Review by the Chief Executive Officer
The beginning of 2010-11 brought with it a reassessment globally on how different markets and economies weathered the consequences of the financial crisis and its associated recessionary impacts. Governments in a number of countries have spent a considerable amount of political and financial capital addressing these impacts. However the speed and extent to which a number of underlying sovereign credit and liquidity issues re-emerged, particularly in Europe, created renewed volatility in financial markets.
Sovereign debt and credit issues in a number of major advanced economies, and speculation about the ability of some emerging economies to contain inflationary pressure while maintaining high rates of economic growth, have both had implications for Australia and its bond market. The scrutiny applied by investors to differentiating between the credit statuses of sovereigns, even within specific credit rating bands, has sharpened rather than reduced. This has increasingly brought Australia into a positive light for investors and asset managers.
At the same time, there has been greater attention to the links between Australia and the Asian region. Views on this continue to vary markedly, but a prevailing view seems to be that Australia’s rich resource endowments and skilled workforce leave it well-placed to benefit from the underlying growth trend emerging in Asia. Investors in Commonwealth Government Securities (CGS) have increasingly made strategic decisions to allocate a part of their portfolios to Australian bonds, reflecting a positive medium to long-term outlook for Australia and the Asian region more broadly.
Investors will increasingly assess Australia’s currency, economic and financial fundamentals to determine whether CGS remain an attractive option to them. Key considerations will undoubtedly include Australia’s exposure to volatility in the demand for and prices of its commodity exports (together with its close geographic proximity to the current centre of global growth) and the underlying potential for economic growth. They will also focus on the medium to long-term management of Australia’s fiscal position; the efficiency of its financial markets (including further measures to comply with the regulatory framework for international banking); the extent to which unemployment and monetary policy impact domestic demand; and Australia’s AAA sovereign credit status (and the yields on its bonds).
Gross Treasury Bond issuance for the year in total was approximately $55 billion. This program was readily absorbed by the market reflecting investor confidence in Australia’s underlying economic, fiscal and credit risk fundamentals. It also reflects positively on the AOFM and its approach in terms of transparency, attention to market feedback, engagement with investors and sound issuance processes.
During the year the AOFM issued into areas of strongest demand to ensure the Government’s financing task could be most efficiently met, and continued a strategy of supporting liquidity in the market for CGS as required. A strong currency, higher stock of bonds outstanding and changes in international markets (including the changing perceptions and requirements of investors), has resulted in the CGS market assuming a new status in a global context. These factors have all helped to contribute to supporting demand for the issuance task. However, the increased focus on CGS as an investment option has brought a range of portfolio management and issuance considerations for the AOFM, highlighting the need for continued market vigilance and constant review of the strategies supporting management of the overall portfolio.
The opportunity was taken to launch four new Treasury Bond lines in 2010-11 and these targeted the short, medium and longer segments of the existing yield curve. The new lines were for maturity in October 2014; June 2016 and January 2018; and April 2023 (this latter line to maintain the length of the yield curve and support the operation of the 10-year Treasury Bond futures contract). All new Treasury Bond lines are now being issued with maturity dates that fall on either 21 January, 21 April, 21 July or 21 October. Therefore, future maturities will coincide with quarterly tax collections, which will assist in refinancing the Bonds when they fall due.
Treasury Indexed Bond issuance for 2010-11 totalled $3.25 billion, including a syndicated offer for the new Treasury Indexed Bond maturing in September 2030. Investor feedback has been very positive regarding the Government’s commitment in the 2011-12 Budget to ongoing support for this segment of the market. Feedback from intermediaries and investors will continue to shape our considerations on the future structure of this part of the portfolio.
Turnover for both Treasury Bonds and Treasury Indexed Bonds in the secondary market continues to grow broadly in line with increasing volumes on issue. A number of factors have contributed, amongst them are: continued improvement in investor perceptions about Australia (and the CGS market); an increasing strategic investment focus on CGS by central banks and sovereign wealth fund managers; and a strong competitive presence by a large number of price-makers.
Portfolio management and outcomes
The Government‘s budget financing requirement in 2010-11 was fully met and this was achieved using a similar mix of debt instruments to that in 2009-10.
About $5 billion of pre-funding undertaken in 2009-10 and the subsequent investment of it in short-dated semi-government bonds with maturity dates on or before the maturity of the June 2011 Treasury Bond, was a successful measure in smoothing the issuance task across 2009-10 and 2010-11. Arrangements were also established to repo semi-government bonds, adding to the AOFM’s cash management flexibility.
As in previous years, the Government’s cash flows were highly variable over the course of the year. Over the last few years there have been changes to the pattern and timing of Government cash needs. These changes have emerged for a number of reasons, such as the requirement to meet intergovernmental commitments developed over recent years. The AOFM reviewed these changes during the year to ensure that the annual issuance programs for 2011-12 and coming years take all relevant influences into account.
The average cost of funds for 2010-11 was 5.22 per cent. The average return on gross assets in 2010-11 was 5.38 per cent. Taken together, the net servicing cost of the combined portfolio of debt and assets for 2010-11 was $7.90 billion, which represented a 17 basis points reduction in effective yield, to 5.19 per cent. This represents the average outcome for the year, although yields on CGS fell most throughout the second half of the year. Key influences on yield curve movements during this period include anchoring of short-term interest rate expectations around the RBA cash rate of 4.75 per cent, and a ‘flight to quality safe investments’ like CGS as a result of the increasingly heightened uncertainty in global financial markets.
Residential mortgage-backed securities
In December 2010, the Treasurer announced a further extension of the residential mortgage-backed securities (RMBS) program as part of the Government’s Competitive and Sustainable Banking System package. In April 2011, the AOFM was directed to invest up to an additional $4 billion; this taking the cumulative total of the AOFM’s investment mandate from $16 billion to $20 billion. Furthermore, at the time of the December announcement, the Government identified the need to encourage a transition towards a market that is not reliant on on-going Government support. Implementation of the RMBS program has successfully contributed to the preservation of securitisation as an important channel of financing.
The AOFM’s pricing of RMBS investments has continued to balance the objective of maintaining a competitive flow of funds for new lending with the objective of attracting other investors. The presence of other investors alongside the AOFM is one of several indicators that conditions in the Australian securitisation market are improving. In several recent deals the AOFM has been scaled back due to demand from other investors; in one deal it was scaled out of the need for participating.
While 2010-11 concluded with RMBS market conditions having continued to improve, the Australian market still faces some challenges consistent with events in global credit markets generally. That said, over the course of 2010-11 private sector participation in primary issuance improved, with there being a number of other transactions without the need for support from the AOFM.
Several innovative structures have enabled issuers to tap new sources of domestic and overseas demand. The AOFM supported a number of these structures through purchasing tranches with a greater degree of sensitivity to mortgage prepayment rates. This has facilitated the creation of bullet securities and scheduled amortisation tranches.
What lies ahead for the AOFM in terms of the international context in which it must operate is unlikely to be a return to the past – at least for the foreseeable future. It will continue to face the challenges of issuing into a volatile global financial market. In terms of its tasks domestically, the year ahead requires an issuance program similar in magnitude to 2010-11, with the 2011-12 Australian Government Budget indicating a return to surplus in the following year and thereafter. While the impacts of the global financial crisis shifted the focus of the AOFM from supporting liquidity in the CGS market to the need for building issuance quickly and effectively to match the changing underlying Budget position, the forthcoming years will not require a continuation of this latter focus. However, the need to further diversify the CGS investor base will grow rather than abate as the CGS market has grown not only in size but stature, attracting investor attention previously not experienced. Diversity in the investor base will aim to facilitate liquidity in CGS.
Careful thought will need to be given to a range of issues that will set the direction for the future shape of the portfolio. The Government’s support for an extension of the yield curve (with the AOFM having announced its plan to extend the curve out to 15 years in AOFM Operational Notice No. 3/2011 on the agency’s website) and its announcement to maintain a mix of Treasury Indexed Bonds and nominal bonds as part of the overall portfolio will be important for the AOFM to implement. Therefore, seeking a balance between the minimisation of debt servicing costs and the pursuit of broader policy objectives, while at the same time keeping a ‘weather eye’ to changes in market conditions that could ultimately impact the demand for CGS, will remain core to the AOFM’s challenges.
Former CEO retires
Mr Neil Hyden retired as Chief Executive Officer of the AOFM in November 2010. He had spent seven years in the position and during that time implemented a range of procedures and arrangements to support the efficiency and accountability of the organisation. It was Neil Hyden who guided the organisation through the challenges arising from the onset of the global financial crisis, a period during which quick responses and sound judgement were required to successfully navigate rapidly evolving events. His considerable efforts in this regard have been widely appreciated and we wish him the best of health and good fortune in his retirement.
Chief Executive Officer
Last updated: 2 July 2013