[SYDNEY] Fixed income investors are bullish on the prices of Australia's state government bonds, with the supply of new debt contracting just as demand increases because of tougher liquid capital rules for banks. "In the past, we could hold a mix of paper including bank bonds, now we are forced to own government (or state government) paper," said Anthony Issa, deputy treasurer at Industrial and Commercial Bank of China (ICBC) in Sydney. ICBC Australia has a A$10 billion balance sheet. "So naturally, semi-government (state) bond spreads will compress as, at the same time, the amount of issuance is also being reduced," he added.

The yield gap between Australia's AAA-rated sovereign and state 10-year bonds could shrink to a decade-low around 20 basis points, traders say, a long way from the 115 basis points seen during the 2007/08 credit crisis.

While opinions vary on which of the major borrowing states will ultimately perform best, fund managers said there is little doubt that state's debt will be in high demand as local banks scramble to find highly liquid assets that are acceptable by the banking regulator.

Banks already own half the states' total debt, according to TD Securities data, from a quarter four years ago.

As of Jan. 1, banks operating in Australia can only hold cash, sovereign and state bonds to meet the Australian Prudential Regulation Authority's definition of high quality liquid assets, which used to accept bank bonds and other highly-rated corporate debt as regulatory capital.

APRA's standard is tougher than required by the Bank of International Settlement's Basel Committee, the international banking regulator, which permits a broader range of assets.

Australian states plan to privatise around A$130 billion worth of assets, from ports to power stations, to offset falling revenues and reduce their substantial debt, although there is no formal schedule of privatisations.

This means the states' new net debt issuance could be cut to just A$4 billion by mid-2016, from A$13 billion forecast for 2014/15, the lowest amount since the global financial crisis, said Andrew Lilley, a strategist at UBS. Some borrowers may even opt to put debt issuance on hold for a couple of years.

Australian state debt boasts top AAA to AA+ ratings, yet offers yields about twice as large as those on Spanish sovereign debt - one of the weakest and most debt-laden European economies.

Five-year Australian dollar bonds issued by the resource-rich states of Queensland and Western Australia, rated AA+ and Aa1, pay around 2.5-2.7 per cent. This compares with yields of less than 1 per cent offered by Spain's euro-denominated debt, rated some 7 notches lower.

REUTERS