Review by the Chief Executive Officer
Global financial markets remained volatile in 2009-10 in the wake of the global financial crisis and the volume of sovereign debt on issue by overseas governments soared to fund growing budget deficits. Sovereign gross debt to GDP ratios exceeded 65 per cent in Canada, France, Germany, the United Kingdom and the United States, 110 per cent in Greece and Italy and 180 per cent in Japan. Investors became more wary in distinguishing between the credits of different sovereign issuers, including between issuers that shared the same rating from credit rating agencies.1 In some countries bond issuance was helped by monetary policies that allowed large scale purchases of bonds by central banks, but this support weakened when the policies began to be wound down.
Some emerging countries experienced more favourable conditions than many developed countries, with relatively vigorous economic growth driven by resource industries (Brazil, Chile, Russia) or domestic demand (China, India). Nevertheless, few if any countries were untouched by the global financial crisis and its consequences.
The Australian economy rebounded during the year, sustained by policy stimulus and demand for minerals and energy from our Asian trading partners. Most, but not all, domestic financial markets recovered their dynamism, and the access of Australian borrowers to overseas credit was maintained by Commonwealth guarantees for borrowing by financial institutions and State governments.
For the AOFM, the year held many challenges. The Budget funding task grew substantially due to the impact of the crisis. The underlying cash deficit increased to $54.8 billion from $27.1 billion the previous year. Gross bond issuance in 2009-10 amounted to $58.4 billion, compared to $34.1 billion in 2008-09 and $5.1 billion in 2007-08. The funding task was accomplished relatively smoothly, supported by active liaison with investors including the provision of information to overseas investors. During the year, the AOFM conducted 81 tenders for Treasury Bonds, resumed the issuance of Treasury Indexed Bonds and held 68 tenders for Treasury Notes.
- 1 Bond issuance
- 2 Maintaining a liquid sovereign bond market
- 3 Management of the portfolio
- 4 Portfolio outcomes
- 5 Residential mortgage-backed securities
- 6 Office operations
- 7 Cooperation with other debt managers
- 8 Retirement
Treasury Bond issuance occurred steadily over the course of the year and was spread across existing bond lines with the aim of enhancing their liquidity. Three new lines were launched, including two with short maturities to help manage refinancing risk.
The resumption of issuance of Treasury Indexed Bonds was launched in September 2009 with the syndicated issue of a new bond line maturing in 2025. There was excellent demand for the new bond and the size of the issue – $4 billion – immediately established it as a liquid line and helped to re-invigorate the Australian market for inflation-indexed securities. Following the syndicated issue, monthly tenders were conducted for further issuance of indexed bonds across the existing bond lines. This helped to maintain activity in the market and foster on-going investor interest.
Secondary market turnover increased for both Treasury Bonds and Treasury Indexed Bonds, broadly in line with the increased volumes on issue. The vitality and competitiveness of these markets has improved markedly, helped by an increase in the number of price-makers.
Maintaining a liquid sovereign bond market
Successive governments have committed to maintaining a liquid and efficient market in Australian Government Securities.2
The experience of the past two years during the global financial crisis has demonstrated the benefits of this approach. Government bonds are one of the foundations of the Australian financial system, as they are risk-free assets that provide both liquidity and reference points for pricing. A well-functioning government bond market strengthens the resilience of the system to shocks, and it enables governments to fund changes in their Budget position quickly and efficiently, whether due to changes in the economy or to implement fiscal objectives.
Management of the portfolio
The funding position in the early part of the year was relatively strong due to a better than projected Budget outcome for 2008-09, an unanticipated receipt of Special Drawing Rights from the International Monetary Fund and additional issuance of Treasury Notes in June 2009 as a precaution against increased uncertainty about bond issuance in June and July 2009. The volume of Treasury Notes on issue was gradually reduced from August 2009.
The planned bond issuance program was reviewed following the release of the Government’s Mid-Year Economic and Fiscal Outlook statement in November 2009. It was decided to maintain the planned program in 2009-10 in order to reduce the issuance that would be required in 2010-11 when heavy redemptions are due. The proceeds from this pre-funding were invested in short-dated State government bonds.
As in previous years, the Government’s cash flows were highly variable over the course of the year, with the swing between peak and trough in the within-year funding requirement being $28.7 billion. The AOFM’s task in managing the daily cash balances is a demanding one, using both short-term assets and borrowing instruments. During the year, it issued a total of $31.9 billion in Treasury Notes, placed 457 term deposits with the Reserve Bank of Australia and made 89 investments in bank accepted bills and certificates of deposit issued by highly-rated Authorised Deposit-taking Institutions. In future it also plans to use repurchase transactions as an additional cash management instrument; work on agreements with counterparties for this commenced during the year.
Like other financial institutions, the AOFM manages its portfolio of debt and financial assets to maintain a balance between risk and return. In the AOFM’s case, the debt exceeds the financial assets, so the net return represents a cost to the Budget. Balancing risk and return includes managing the composition of the portfolio between different instruments and different maturities. The volume and tenor of assets held as term deposits and bank paper are largely determined by the Government’s daily and weekly cash flows, but the volume and maturity structure of the debt on issue are managed through issuance decisions, including the selection of bond lines and the size of tenders.
Since the onset of the global financial crisis and the resultant increase in bond issuance, the AOFM has issued across the yield curve, sensitive to fluctuations in the demand for bonds of different maturities and the need to limit refinancing risk.
The AOFM no longer targets duration, nor does it use interest rate swaps to manage its portfolio; all remaining swaps were allowed to mature during the year. The program was terminated in 2008 when yield curves had been flat for several years and the AOFM concluded that it no longer provided a firm basis for achieving future savings. During the life of the program, interest rate swaps generated total direct and indirect savings of $4.165 billion for the Commonwealth over a 17 year period.
The debt servicing cost of the gross debt managed by the AOFM in 2009-10 was $6.3 billion. This represented a cost of funds of 5.05 per cent, compared with 4.39 per cent the previous year. The increase in yield is more than fully accounted for by reduced savings from interest rate swaps: in 2008-09 these swaps contributed $969 million in interest revenue, mainly from the proceeds from the termination of swaps, whereas in 2009-10 there were no terminations and swaps contributed only $41 million in interest revenue. The yield on gross debt before swaps fell from 5.82 per cent to 5.08 per cent between the two years.
The interest revenue on assets in the portfolio was $1.3 billion, which represented a yield of 4.16 per cent compared with 5.36 per cent the previous year. The fall was due mainly to lower short-term market interest rates on average over the course of the two years.
As a result, the net cost of funds on the combined portfolio was 5.36 per cent in 2009-10, compared with 3.64 per cent the previous year. This apparent deterioration is more than fully attributable to the one-off effects of the termination of interest rate swaps and the realisation of accumulated savings that they released. 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 by $2.77 billion.3
Residential mortgage-backed securities
The 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. In October 2008 the Government decided to invest in Australian RMBS as a temporary measure to support competition in lending for housing while the market was disrupted by the impact of the global financial crisis. To this end, the Treasurer has directed the AOFM to invest up to $16 billion in eligible RMBS. Since November 2009, the program has had the additional objective of providing support for lending to small business, which is to be achieved through participating lenders using some of the proceeds of the AOFM’s investment for lending to small business.
Building on the experience it has gained from the operation of the program, in December 2009 the AOFM introduced new procedures to provide greater flexibility. This allowed for proposals to be submitted to it either on a reverse enquiry basis (without the need to go through a tender procedure) or under pipeline arrangements (which provide greater funding certainty for issuers by allowing them to submit proposals for a series of separate RMBS issues). By the end of the financial year, the AOFM had invested $1.0 billion in six reverse enquiry transactions and approved pipeline arrangements for the investment of up to a total of $3.4 billion by December 2010.
The pricing of the AOFM’s investments in RMBS 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 to small business with the objective of attracting other investors. Where other investors participate in a transaction, the AOFM participates at the same price. In May 2010 the AOFM adjusted its approach to pricing with the aim of making RMBS a more competitive source of funding. It indicated that it was prepared to invest at tighter levels than previously.
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. However, there was a sharp contraction in deal flow in the second quarter of 2010 due to weakness in global credit markets and reduced offshore interest in Australian RMBS. The contraction was exacerbated by a slowing of housing loan originations and prepayments.
By 30 June 2010, the AOFM had completed 28 investments in RMBS, totalling $9.0 billion, sponsored by 14 issuers. Together with investments by other parties, the total volume of RMBS issued with the support of the program since its inception was $17.2 billion. This represents a significant component of total lending for housing and small business. Without it, new lending by lenders other than the major banks would have been lower and the ability of these lenders to compete with the major banks, now and in the future, would have been curtailed.
In the 2009-10 Budget the AOFM received additional funding of $19.2 million over four years to expand its investor relations and bond promotion activities and support its increased workload and transactional costs arising from greater debt issuance and debt levels.
An Investor Relations Unit was established in July 2009 with three staff. It has undertaken an active program, with over 100 bilateral meetings with investors and conference presentations to audiences totalling around 650 investors. Promotional material was provided to specialised journals serving institutional investors. This included the annual Australian Supplement published by Finance Asia, which has a readership of over 20,000.
The AOFM recorded an operating deficit on agency activities of $1.55 million in 2009-10. The deficit was due to fees and other costs associated with the syndicated issuance of Treasury Indexed Bonds being met from the agency’s operating funds. The use of syndication brought cost savings by allowing a new liquid bond line to be established quickly and competitively. These savings accrue as lower debt servicing costs under administered appropriations, not operating funds.
Treasury system upgrade
The AOFM partially upgraded its Quantum/QRisk treasury system during 2009-10. The upgrade provided no additional benefits to the AOFM but was necessary in order to ensure continued servicing by the vendor, Sunguard Asia Pacific Inc. A second phase of the upgrade will be undertaken in 2010-11.
The AOFM also commenced work during the year for the selection of a treasury system to operate when the current contract expires.
The AOFM negotiated an enterprise agreement with its staff in 2009-10, in accordance with the Fair Work Act 2009 and Government policy requirements. Previously, employment conditions for all AOFM staff had been set under Australian Workplace Agreements and common law agreements. The Agreement meets the Government’s requirement that improved remuneration and conditions for Australian government employees be underpinned by improved productivity and performance. The parties recognised that to meet this objective the AOFM needs to recruit and retain high quality professional staff and to motivate and reward individual performance. The pay rates agreed took account of market rates for conservative financial services organisations using survey data provided by the Financial Institutions Remuneration Group. This data covers a wide range of public and private sector financial institutions, including banks, corporate treasuries and State debt management agencies. Consideration was also given to comparisons with rates in central APS agencies, taking account of differences in classification standards and employment conditions.
Classification of senior positions
A review undertaken by Mercer Human Resource Consulting concluded that four Group Head positions in the agency currently with formal APS classifications of Executive Level 2 should properly be classified as Senior Executive Service Band 1. One position was advertised at this level in April 2010, at its existing pay scale, but action on filling the position was suspended when the Government imposed a cap on SES numbers pending a review of the size, capability and work level standards of the SES. Further action will depend on the outcome of the Government’s review. If the review results in greater constraints on the size and coverage of the SES, it would be desirable for it also to provide for appropriate status to be given to senior professional positions that are not included in the SES.
Cooperation with other debt managers
The AOFM supports the debt management activities of the Papua New Guinea and 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 them develop their cash and debt management capabilities, systems and procedures. Officials of the three debt management agencies met this year in Honiara to discuss progress and experiences.
During the year the AOFM also hosted visits by debt management officials from Indonesia, Papua New Guinea, the Solomon Islands, Sri Lanka and Vietnam. It participated in activities of the Working Party on Debt Management of the Organisation for Economic Development and cooperated with the central financing authorities of the Australian States and Territories.
This is my final annual report as Chief Executive Officer of the AOFM as I plan to retire in November 2010. I have had a varied career since I joined the Australian Public Service in January 1965, including work in the Office of the Public Service Board, the Prime Minister’s Department and the Treasury, as well as the AOFM. I also worked for four years as Executive Director on the board of the World Bank.
It has been a particular joy to work in the AOFM. It has a fine body of staff, with excellent skills and experience, who have provided great support in the challenges we have faced together over the past seven years. I thank them all for the roles they have played and the contributions they have made, and wish them well in their future careers.
I also thank Dr Ken Henry, the Secretary to the Treasury, the members of the AOFM Advisory Board and the AOFM Audit Committee, and other officials in Treasury, the Australian Government Solicitor’s Office, ANAO and other government departments and agencies for the invaluable support they have provided. It has been greatly appreciated.
Chief Executive Officer
- Australia was ranked favourably in such comparisons among AAA rated sovereigns. ↩
- This commitment was reiterated in the 2010-11 Budget papers. ↩
- Re-measurement effects are not realised unless the debt or assets involved are bought or sold. Re-measurements on debt that is not redeemed ahead of maturity sum to zero over the life of the debt. ↩
Last updated: 2 July 2013