Tuesday 16 September 2014 by Legacy

Australian Dollar doldrums - how to use bonds to profit from a falling Aussie dollar and earn 3-4% p.a.

Fundamentally overvalued. That is commonly held view of the Australian Dollar

Reserve Bank of Australia (RBA) Governor Glenn Stevens is just one of many respected figures predicting a lower dollar.

"It's going to be pretty surprising if it remains this high over a very long period," Mr Stevens told a parliamentary committee last month.

For weeks FIIG has been highlighting the risk of a sharp fall in the AUD and how bond investors can profit from this.  Last week we saw the AUD fall from 93c to 90c in just four days, and for no one particular reason. 

Falling coal and iron ore prices; a slump in business investment; an overpriced housing market; rising unemployment; falling national income; government spending cuts; and the high AUD itself are combining to put the risk of an Australian recession at its highest level for more than 20 years. 

Yet the AUD stubbornly remains above 90c.  Most people blame currency traders chasing yield for this disconnect with the “real” value of the AUD.  This disconnect between the strong actual value and weak fundamental value of the dollar provide investors with an opportunity to profit.

The truth is investment markets tend to rise smoothly and fall hard.  This is the impact of the cycle of human greed and fear.  Greed builds slowly, but fear is instantaneous.  You don’t hear about markets crashing up, only down.      

When it comes to currency, the three largest corrections in the AUD versus the USD have occurred around major global crises in confidence such as the 1997/98 Asian crisis, the 2001 “Dotcom” crisis, and the recent GFC.

There are profits to be made as an investor in these times, and one way to do this is through an investment in USD denominated corporate bonds (“USD bonds”).  For Australian investors, a fall in the AUD against the USD will increase the AUD value of these bonds.  This increase in value will most likely occur at a time of losses in equities, i.e. times of global fear.  So you can either look at a USD bonds investment as a trading strategy if you believe there is a market shakeup on the horizon, or as a hedge to cover your losses in equities at such times.

The charts below illustrate that the USD has jumped 20-30% against the AUD during each of these crises.  Smaller shocks to confidence have seen smaller moves too, i.e. it won’t take a major global crisis to provide an opportunity to profit from a rising USD.

Source: Bloomberg

Figure 1: Rise in the USD vs the AUD during global financial crises
Note: These charts are shown as USD/AUD.  In Australia we are accustomed to seeing this expressed as AUD/USD. The current rate of AUD/USD is 90.23 cents, which is USD/AUD 110.83 cents, or 1.10 on the chart above.

When the next correction occurs for the AUD, it will be fears of a “hard landing” of the Chinese economy coupled with the unwinding of the cheap leverage that the US Federal Reserve has made available in recent years. 

A China-related fear cycle is the worst possible scenario for most Australian investors.  The world sees Australia as the beneficiary of Chinese economic growth, so if there are fears of a slowdown in that growth that in turn will hurt our stock market and the AUD.  Both are likely to see 10-20% corrections depending upon how significant the fear regarding China.

These are not forecasts.  It is critical when setting an investment strategy not to have one forecast and put all of your money behind that bet.  Most SMSF investors were successful at running their own business or running a business for someone else.  A good business manager sets a business plan around an expected set of forecasts, but then builds in contingency plans for other scenarios.  Investment planning is no different to business planning – invest for your expected set of forecasts, but have contingency plans. 

Most people don’t believe China will collapse in a property or credit bubble any time soon.  But if you think there is a chance it will happen, you need to have investments in place that will profit from this scenario.  It was intuitive for you to plan for contingencies when you ran a business, and so it should be intuitive to do the same as you manage your investments. 

Some Australian investors use unhedged international shares for this purpose.  That’s an ineffective hedge as fears of a China slowdown will hit all international share markets.  Some simply buy US Dollars, but find they are earning no interest while they sit and wait for a fall in the AUD. 

At FIIG we have another idea.  A portfolio of Investment Grade Australian companies currently pay a running yield of around 4.66% p.a. in USD.  In other words, for every USD $100,000 invested, you will receive USD $4,660 per annum on average.  (You can exclude Newcrest if you want to avoid the mining sector, but this will lower your total return slightly.)

Figure 2: USD Investment Grade Portfolio Illustration  

There are other bonds available with yields of up to 8.5% p.a. in USD.  Ask your FIIG relationship manager for details.

This means you can invest in USD bonds, offering a hedge against a fall in the AUD, but earn 3-4% p.a. rather than the zero interest USD bank accounts offer.  And unlike using international shares as a way of getting an exposure to the USD, with USD denominated corporate bonds you have a simple, transparent and low capital risk investment with the security of some of Australia’s largest companies.