The announcement of the details of the future New Zealand government bond (NZGB) programme may not be the most exciting or widely reported part of the Budget on 25 May. However, the bond programme and its composition can have significant implications for fixed income markets in New Zealand. The 2017 budget was no exception and following the release of the details of this year’s budget there were two key take-outs for fixed income investors:
- The government has committed to maintaining a functioning government bond market; and
- The issuance of inflation indexed bonds would be set at NZ$1 billion of the planned NZ$7 billion issuance in the 2017/2018 budget year.
Maintaining a functioning government bond market
The New Zealand Debt Management Office (NZDMO) in their press release accompanying the Budget noted:
The Government recognises the importance of maintaining a sustainable NZGB market and intends to maintain levels of NZGBs on issue at not less than 20 percent of GDP over time.
This commitment is significant as the government bond market forms the core of many fixed income portfolios, and we need the market to remain active for both investors and the government.
In the last period when the government ran sustained surpluses (during the early to mid- 2000s prior to the Global Financial Crisis), the level of outstanding government bonds fell to a level that saw secondary market activity decline, and both investors and market makers exit the market. These were clearly backward steps for the efficient functioning of the government bond market. Therefore it is very pleasing to see the government’s commitment to maintaining the market by ensuring a critical mass of outstanding issuance.
Having a well-functioning market with a broad range of participants and investors should ensure the government can fund its activities now and in the future in the most efficient manner. As an investor in the market, AMP Capital will also be able to actively invest in government bonds more confident in the available liquidity going forward.
Inflation indexed bond issuance
The second key take-out from the budget documents, and highlighted again in the NZDMO press release, relates to the inflation indexed bond issuance. The NZDMO press release noted:
Inflation-indexed bond issuance is expected to be around $1.0 billion of the $7.0 billion 2017/18 domestic bond programme.
The key implication of this announcement is that it should support the performance of inflation indexed bonds relative to non-indexed government bonds.
Over the longer-term, the level of inflation and inflation expectations drives performance of the inflation linked bonds. That is, higher current inflation and expectation of higher future inflation will see yields on inflation linked bonds fall and their prices go up relative to nominal government bonds. Another way of saying this is that breakeven inflation rates (BEI) will go up. For a more detailed explanation of the mechanics of inflation indexed bonds and BEI please refer to investment insights ‘New Zealand Inflation-Indexed Government Bonds (IIBS)’, June 2016.
However, in the short-term other factors can drive performance of inflation linked bonds. One of these factors is the level of supply. The New Zealand inflation indexed bond market is not as liquid as the nominal government bond market and as a consequence the quantity of issuance can drive yields away from what would be implied by views around inflation.
In February 2017 the NZDMO announced that it would be issuing NZ$1.5 billion face value of the 2040 inflation indexed bond via syndication. The bond was issued in March 2017. The announcement and issuance saw inflation indexed bonds underperform nominal bonds and hence BEIs to fall as this relative supply was absorbed by the market. This fall in BEI came despite the pickup in inflation and inflation expectations that were occurring around the same time – both factors which should have seen BEIs go higher – refer figure below.
Figure: New Zealand inflation, inflation expectations and breakeven inflation (BEI), %
The announcement in the Budget that the issuance of inflation indexed bonds for the 2017/2018 fiscal year would be only NZ$1 billion will provide comfort to the market that there is not significant issuance to absorb in the year ahead. The market will then re-focus on current inflation and inflation expectations (which have moved higher) as the primary drivers of BEI. This budget announcement should support the performance of inflation indexed bonds in the period ahead.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.