affect by a 25% partial Greek default, it is uncertain what meaning or effect a full blown Greek default may actually have throughout the whole European region. Given their restructuring progress and improved performance, as outlined above, the medium term maturity of this bond, and the U.K. government’s hefty ownership of RBS, it is our opinion that the default risk is minimal relative to the modest return, and that it is less than the currency risk.
The currency risk could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to the Australian economy.
The Royal Bank of Australia has stated that delays in resuming coal production following flooding early in the year, meant the Australian economy was unlikely to grow as fast in 2011 as expected just a couple of months earlier. While the central bank sees sovereign debt woes in Europe as “a significant downside risk for the global economy” and a US economy where “growth had moderated,” the nation’s close ties to Asia meant medium-term growth prospects remained healthy.
Many people ask, how do I invest in Australian Corporate bonds? With most firms it often require an institutional sized single bond purchase. To circumvent this constraint and allow greater diversification, we at Durig Capital combine world bond buyers into a larger institutional sized purchase. In our previous syndicates, we were able to facilitate purchases as low as $10,000 US Dollar and should be able to do the same for your interest.
Indications of a slow or modest US economic recovery remain very fragile and sensitive to commodities inflation. Considering Australia’s long term position as a stable economy and political system with shrew fiscal management will likely correlate with a stable and possible strengthening of the commodity based Australian dollar relative to the US dollar, we view the gaining of a 2.5 multiple on the yield as an incredibly compelling reason for choosing the currency risk of RBS’s Aussie dollar bond over their similar Yankee (US dollar) bond. The combination of offering a remarkably high yield, a hedge against the possible continuation of the US dollar’s weakness against the Aussie dollar, and a diversification away from heavily overweighted US dollar based assets into one of the world’s top tier fiscally conservative countries is why we are adding it at this time to our Foreign and World Fixed Income holdings.
Disclosure: Durig Capital clients may currently own these Bank of Scotland bonds.
To know more about this Bank of Scotland bond call our fixed income specialist at 971-327-8847