Part 2: Operations and Performance
- 1 Introduction
- 2 Treasury Bond and Treasury Indexed Bond issuance
- 3 Cash management
- 4 Minimising debt servicing costs subject to acceptable risk
- 5 Interest rate swaps
- 6 Residential mortgage-backed securities
- 7 Investor relations
- 8 Public Register of Government Borrowing
- 9 Information technology operations
- 10 Operational risk
- 11 Settlement operations
- 12 Cooperation with other debt managers
- 13 Agency financial performance
The principal functions of the AOFM are:
- funding the Budget through the issuance of Australian Government debt;
- managing the Australian Government’s daily cash balances through short-term borrowings and investments;
- undertaking investments in financial assets in accordance with Government policy objectives;
- managing its portfolio of debt and financial assets in a cost effective manner, subject to acceptable risk; and
- supporting the efficient operation of Australia’s financial system.
This section outlines the activities undertaken in 2009-10 and reports on their performance.
Treasury Bond and Treasury Indexed Bond issuance
The primary objective of Treasury Bond and Treasury Indexed Bond issuance is to raise monies to fund the Australian Government Budget.
A secondary objective is to support the efficient operation of Australia’s financial system. This objective is achieved in the following ways:
- Treasury Bonds, Treasury Indexed Bonds, and Treasury Bond futures are used by financial market participants as benchmarks for the pricing of other capital market instruments and to manage interest rate risk.
- The existence of active and efficient physical and futures markets for sovereign debt also strengthens the robustness of the financial system and reduces its vulnerability to shocks.
Achieving the objective
This year’s debt issuance task occurred against the backdrop of considerable uncertainty about the health of the global economy and financial system in the wake of the global financial crisis. Many OECD economies undertook large borrowing programs to fund growing budget deficits and support weakened financial institutions. Chart 1 shows the stock of gross government debt on issue as a proportion of GDP in Australia and several other OECD countries over recent years.
Source: IMF World Economic Outlook April 2010, Treasury
It can be seen that Australia started from a much lower level of government debt relative to GDP and has maintained this position throughout the global crisis. We therefore faced a much less formidable issuance challenge than the comparator countries. Nevertheless the task was still a substantial one as indicated in Chart 2.1
The AOFM’s debt issuance task was assisted by investors’ perceptions of Australia’s high credit quality, the relative strength of the Australian economy and fiscal outlook, and the attractive yields on the debt. These factors resulted in the relatively large volume of issuance being absorbed smoothly by financial markets.
In addition, legislation came into effect in December 2009 making Commonwealth Government Securities exempt from non-resident interest withholding tax. The exemption removed a barrier to investment for many offshore investors who had been unwilling or unable to invest in assets subject to interest withholding tax. Non-resident holdings of Commonwealth Government Securities were around sixty per cent of the total outstanding during 2009-10.
Gross Treasury Bond issuance for the year totalled $52 billion. The bulk of issuance was in existing bond lines in order to enhance their liquidity and improve their attractiveness, particularly to large global investors. By the end of June 2010, the average face value of these lines was over $11 billion, compared with an average around $7 billion for the same lines a year earlier.
Issuing over a range of bond lines with differing maturities was also designed to help the management of the debt portfolio by ensuring that the maturity of the debt was not unduly concentrated but spread over a period of years. To further assist this objective, two new short-dated bond lines maturing in November 2012 and December 2013 were introduced to allow issuance to be spread across a larger number of lines and help limit the growth of the largest lines. A new bond line with a maturity date of July 2022 was also launched in order to maintain the length of the yield curve and support the operation of the 10-year Treasury Bond futures contract.
In selecting the bond lines to issue each week, the AOFM took account of prevailing market conditions, information from financial market contacts concerning investor demand, relative value considerations, the aim of increasing the liquidity of outstanding bond lines and the need to manage the maturity structure to limit refinancing risk. Most weeks two tenders were held: typically a tender for the issue of $500 million of a long-dated bond line and a tender for the issue of $700 million of a short-dated bond line.
Chart 3 shows the Treasury Bonds outstanding as at 30 June 2010 and issued over the financial year.
During the year the total volume of Treasury Bonds on issue increased by around $46 billion, to $125 billion. At the end of the year there were seven Treasury Bond lines with over $10 billion on issue.
Treasury Indexed Bonds
Treasury Indexed Bond issuance was recommenced in September 2009 to assist the management of Australian Government debt by widening the range of available debt instruments, diversifying risk and tapping additional sources of investor demand. Treasury Indexed Bonds were last issued in 2003. The decision to recommence issuance followed consultations with a wide range of financial market participants.
Issuance recommenced with the syndicated offer of a new Treasury Indexed Bond maturing in September 2025. A panel of six financial institutions was appointed to manage the $4 billion issue. The offer generated considerable interest both domestically and from offshore. As part of the issue, holders of the Treasury Indexed Bond maturing in August 2010 were given the opportunity to convert their holdings of that bond to stock of the new bond. Approximately $716 million face value of the 2010 Treasury Indexed Bond was repurchased in this manner.
Following the syndicated offer, Treasury Indexed Bonds were offered at monthly tenders of $300 million face value each. The volume of each line outstanding, relative yields and other prevailing market conditions were considered in the selection of which line to offer each month.
Chart 4 shows the Treasury Indexed Bonds outstanding as at 30 June 2010 and issued over the financial year.
* $716 million of the $1,452 million face value of the 2010 Treasury Indexed Bond was repurchased during 2009-10.
In September 2009 the securities lending facility was expanded to enable borrowing of Treasury Indexed Bonds. During the year the facility was used twice to borrow such bonds.
In April 2009 the Government announced that its investment in the National Broadband Network would be partly funded by the issuance of Aussie Infrastructure Bonds to household and institutional investors.
The 2010-11 Budget papers indicated that the component of this funding to be provided by institutional and other wholesale investors will be through the issue of CGS as part of the Government’s overall debt issuance. These bonds will not be identified separately from other CGS at the time of issue, but will be reported in the annual Budget Statements.
Funding the Budget
The Government’s budget financing requirement in 2009-10 was fully met, together with $5 billion of pre-funding for 2010-11.
The Treasury Bond market was affected in the first part of the year by increased issuance by State governments following the passage of Commonwealth guarantee legislation in June 2009. Some investors sold holdings of Treasury Bonds to purchase higher yielding semi-government bonds of a similar maturity. This resulted in a large volume of Treasury Bonds coming onto the secondary market, making primary issuance of bonds with long maturities more difficult for a period. In view of the increased uncertainty about bond issuance at this time the AOFM increased its issuance of Treasury Notes in June 2009 and held an increased volume of short-term assets. Nevertheless, Treasury Bond issuance was maintained throughout this period, although only one long maturity bond line was issued at tender in the first six weeks of the financial year.
The funding position in the early part of the year was stronger than expected because the performance during the 2008-09 financial year exceeded the forecast in the 2008-09 Budget and the receipt for $4.8 billion from allocations of Special Drawing Rights by the International Monetary Fund that had not been anticipated at the time of the 2010-11 Budget. From August 2009 the volume of Treasury Notes on issue was reduced gradually, offsetting the build up that had occurred in June 2009.
The AOFM reviewed the planned bond issuance program for 2009-10 following the release of the Government’s Mid-Year Economic and Fiscal Outlook statement on 2 November 2009. It decided to maintain the planned program so as to reduce the bond issuance that would be required in 2010-11. Proceeds from this pre-funding were invested in short-dated semi-government bonds. The assets purchased were those with maturities on or before the maturity dates of Commonwealth debt maturing in 2010-11. During 2009-10, holdings of semi-government bonds peaked at over $4 billion.
Market liquidity and efficiency
The Treasury Bond market operated relatively smoothly throughout 2009-10. This was helped by the enhanced liquidity of the market due to increased issuance, and by more settled financial markets conditions than in 2008-09. The liquidity and efficiency of the Treasury Indexed Bond market also improved dramatically with the resumption of issuance.
One measure of liquidity is turnover in the secondary market. Chart 5 shows the evolution of total secondary market turnover2 from July 2008 through to June 2010.
The Australian Government bond market displayed improved liquidity3 in 2009-10 with:
- Treasury Bond turnover increased by 45 per cent in 2009-10 compared to 2008-09.
- Treasury Indexed Bond turnover increased by 209 per cent in 2009-10 compared to 2008-09.
- The turnover of 3-year Treasury Bond futures contracts increased by 36 per cent in 2009-10 compared to 2008-09, and turnover of the 10-year contracts increased by 4 per cent.
The liquidity and efficiency of the Treasury Bond and Treasury Indexed Bond markets were helped by an increase in the number of price-makers. During the year four new institutions registered to become bidders in tenders for the issue of Commonwealth Government Securities and also began making secondary market prices in these securities.
The AOFM’s securities lending facility allows market participants to borrow Treasury Bonds and Treasury Indexed Bonds for short periods when they are not otherwise available. This enhances the efficiency of the market by improving the capacity of intermediaries to make two-way prices. The more settled market conditions resulted in significantly less use of the securities lending facility in 2009-10 than in the previous year. The facility was used 60 times for overnight borrowing in 2009-10 compared with 374 instances of use in 2008-09. The face value amount lent was around $2.4 billion compared to $12.8 billion in 2008-09.
All Treasury Bond futures contract close-outs in 2009-10 occurred smoothly.
Efficiency of issuance
All issuance of Commonwealth Government Securities in 2009-10 was by competitive tender apart from the syndicated offering of the new 2025 Treasury Indexed Bond.
Tenders held during 2009-10 were well supported. Table 1 summarises the results of Treasury Bond tenders conducted during the year. The results are shown as averages for each half year and grouped by the maturity dates of the bonds offered.
|Period||Maturity||Face value amount allocated ($m)||Weighted average issue yield (%)||Average spread to secondary market yield (basis points)||Average times covered|
|July – December 2009||Up to 2015||18,103||5.0751||-0.01||3.74|
|2016 – 2022||6,298||5.4122||-0.20||3.33|
|January – June 2010||Up to 2015||16,600||5.0694||-0.03||3.59|
|2016 – 2022||11,300||5.6190||0.08||3.33|
The average ratio of the volume of bids received to the amount of stock on offer was 3.54 for Treasury Bonds in 2009-10, broadly in line with the averages for previous years, despite the much larger volume of total issuance in 2009-10. Only one tender had a cover ratio less than two.4 In general, bids at tender were stronger for short-dated bonds compared to long-dated.
The strength of bidding at tenders was also reflected in the yield spreads to the secondary market. At many Treasury Bond tenders, and all Treasury Indexed Bond tenders, the weighted average yields obtained were below prevailing secondary market yields. The average spreads obtained on Treasury Bond tenders during the year were lower than those in recent years.
The syndicated offering of the new 2025 Treasury Indexed Bond allowed the new bond to achieve a benchmark size immediately and ensured the issue attracted the attention of both domestic and foreign investors. Feedback from investors regarding the syndication process was positive. Following the syndicated offering, there were seven competitive tenders for Treasury Indexed Bonds during the year. The average ratio of the volume of bids received to the amount of stock on offer was 3.91, with an average spread to the secondary market yield of -2.57 basis points.
Full tender details are given in Part 5 of this annual report for Treasury Bonds and Treasury Indexed Bonds.
The AOFM manages the daily cash balances of the Australian Government in the Official Public Account (OPA).5 The AOFM’s primary objective in managing these balances is to ensure that the Government is able to meet its financial obligations as and when they fall due. Other objectives are to minimise the cost of funding the balances and to invest excess balances efficiently. In minimising cost the AOFM seeks to avoid undue use of the overdraft facility provided by the RBA.6
Achieving the objective
Achieving the objective in relation to cash management involves undertaking appropriate short-term investment and debt issuance.
Cash balances not required immediately are invested outside the OPA for nominated periods of time, with the maturity dates set primarily to finance large future outlays. The types, magnitudes and tenors of the short-term investments are determined by the AOFM. Investments are made in term deposits at the RBA, bank accepted bills and negotiable certificates of deposit issued by highly-rated Authorised Deposit-taking Institutions (ADIs) and short-dated bonds issued by Australian State and Territory governments (semi-government bonds). Investment outside the RBA is not risk-free and therefore requires an appropriately higher rate of return.
- Interest rates for term deposits at the RBA are based on Overnight Indexed Swap rates.
- Interest rates for bank accepted bills, certificates of deposit and semi-government bonds reflect prevailing market rates for those instruments.
Borrowing to support the cash management task is undertaken by the issue of Treasury Notes. At least $10 billion of notes were kept on issue at all times during 2009-10 to maintain a liquid market.
The AOFM also plans to undertake repurchase transactions in the future to borrow for cash management purposes using semi-government bonds as collateral. It began negotiating repurchase agreement documentation with members of its Investment Panel towards the end of the year.
The size and volatility of the within-year funding requirement are indicated by changes in the short-term financial asset holdings managed by the AOFM, after deducting Treasury Notes on issue. Chart 6 shows the movement in the funding requirement in 2009-10.
The objective of meeting the Government’s financial obligations as and when they fall due was met in 2009-10 without any use of the overdraft facility.
During 2009-10 the AOFM placed 457 term deposits with the RBA. The stock of term deposits fluctuated from a maximum of $33.4 billion in September 2009 to a minimum of $3.0 billion in January 2010.
- The average yield obtained on term deposits during 2009-10 was 3.60 per cent, compared with 4.97 per cent in 2008-09. The decrease in average yield reflects the lower average level of interest rates that prevailed in 2009-10.
Investment in bank accepted bills and certificates of deposit was undertaken when excess funds were available for investment and there was an acceptable higher return from investing in such instruments compared with placing funds on deposit at the RBA.
The face value amount invested in bank accepted bills and certificates of deposit peaked at $4.8 billion in April 2010. The average additional return in 2009-10 from investing in bank accepted bills and certificates of deposit compared with investing funds on deposit at the RBA was approximately 26 basis points per annum. This is estimated to have generated additional investment earnings in 2009-10 totalling around $8 million. The additional earnings generated on short-term bank debt were lower than earned in 2008-09 due to a contraction in the spread between Overnight Indexed Swap rates and bank bill yields.
Forty tenders for Treasury Notes were conducted during the year, for the issue of $31.9 billion (in face value terms). The tenders were well supported with an average cover ratio of 4.75. Yields averaged around 23 basis points less than bank bill yields of corresponding maturities. Details are in Part 5 of this report.
The movement in total short-term financial asset holdings managed by the AOFM (OPA cash balance plus term deposits with the RBA and other short-term investments managed by the AOFM), together with the volume of Treasury Notes on issue, during 2009-10 are shown in Chart 7.
In undertaking its cash management activities, the AOFM is required to maintain the 91-day rolling average of the daily OPA cash balance within operational limits around a target level. In 2009-10 these limits were the same as applied in 2008-09, with an operational target of $750 million and upper and lower limits of $1,000 million and $500 million respectively. There is also a Ministerially-approved upper limit of $1.5 billion.
The 91-day moving average OPA cash balance was maintained within operational limits, and within the Ministerial limit, throughout the year.
Movements in the 91-day rolling average OPA cash balance over the year are shown in Chart 8.
Minimising debt servicing costs subject to acceptable risk
In managing its debt portfolio, the AOFM generally seeks to minimise debt servicing costs over the medium-term at an acceptable level of risk, by which is meant an acceptable level of variability in cost outcomes. It also seeks to maintain liquid bond lines to facilitate the issuance of debt at acceptable cost and to manage the refinancing risk that arises when bond lines mature.
The primary measure of cost used in balancing cost and risk is historic accrual debt servicing cost. This includes interest on physical debt and derivatives, realised market value gains and losses, capital indexation of inflation-linked debt and the amortisation of any issuance premiums and discounts. However, it does not include unrealised market value gains and losses. Accrual debt servicing cost is the most appropriate measure of cost in circumstances where financial assets and liabilities are intended to be held or to remain on issue until maturity and there is little likelihood that unrealised market value gains and losses will be realised.
Information on unrealised market value gains and losses is useful in circumstances where it is possible that they may be realised in the future. In the AOFM’s financial statements, debt servicing cost outcomes are presented on a ‘fair value’ basis that includes movements in the unrealised market value of physical debt, assets and interest rate derivatives. A comprehensive income format is used that allows revenues and expenses on an historic basis to be distinguished from the effects of unrealised market value fluctuations.
Achieving the objective
The AOFM’s portfolio management strategy seeks to maintain balance in its portfolio of debt and investment instruments. The volume and tenor of assets held as term deposits and bank paper are largely determined by cash management requirements. However the volume and maturity structure of the debt on issue are managed to meet cost, risk and liquidity objectives.
The selection of bond lines and the size of tenders have a direct impact on the cost and risk of the overall portfolio. Factors such as the overall maturity structure of the portfolio, market conditions and the relative demand and cost of different bond lines are considered when issuance decisions are made. The duration of the nominal debt portfolio is thus determined by the cumulative effect of issuance decisions.
For Treasury Bonds, issuance is spread across the yield curve. Typically (but not universally) two tenders are undertaken per week, with one in the short to mid part (for example 1 to 6 years) of the curve and the other in the long part (for example 7 to 15 years) of the curve. The tenders may be of different sizes, providing flexibility in the maturity profile of the portfolio as it changes in size over time.
It is usually found that debt issued for long periods at fixed rates of interest pays higher interest rates than shorter-term debt, because lenders demand a higher return for having their funds locked away for longer periods. For many years the AOFM obtained savings in debt servicing costs by using interest rate swaps to swap from longer to shorter-term debt (or from fixed-rate debt to floating-rate debt). However, over recent years market yield curves have flattened and reduced the savings available from this approach. As a result, in 2008 the AOFM concluded that duration targeting using swaps no longer provided a firm basis for achieving future savings in debt servicing cost. The last swap matured in May 2010.
Reducing debt servicing cost
The debt servicing cost7 of the gross debt managed by the AOFM in 2009-10 was $6.3 billion (after swaps). This represented a cost of funds of 5.05 per cent.
The cost increased by $3.31 billion over the previous year. In large part, this reflected the increase in the average book volume of debt, from $67.8 billion in 2008-09 to $124.5 billion in 2009-10. In addition, there was a large fall in savings from interest rate swaps. Interest rate swaps contributed $969 million in interest revenue in 2008-09, mainly as proceeds from the termination of swaps, but only $41 million in 2009-10.
The return on gross assets in 2009-10 was $1.3 billion, on an average book value of $31.8 billion. Interest revenue on gross assets fell by $253 million between the two years while the average book volume increased by $2.4 billion. The average yield earned on assets fell by 1.20 per cent from 5.36 per cent in 2008-09 to 4.16 per cent in 2009-10.
Taken together, the net servicing cost of the combined portfolio of debt and assets was $5.0 billion, with an effective yield of 5.36 per cent. The corresponding figures for 2008-09 were $1.4 billion and 3.64 per cent, respectively.
Table 2 provides further details of the cost outcomes for the combined portfolio by instrument and portfolio for 2008-09 and 2009-10.
|Interest expense||Book volume||Effective yield|
|$ million||$ million||per cent per annum|
|Contribution by investment|
|Treasury fixed coupon bonds||(3,182)||(5,186)||(56,514)||(100,956)||5.63||5.14|
|Treasury inflation indexed bonds||(687)||(731)||(8,677)||(11,826)||7.92||6.18|
|Other miscellaneous domestic debt||(0)||–||(0)||–||7.20|
|Foreign loans (a)||(2)||(0)||(7)||(6)||23.27||2.98|
|Gross physical CGS debt||(3,946)||(6,328)||(67,840)||(124,479)||5.82||5.08|
|Interest rate swaps||969||41||–||–|
|Gross CGS debt (after swaps)||(2,977)||(6,287)||(67,840)||(124,479)||4.39||5.05|
|Term deposits with the RBA||981||647||19,759||17,996||4.97||3.60|
|Investments in bank paper||140||102||2,108||2,579||6.64||3.97|
|Term investments (b)||199||37||2,864||1,326||6.96||2.80|
|State Housing Advances||166||162||2,826||2,757||5.89||5.89|
|Net CGS debt||(1,400)||(4,964)||(38,423)||(92,631)||3.64||5.36|
|Contribution by portfolio|
|Long-Term Debt Portfolio (c)||(2,690)||(5,900)||(62,070)||(112,707)||4.33||5.24|
|Cash Management Portfolio||1,034||400||18,961||10,129||5.45||3.95|
|State Housing Portfolio||166||162||2,826||2,757||5.89||5.89|
|Total debt and assets||(1,400)||(4,964)||(38,423)||(92,631)||3.64||5.36|
|Total after re-measurements||(1,632)||(7,737)||(38,423)||(92,631)|
Note: Sub totals and totals are actual sum results, rounded to the nearest $ million. Effective yields are based on actual results before rounding, rounded to two decimal places.
- Interest expense and effective yield on foreign loans incorporates foreign exchange revaluations effects.
- Investments in State and Territory government bonds (2008-09 and 2009-10) and Kangaroo bonds (2008-09 only).
- Includes the Debt Hedge Portfolio which operated separately for part of the year (refers only to 2008-09).
- Re-measurements refer to unrealised changes in the market valuation of financial assets and liabilities.
Chart 9 sets out the components by instrument of the change in the debt servicing cost of the total portfolio, broken down to show contributions from changes in the overall volume of debt and in the composition of the portfolio, and from movements in interest rates, exchange rates and the Consumer Price Index (CPI).
The major part of the increase in total debt servicing costs was due to the increase in the volume of Treasury Bonds, Treasury Notes and Treasury Indexed Bonds on issue and reduced savings on interest rate swaps. In particular, the increase in the volume of Treasury Bonds contributed an extra $2.5 billion to total debt servicing cost in 2009-10 compared to the previous year. This was partially offset by relatively expensive debt maturing and being replaced with new debt issued at lower interest rates. It was further offset by a smaller capital indexation impact on indexed bonds due to smaller CPI increases.
The savings provided by interest rate swaps were $928 million less in 2009-10 than in 2008-09. When comparing the two years, it should be noted that the savings in 2008-09 were largely due to the one-off proceeds from the termination of swaps, while no terminations were undertaken in 2009-10.
Low short-term interest rates, particularly in the first half of the financial year, reduced the return obtained on term deposits and other assets. The interest revenue on term deposits in 2009-10 was $647 million on an average book volume of $18.0 billion. This represented a return on funds of 3.60 per cent, compared with 4.97 per cent in 2008-09. Overall, term deposits in 2009-10 contributed $334 million less in interest compared to 2008-09, on a similar book volume. A similar effect occurred for investments in bank paper.
Holding relatively high short-term asset balances for precautionary reasons added to the net cost of the portfolio in 2009-10. The average yield earned on term deposits with the RBA and investments in bank paper during the year was 3.67 per cent, while the average yield on Treasury Bonds issued was 5.19 per cent and on Treasury Notes was 3.85 per cent. If the short-term asset balances had been $5.0 billion lower on average over the year, and the issuance of Treasury Bonds and average stock of Treasury Notes had been lower by $3.3 billion and $1.7 billion respectively, the net servicing cost would have been around $53 million lower, or about 6 basis points on the yield on the total portfolio.9
The term investments in the portfolio in 2009-10 comprised two distinct sets of investments in semi-government bonds: (i) the first set were held in the Debt Hedge Portfolio against additional Treasury Bond issuance undertaken to support market liquidity in 2008-09 and disposed of between June 2009 and July 2009; and (ii) the second set comprised shorter-dated semi-government bonds purchased and held in the cash management portfolio after the release of the improved fiscal outlook in November 2009 in order to pre-fund stock maturing in 2010-11.
- As noted in last year’s annual report, the assets held against the additional bond issuance in 2008-09 generated a positive return, including an overall capital gain on disposal. However, the subset of these assets that was sold in 2009-10 incurred a capital loss, as yields had risen since their purchase. The effect of this capital loss was to reduce the effective average return on term investment holdings overall to 2.80 per cent for the financial year.
- On the other hand, the shorter-dated semi-government bonds generated an average accrual return of 4.90 per cent in 2009-10, which was higher than the return available on bank paper and term deposits with the Reserve Bank.
Movements in market interest rates had an unfavourable impact on the market value of the portfolio in 2009-10, with unrealised losses from re-measurements amounting to $2.77 billion. They comprised unrealised losses of $2.30 billion on nominal debt, $518 million on indexed debt, $13 million on Treasury Notes and $44 million on interest rate swaps, offset by unrealised gains of $36 million on term investments and $64 million on RMBS investments. The re-measurement loss was driven by a year on year fall in the level of market interest rates, which pushed both liability and asset valuations higher. The effect was more pronounced on the liabilities due to their greater volume and longer average durations (which determine the sensitivity of market value to movements in interest rates).
In summary, a significant increase in the volume of debt generated a larger net interest cost. However, in percentage terms the yield on the portfolio benefited from the relatively low level of interest rates experienced in 2009-10, and would have fallen but for the one-off impact of the ending of swaps. If the savings from interest rate swaps are excluded in both years, the yield on the net portfolio fell from a cost of 6.17 per cent in 2008-09 to 5.40 per cent in 2009-10. Lower interest rates also had the effect of increasing the market value of net liabilities, leading to an unrealised loss in market value.
Interest rate swaps
At 30 June 2009, the Long-Term Debt Portfolio included 21 interest rate swaps with a notional face value of $2.425 billion. All of these swaps were allowed to mature, with the final swap maturing on 18 May 2010. No new swaps were entered into. The AOFM now has no interest rate swaps and therefore has no credit risk exposure to swap counterparties.
As at 18 May 2010, the AOFM swap program had generated $2.961 billion in cumulative realised direct savings for the Commonwealth since 1992 (when interest rate swaps were first executed). Of this amount, $63.6 million was generated post 30 June 2009.
These direct savings generated additional indirect savings from interest earned on the resulting higher asset balances and interest that did not need to be paid on lower liability balances.10 As at 30 June 2010, the swap program had generated cumulative indirect savings amounting to $1.204 billion and a total cumulative benefit (that is direct and indirect savings) of $4.165 billion for the Commonwealth.
Chart 10 shows the total savings provided by swaps over the period since 1992-93. The chart shows the cumulative realised direct saving from swaps, cumulative realised savings (i.e. direct and indirect savings) and cumulative realised savings and revaluations (that is market value, direct and indirect savings). It also shows the yearly components of these aggregates.
Residential mortgage-backed securities
The Australian residential mortgage-backed securities (RMBS) market provides an important source of funding for smaller mortgage lenders to compete with the major banks in lending for housing. The global financial crisis in 2007-08 reduced the liquidity of the Australian RMBS market, which in turn limited mortgage lenders’ access to RMBS funding. In particular, margins on mortgage-backed bonds widened to a point that rendered securitisation uncompetitive as a source of finance for lenders. This deterioration occurred despite the high quality of Australian RMBS and the fact that there has never been a credit-related loss on a rated prime RMBS in Australia. While conditions and investor sentiment improved in the Australian RMBS market through 2008-09 and 2009-10, the market continued to be affected by the fallout from the crisis and constrained lenders’ ability to offer competitive mortgage products.
In view of these developments, the Government decided to invest in Australian RMBS to support competition in lending for housing during the current market dislocation. In October 2008, the Treasurer directed the AOFM to invest up to a total of $8 billion in eligible RMBS, of which up to $4 billion was to be invested in deals with sponsors that were not ADIs. In November 2009 the Treasurer extended the program by directing the AOFM to invest up to a further $8 billion in RMBS, together with $0.246 billion remaining from the initial program.
Under the Treasurer’s Direction of November 2009, the aim of the RMBS Investment Program is to support competition in residential mortgage lending from a diverse range of lenders, with an additional objective of providing support for lending to small business. The latter objective is achieved through participating lenders using some of the proceeds of supported RMBS issues for lending to small business.
Achieving the objective
Developments in the Program
The allocation of the initial $8 billion was spread over three selection rounds. In each round the AOFM invited proposals from arrangers for it to participate as a cornerstone investor in primary RMBS transactions. Table 3 summarises investments under the three rounds. The third round was limited to non-ADI issuers to complete the $8 billion allocation provided for them by the Treasurer’s direction.
|Selection round||Issue date||Completion date||No. of transactions||Funds invested ($m)|
|First round||13 October 2008||10 December 2008||4||1,996|
|Second round||18 December 2008||28 August 2009||13||5,386|
|Third round||31 August 2009||10 November 2009||3||372|
Following the extension of the program in December 2009 the AOFM adjusted its approach to provide for the submission of investment proposals on a reverse enquiry basis and for serial investment, or ‘pipeline’, arrangements. The minimum requirements for proposals were altered to allow investments in transactions backed by a higher proportion of low documentation loans, subject to additional requirements designed to mitigate risks where low documentation loans exceed 10 per cent of the pool. This was done so as to support competition in mortgage lending through clearing warehouse facilities. The other minimum requirements11 were not changed. These changes took account of changing market conditions and feedback from consultations with the industry.
The reverse enquiry approach was adopted to provide arrangers and issuers with more flexibility in the development of proposals and the timing of issues. Under this approach, proposals for individual deals could be submitted to the AOFM at any time rather than through a tender process. Reverse enquiry proposals are assessed against the two objectives of supporting competition in lending for housing and supporting lending to small business. This approach was expected to be most relevant to regional banks and mutuals, many of which undertake significant lending to small business. Applicants using the reverse enquiry channel are requested to indicate the extent of their support for small business lending. During 2009-10, a total of $1.01 billion was invested in six reverse enquiry transactions, each from different issuers.
The pipeline arrangement allows an issuer to undertake a series of separate RMBS issues that the AOFM will support. This approach was designed to provide lenders who are largely or wholly reliant on securitisation markets with greater funding certainty and so a greater capacity to compete in mortgage lending. A request for proposals for pipeline funding was issued on 8 December 2009 and five were accepted (from AMP Bank, FirstMac, Liberty Financial, Members Equity Bank and RESIMAC). The five arrangements provide for investment by the AOFM of up to a total of $3.4 billion. The AOFM needs to be satisfied on the proposed terms and pricing for each transaction. The arrangements are available until 15 December 2010 unless terminated earlier. By 30 June 2010, a total of $260 million had been invested in two transactions under pipeline funding arrangements.
The pricing of AOFM’s investments in RMBS issues is determined in consultation with issuers after mandates have been awarded. In this, the AOFM aims to balance the objective of maintaining a competitive flow of funds for new lending to housing and small business with the objective of attracting other investors. Where the AOFM and other investors purchase the same RMBS tranche, they do so at the same price.
In May 2010 the AOFM adjusted its approach to investing with the aim of making RMBS a more competitive source of funding. At this time, the pricing of primary and secondary RMBS had stabilised at around 130 basis points above the one month bank bill rate for senior AAA-rated securities. The AOFM indicated it was prepared to invest at tighter levels but this was balanced with the desire to encourage continued private sector participation in AOFM supported issues. Additionally, the change in approach was designed to facilitate the creation of new structures whereby existing or potential demand from private sector investors for RMBS of a particular duration could be satisfied more effectively. One example of such a structure is the APOLLO 2010-1 transaction, where the AOFM invested in a long duration tranche so as to sponsor a shorter duration tranche in the transaction. This shorter duration tranche attracted strong demand from private sector investors and priced at the relatively tight margin of 100 basis points over the one month bank bill rate.
RMBS market conditions
Investor sentiment towards RMBS improved over the course of 2009-10 and brought an overall increase in the level of private sector participation in primary issuance.
Chart 11 shows the participation of other investors in RMBS issues supported by the AOFM since the inception of the program. Participation was around 20—30 per cent12 until about July 2009; thereafter it trended upwards to around 70 per cent in the first half of 2010. In addition, five RMBS issues were undertaken in late 2009 without reliance on AOFM support.
The market continued to strengthen in the first quarter of 2010, when there was solid demand from other investors for six issues undertaken with AOFM support and one without. As a result of this investor demand, five of the transactions supported by the AOFM were increased in size; in two cases, the AOFM’s contribution was able to be reduced significantly.
However, there was a sharp contraction in deal flow in the second quarter of 2010 due mainly to an easing in funding pressures for lenders and renewed weakness in global credit markets. The AOFM supported two RMBS transactions during the quarter. This included one backed by a pool of around 70 per cent low documentation mortgages; the AOFM was satisfied that the mortgage pool and the securities for this issue were of high credit quality. The other transaction supported by the AOFM had an innovative structure in which the AOFM supported a tranche with a longer weighted average life than for the issues it had previously supported. This was in accordance with its revised approach to pricing RMBS (as outlined above).
By 30 June 2010, the AOFM had invested in 28 RMBS transactions, totalling $9.023 billion, sponsored by 14 issuers. Including investments from other parties, the total volume of RMBS issued with the support of the program since its inception was $17.188 billion.
The Australian RMBS market has significantly reduced in size since the beginning of the global financial crisis. Standard & Poor’s data indicates that the stock of outstanding RMBS peaked at just under $170 billion in mid 2007, but fell to around $90 billion (excluding self-securitised transactions undertaken by ADIs) by June 2010. The AOFM program was crucial for the continued functioning of the primary market at this time.
The funds raised by the RMBS issues supported by the AOFM provided an important component of total lending for housing and small business over this period. Without them, new lending by financial institutions other than the major banks would have been lower, and their ability to provide competition to the major banks, now and in the future, would have been curtailed. The broad based improvement in market conditions in RMBS markets over the past year, the substantial increase in participation by other investors and the maintenance of origination capacity of smaller financial institutions and mortgage originators reliant on securitisation suggest that the program has made a significant positive contribution towards maintaining competition in the domestic mortgage market.
The investments made under the program are also providing reasonable financial returns. Interest income in 2009-10 was $374 million, which represented an annualised return of 5.2 per cent. All the securities purchased under the program have been floating-rate notes, paying as at 30 June 2010 a weighted average margin of 131 basis points over the one month bank bill rate. In addition, capital repayments of $1.03 billion have been received.13
The RMBS securities that the AOFM holds are valued in its accounts using indicative margins for secondary market trading as estimated by an independent valuation service provider. As secondary market margins have typically been higher than the margins set on issuance, the estimated market value of these securities has been less than their accrual book value. At the end of 2008-09 the RMBS portfolio showed an unrealised mark-to-market loss of $136 million; by the end of June 2010 this had fallen to a loss of $72 million, due to a narrowing in indicative secondary market margins over the course of the financial year.
Further information on the AOFM’s investments in RMBS up to 30 June 2010 are given in Part 5 of this annual report.
The AOFM has increased its investor relations activities to promote Australian Government Securities to support the increased issuance task. Additional funding for four years was provided for this purpose in the 2009-10 Budget.
Achieving the objective
An Investor Relations Unit was established in July 2009 to expand the AOFM’s marketing and promotional activities. It aimed to engage with investors and financial intermediaries, including large overseas institutional investors that provide good prospects for rapid increases in investment.
Meetings held by the AOFM officials with investors during the year are summarised in Table 4. Over 100 bilateral meetings were held with overseas investors. In most cases, they were arranged with the assistance of financial intermediaries operating in the Australian market. The AOFM is grateful for their support. In addition, presentations were made to conferences with audiences totalling around 650 investors. The presentations were particularly useful in encouraging interest from a wide range of potential investors, many of whom may have had limited prior contact with and knowledge of Commonwealth Government Securities. The unit also assisted with meetings by the Treasurer in London and New York and one by the Assistant Treasurer in the Middle East.
Informational material was prepared and provided to specialised journals serving institutional investors. This included Finance Asia‘s annual Australian Supplement where the AOFM contributed an article on Australian Government debt. The magazine has a readership of over 20,000 predominantly located in Asia.
|October 2009||CBA Fixed Income Conference (Sydney): presentation|
|December 2009||Sydney investor meetings: 4|
|February 2010||Asset Allocation Conference (Sydney): roundtable discussion facilitated by CEO|
|Industry conferences/events in which AOFM presented||10 events|
|Total audience reach (approximately)||650 investors|
|Individual investor meetings conducted||107 meetings|
|Cities visited||Europe (11), North America (4), North Asia (6), South East Asia (3) and Australia (2)|
|AOFM staff in attendance||CEO, Head of Investor Relations, Director of Financial Risk, Head of Treasury Services|
|Banks used for investor meetings||ANZ, Citibank, Deutsche, HSBC, Nomura, RBC, RBS, Societe Generale, UBS, Westpac|
|Supporting the Minister||Treasurer 2 presentations (London, New York),Assistant Treasurer 2 bilaterals (Middle East)|
Public Register of Government Borrowing
The Guarantee of State and Territory Borrowing Appropriation Act 2009 requires the AOFM to maintain and publish a quarterly register that records the beneficial ownership by country of all securities on issue by the Commonwealth and any Commonwealth guaranteed issuance by the States or Territories. The register was published on the AOFM’s website on 24 May 2010. It shows monthly data commencing from December 2009 and will be updated quarterly.
The Act does not make any provision to require beneficial owners of securities or persons holding securities on their behalf to provide data on these holdings to the AOFM. The AOFM has therefore sought information on a voluntary basis. The New South Wales and Queensland Treasury Corporations, and the Australian Securities Exchange, have cooperated with the AOFM in the compilation of the register, subject to restrictions on the publication of data that would allow the identification of individual holdings. We are grateful for their assistance.
However the Australian Custodial Services Association advised the AOFM that, because of their fiduciary and contractual obligations to their clients, its members could not provide client information to the AOFM unless there was a clear legal or regulatory compulsion to do so. Accordingly the AOFM has not been able to obtain information from Australian nominee and custodial firms. These firms held around 62.3 per cent of CGS and Commonwealth guaranteed State securities as at 30 June 2010. The absence of this information limits the usefulness of the register.14
Information technology operations
The AOFM’s operations are highly dependent on its treasury system, which is used to support debt and financial asset deal capture, portfolio management and reporting, settlements, accounting and compliance activities. The current system, Avantgard Quantum/QRisk, was installed in 2002 with a five year licence, subsequently extended until April 2012. During the year the AOFM reviewed the options for a new contract.
A consultant was appointed to assist in identifying possible systems through an informal market scan. This confirmed that there are several systems that could potentially meet the AOFM’s business needs, including some that could provide enhanced functionality, particularly in cost forecasting, limits management and portfolio reporting. The estimated capital and recurrent costs of ownership of most of these systems were concluded to be within the AOFM’s budgetary constraints. However, significant further due diligence would be necessary to reach a definitive assessment on the merits of each system.
In the light of these conclusions, the AOFM decided to conduct an open market testing procurement process and in June 2010 it sought expressions of interest via AusTender (the Government’s online tendering system). It also wrote to 29 treasury system vendors, both domestically and overseas, informing them of the process. Over 10 responses were received and are currently being evaluated. It is expected that a short-list will be finalised by the end of September 2010. The vendors on the short-list will then be invited to participate in further selection processes, including a select tender, system demonstrations and proof-of-concept testing. These selection processes are expected to be completed in the first half of the 2011 calendar year. The implementation of a replacement system, if that were the outcome, would be a large task that could take up to three years. The AOFM has therefore negotiated an extension of its licence for the existing system to April 2014.
The AOFM has an established technology platform that includes integrated services for the delivery of treasury management and market data. During the year server hardware was upgraded and virtualisation was implemented. The virtualised environment has improved the efficiency and availability of IT resources and is contributing towards the objectives of the Australian Government ICT Sustainability Plan.
Over the past few years the AOFM has worked to improve its recordkeeping framework. This has included the development of recordkeeping policies and procedures, creation of a recordkeeping taxonomy, establishment of disposal authorities under the Archives Act 1983, staff training and the introduction of electronic recordkeeping.
Until recently the AOFM’s recordkeeping was entirely paper-based. This required documents that originated electronically to be printed to paper. An increasing percentage of business documents are now being handled and stored electronically. This has improved efficiency, facilitated the collection of records and ensured that they are more readily accessible. Record handling practices are being monitored to maintain these gains and identify further improvements.
Operational risk is the risk of loss due to operational failures resulting from internal processes, people, systems, or from external events. It encompasses risks such as fraud risk, settlement risk, accounting risk, personnel risk and reputation risk.
The AOFM aims to manage its exposure to operational risk to acceptable levels. It maintains a culture of prudence and high ethical standards, which are reinforced by adherence to the Australian Public Service Code of Conduct and the Australian Financial Markets Association (AFMA) Code of Conduct. The Compliance Unit monitors compliance with detailed controls and procedures, while the Operational Risk and Compliance Committee and the Audit Committee provide oversight.
Operational risk activities undertaken in 2009-10 included:
- internal audits of controls over settlements and the management of investments, and the methodology and documentation for fraud controls;
- completion of the Certificate of Compliance on the AOFM’s compliance with the financial management framework under the Financial Management and Accountability Act 1997. No instances of non-compliance were identified in 2009-10; and
- a review of the AOFM’s Chief Executive Instructions and internal financial delegations issued under the Financial Management and Accountability Act 1997.
The AOFM is a low transaction volume, high transaction value environment arising from its management of its portfolio of debt and financial assets. In 2009-10, it settled around $51.3 billion of payments of interest, principal and redemptions on Commonwealth Government Securities and around $360.9 billion in financial asset acquisitions, including term deposits with the Reserve Bank of Australia, money market securities and fixed interest securities. The AOFM also ensures that administered receipts are settled promptly and correctly by its transaction counterparties.
In 2009-10, the AOFM was not late in settling any payment obligations. There were no instances where compensation was sought from a counterparty because it failed to settle a payment obligation in line with its contractual obligations.
Cooperation with other debt managers
The AOFM supports the debt management activities of the Papua New Guinea and the Solomon Islands governments under the Strongim Gavman Program and the Regional Assistance Mission to the Solomon Islands. It seconds a staff member to each of these countries to help develop cash and debt management capabilities. Officials of the debt management agencies of the three countries, including the seconded AOFM staff, met in Port Moresby in November 2009 to discuss their experience with debt management over the year and the development of management capabilities.
During the year the AOFM also hosted visits by officials from Indonesia, Papua New Guinea, the Solomon Islands, Sri Lanka and Vietnam.
Agency financial performance
The AOFM recorded an operating deficit on agency activities of $1.55 million for 2009-10 financial year, comprising total revenue of $13.78 million and expenses of $15.33 million. The deficit in 2009-10 was due to the fees associated with the syndicated issuance of Treasury Indexed Bonds being met from the agency’s operating funds. The AOFM obtained approval to budget for an operating loss of up to $5 million from the Finance Minister on 25 September 2009. On previous occasions when bonds have been issued by syndication, the fees have been met under standing appropriations in the relevant annual Loans Acts. However, when the Commonwealth Inscribed Stock Act 1911 was amended in 2008 to provide ongoing borrowing authority, no provision was made for borrowing costs.
As at 30 June 2010, the AOFM was in a sound net worth and liquidity position, reporting net assets of $12.65 million, represented by assets of $14.70 million and liabilities of $2.05 million.
As at 30 June 2010, the AOFM had cash and unspent appropriations totalling $13.51 million. These funds are held to settle liabilities as and when they fall due and for future asset replacements and improvements.
During 2009-10, the AOFM returned $2.18 million to the Budget representing unspent depreciation funding. With the introduction of the ‘net cash appropriation framework’ from 1 July 2010 agencies were required to return unused depreciation funding as at 30 June 2010 that had accumulated since the introduction of accrual budgeting in 1999-2000.
- Bonds include Treasury Bonds and Treasury Indexed Bonds, with forecast amounts consistent with the 2010 Pre-Election Economic and Fiscal Outlook. ↩
- Total turnover includes repurchase transactions with data sourced from Austraclear. ↩
- Treasury Bond and Treasury Indexed Bond turnover data sourced from the 2010 Australian Financial Markets Report published by the Australian Financial Markets Association. ↩
- This occurred on 27 January 2010 and may have been affected by the preceding public holiday. ↩
- The Official Public Account (OPA) is the collective term for the Core Bank Accounts maintained at the RBA for Australian Government cash balance management. ↩
- The overdraft facility is more costly than equivalent short-term borrowing (for example, issuance of Treasury Notes). The terms of the facility provide that it is to cover only temporary shortfalls of cash and is to be used infrequently and, in general, only to cover unexpected events. ↩
- Debt servicing cost includes net interest expenses (measured on an accruals basis) plus foreign exchange revaluation gains and losses (now minimal). Unrealised changes in the market valuation of domestic debt and derivatives are not part of this measure. ↩
- The total increase in debt servicing cost between 2008-09 and 2009-10 shown in Chart 9 ($3,562 million) is $2 million less than what is shown in Table 2 ($3,564 million). Unlike Table 2, Chart 9 does not show the change in debt servicing cost attributed to foreign currency debt and State Housing advances. Foreign currency debt reduced debt servicing cost between the two years by $2 million as a result of foreign currency gains and State Housing advances added $4 million due to volume impacts. ↩
- The estimated net cost depends on the assumptions made about the distribution of lower borrowing between the two debt instruments. If it is assumed that the lower borrowings were shared equally, the estimated net cost is $43 million, while if the lower borrowings were entirely through a lower stock of Treasury Notes, the estimated net cost is $9 million. Because of the policy of maintaining a minimum of $10 billion of Treasury Notes on issue at all times in order to maintain an active market in them, the assumption used in the text is perhaps the most realistic. ↩
- Over most of the period when interest rate swaps were held, the Government held substantial short-term assets and issued debt solely to maintain the Treasury Bond market. The direct savings from the swaps therefore largely resulted in higher asset balances rather than lower debt issuance. As a result, the indirect savings came largely from the additional interest earned on these higher asset balances. ↩
- Detailed on pages 32 to 33 of the 2008-09 Annual Report. ↩
- With a 20 per cent participation rate, other investors contribute 25 cents for every dollar invested by the AOFM. ↩
- Additionally, the AOFM sold RMBS investments with a face value of $73.79 million in March 2010 for portfolio management purposes. It announced the details of this sale shortly after its completion. ↩
- The Australian Bureau of Statistics publishes quarterly data on non-resident portfolio investment in debt securities issued by the Australian Government and State and Territory governments. This does not include information on holdings by country of residence. The Bureau has power under the Census and Statistics Act 1905 to require the provision of information. ↩
Last updated: 5 February 2014