NSW, Queensland and WA will have to sweeten their debt offerings to attract overseas money as local banks have fewer incentives to buy their bonds.
Already a subscriber?State governments are looking to raise more money this year than the federal government for the first time to fund ambitious infrastructure projects, but will have to pay investors more to get the deals done.
around $100 billion in debt this financial year with $35 billion left to do before the end of June. This is double the Commonwealth’s funding requirements. The four most populated states may have to sweeten their bond offers by around 0.15 percentage points above the federal government to entice investors to buy their debt, estimates Giulia Specchia, a rate strategist at UBS Australia. Jack Chambers, a senior rates strategist at ANZ, predicts a pick-up of as much as 0.20 percentage points. This is because banks, which are typically their biggest investor source, have less cash to put to work. Bond manager Kashi Trathen at IFM Investors said the estimates were reasonable. “The outlook for semi governments bond spreads over the next couple of years is likely to be a gradual widening unless the economy materially worsens,” he said. Mr Trathen’s $4 billion Australian bond fund has an enhanced passive strategy, which means that it seeks to outperform the Australian Bond Composite Index, 29 per cent of which is in state bonds.For now, the fund manager prefers highly rated covered bonds issued by Australia’s top banks because they pay a higher premium than semi-governments in the three-year part of the curve. As a result, he is overweight major banks and underweight state bonds. IFM has $217 billion of assets under management. Christian Baylis, co-founder at Fortlake Asset Management, is even more pessimistic and only holds a small amount of semi-government bonds because they pay “unattractive” returns. He doubts they will improve significantly, and anticipates a gain of a couple of basis points only.“Spreads are way too tight versus government bonds. Given the fiscal position of the states, the amount of supply, and the compensation above government bonds, the risk isn’t adequately priced,” he said.Indeed, local banks are keen buyers of state debt because they qualify as high-quality liquid assets required by the prudential regulator to cushion deposits at times of crisis.Banks have ramped up their purchases of semi-government debt in the past 12 months to replace $200 billion in ultra-cheap funding put in place during the pandemic, which is due for repayment in June. In simple terms, they have gradually replaced one type of liquid asset with another. The timing was also impeccable as the financing needs of state governments ballooned to fund roads, tunnels, and rails. It means that from June, the massive incentive for banks to buy semi-government bonds will disappear, fuelling speculation that the states will have to make their debt more palatable to investors. Local deposit-taking institutions are now the largest buyers of state debt, holding three-quarters of the $553 billion bonds in circulation. The top four states currently offer between 58 basis points and 68 basis points on top of the Commonwealth bonds with 10-year maturity. UBS expects the premium to gradually increase by 12 to 15 basis points by mid-2026.Adrian Janschek, portfolio manager at First Sentier Investors which manages $60 billion in cash and fixed income, expects semi-government spreads to modestly widen after June. He anticipates they will stay in the range of 60 to 80 basis points over Commonwealth bonds.“We have a natural tendency to be overweight semis most of the time,” he said. First Sentier holds between $1 billion and $2 billion in state bonds and favours those with a long maturity because of their attractive yields. “Semi-government spreads are not exactly tight on a historical basis, the long end in particular,” Mr Janschek said, noting that the 10-year-plus part of the curve has been a very popular spot in the past year. A big question is whether the states will be able to expand their investor base and there is already greater appetite from offshore buyers. Early this year, Treasury Corp Victoria, the state’s funding arm, placed nearly half of its $2.5 billion 2038 bonds overseas in Europe, Asia, and the UK. There is also speculation that Japanese investors may return which has waned in recent years amid expectations that the Bank of Japan will finally exit its ultra-loose monetary policy.Craig Vardy, head of Australian Fixed Income at Blackrock, is hoping to snap up some bargains.“It will depend on offshore flows. If they are in and if they’re in big, they’ll push spreads wide and as a portfolio manager always looking at ways to outperform, you would be looking at them as a relative value opportunity,” he said. Mr Vardy, who manages $33 billion in fixed income, is neutral about state bonds because of the “supply worry”. “I think the states are very motivated to spread their wings and sell their story offshore,” he added.
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