More Australian government bonds? Yes please!

SYDNEY (Reuters) - When governments set out to borrow more it can give investors indigestion, but in Australia's case hungry bond-buyers would welcome a deeper hole in state finances and the safe, but rare, debt it brings.

Australian government bonds are something of a scarce commodity in a country that has run budget surpluses for years and effectively paid off all its debt, but there are growing signs investors may finally get what they wished for.

The Australian government is still counting on a small budget surplus of A$5.4 billion ($3.53 billion) for 2008/09, despite slashing its surplus forecast last month due to the global financial crisis.

However, Prime Minister Kevin Rudd warned he would be prepared to allow a deficit if more spending was needed to stimulate economic growth and many analysts see a budget deficit in the near future.

"The government is likely to run a budget deficit in 2008/09 and likely a bigger one in 2009/10, so it will have to issue more bonds," said Sally Auld, a strategist at JPMorgan.

She predicts a A$5 billion budget deficit for next year and between A$10-A$15 billion the following year.

The government in Canberra said over the weekend it would spend an extra A$15 billion on hospitals and schools, which would come on top of A$10.4 billion stimulus package announced earlier.

RARITY

But in contrast to other governments that may struggle to fund economic rescue efforts in markets saturated with government debt, running a deficit does not seem to be a big problem in Australia because of the scarcity value of Australian bonds.

"One of the problems in Australia in recent years is the insufficiency of government bonds," said Andrew Kennedy, a trader at ABN AMRO in Sydney.

"Supply hasn't met the growing demand," he added.

In part this was because years of diminished supply had shrunk the outstanding bond pool to levels that no longer provided a deep, liquid risk-free yield curve.

"Liquidity was becoming a problem for some issues," said Melbourne-based Lance Pupelis, head of income at Aviva Investors who manages a A$4 billion ($2.62 billion) bond portfolio.

"A short-term move to deficit requiring bonds funding would be welcome," Pupelis added.

Australia has just A$50 billion of government bonds outstanding, a drop in the ocean compared to the $6.4 trillion of U.S. government debt held by the public.

And much of Australia's debt is held by foreign central banks who keep them to maturity, making it an illiquid market where it can be tough to find buyers and sellers and thus a good price.

The nation's Treasury had already taken a small step to easing this problem by issuing a little more debt to take the outstanding total up to A$55 billion in the year to June 2009. That should help provide pricing benchmarks for the much larger bond futures market, where investors use cash bonds as hedges.

But analysts say more was needed.

"Around A$70 to A$75 billion of bonds on issue would be the appropriate size," said JPMorgan's Auld.

There is also reason to believe that a greater supply of Australian debt would attract plenty of overseas interest, particularly from foreign central banks.

"Compared with U.S. yields, which are extremely low, yields in Australia are relatively high and it's a relatively safe credit," said Grant Lovett, head of fixed interest at UBS.

The 10-year bond in Australia yields 4.31 percent compared with 2.70 percent in the U.S. and 3.65 percent in Britain.

Moreover, a declining Australian dollar, which has lost 25 percent of its value since July, makes Australian bonds attractive to international punters, who bet on its recovery.

"We are seeing offshore clients buy Australian government bonds because the exchange rate is very low, it is a nice play on the currency," said UBS's Lovett.

If Australia were to sell more debt, it would tap existing bond lines, a top government official told Reuters on the sidelines of a securitization conference in Sydney.

"These bond lines provide the reference points for the Treasury bond futures contracts and can absorb considerable more issuance," Neil Hyden, chief executive officer of the Australian Office of Financial Management (AOFM) told Reuters.

The AOFM is the debt issuing arm of Australia.

"There is no need for new lines at present," he added.

Government currently offers bond maturities up to 15 years.

($1=1.528 Australian Dollar)

(Editing by Tomasz Janowski)