In January I wrote the easiest trade of 2019 will be long Australian bonds. That is, bond prices will surge as a result of a rapidly declining property market and the RBA will be forced to cut numerous times. I believe that eventually the 10-year bond yield will drop to 1%, the 3 year bond below that and following inflation data last week, bonds are either at or back near their record highs.
As economists are now catching up to what the bond market had been warning us about since last year, focus is really turning towards “when” the RBA will cut rates and not “if”, with many expecting a May rate cut. Despite being the biggest bond bull in Australia, I don’t think the RBA will cut in May. But when they do is largely irrelevant because markets will continue to compress bond yields as the price in two, three and four rate cuts over the next 12-24 months. As I showed in those articles earlier in the year, bonds already price in most rate cuts before the RBA actually moves.
So is there still any opportunity in safely capturing yield in Australia? Yes there certainly is. Despite the 10% move in TCL I still think there is enormous upside. Take into account that if bond yields do reach 1% and the dividend yield on TCL remains the same, for it to yield 3%, the share price will need to reach $18.85 or 40% above current prices! Buyers today can still lock in a 4.1% yield.
As the weekly chart of TCL below shows when a yield crunch begins the surges in the underlying share price can be massive and consistent. The huge break through to record highs this year has left behind a near 3-year consolidation and typically after such a prolonged “rest” the next uptrend can be enormous. We are witnessing one now.
However, if you are unwilling to chase TCL, I believe Sydney Airports (SYD) is about to enjoy a similar breakout and experience a major yield crunch re-rating. Like TCL, SYD enjoys a high yield currently sitting at 4.9% and as bond yields continue to contract there will be a natural flow of money chasing this yield. The breakout that is in the process of unfolding right now, means investors are buying the stock at the equivalent of TCL’s breakout just a couple of months ago. As the chart below shows, SYD too has been consolidating for nearly 3-years and I expect this move to new highs to lead into a major long-term trend in line with the move in bond yields.
I don’t think the market, economists or analysts have yet come to understand the extent to which interest rates will decline and how attractive the yields on infrastructure stocks will be. As an example, property trust Goodman Gorup (GMG) has enjoyed such a massive rise due to its exposure to distribution centres that it yields a paltry 2.1% and trades at 167% premium to its Net Tangible Asset backing. As a comparison for SYD to drop from a 4.9% yield to a 3.9% yield (with no change in dividend amounts) the share price would need to rise to $10.40 or a 36% increase from current levels. This puts some perspective to the size of the trend that can develop not only from such a significant technical breakout but also from the ongoing contraction in interest rates.
To date the moves in interest rates has been in line with my expectations and I see no reason to deviate from this view. In fact the relationship and effects lower interest rates have on other sectors are transpiring as they should which I only gives me confidence that this yield crunch story is a real thematic that investors just cannot miss.