Attracted by Australia's triple-A rating, stable economy and relatively high bond yields, foreign investors, including central banks, have bought record amounts of government bonds, helping to boost the Australian dollar.
The relative improvement in Australia's credit rating should further encourage the Australian safe-haven buying that had been developing, according to a recent UBS research note said.
Given strong demand, Martin Whetton, an interest-rate strategist at Nomura in Sydney, said he expected Australia's 10-year yields to fall to 3.25 per cent by the middle of the year from current levels just below 4 per cent.
Further cuts in interest rates by Australia's central bank will also work to push down yields, as well as demand for Australian bonds from foreign central banks and offshore funds.
"We now occupy a bigger space in the AAA-rated world than ever before. As a result, we will see continued offshore investment in Australian bonds," Whetton said.
"Global funds and central banks have allocated increased amounts of their reserves to Australia, fearful of risks in European and Japanese government bonds."
Standard & Poor's recent downgrading of France, Europe's second-largest economy, following the downgrading of the United States last year, confirms Australia's status as a member of the AAA-rated club, of which there are just 12 members left.
"Australia is attractive on an absolute sense given our 10-year bond yields remain high and in a relative sense," Whetton said.
Australian 10-year bond yields are trading at just below 4 per cent, while yields on 10-year bonds in many triple-A rated countries and in the US sit at 2 per cent or less.
Also reflecting the shift of sovereign money, Citi and Research Affiliates this week launched a new global sovereign bond index, which decreased exposure to aging and debt-laden economies, such as Japan and the US, and increased exposure to less indebted nations, such as Canada and Australia, which would account for 6.5 per cent of the new developed markets index.
This would help to spur on demand for local bonds, though the overall size of Australia's bond market at $210 billion would cap demand, Whetton said.
According to UBS, balance of payments data released by the Australian Bureau of Statistics indicated offshore demand for Australian government bonds reached a record level of $23 billion in the third quarter of last year.
Buying in the fourth quarter was likely to be even higher, given greater volatility in European markets, Whetton said.
"European markets got even worse than the third quarter and the Aussie dollar rallied further, which is a sign of further offshore buying of our bonds," he said, adding that as much as 80 per cent of Australia's government bond market was held by offshore investors, a number which had jumped in recent months.
Australian bonds returned 14.4 per cent to investors last year, beaten only by the United Kingdom's 16.8 per cent and New Zealand's 14.7 per cent among 26 markets worldwide tracked by Bloomberg/EFFAS indexes.
Nomura said it expected spreads to narrow on Australian, Canadian and UK bonds, reflecting strong demand. "They have bond markets that are globally held, relatively liquid and accessible," the bank said in a recent research note.
"Accordingly, we continue to recommend investors increase exposure to these markets."
