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 Residential mortgage-backed securities
- 6 Investor Relations
- 7 Public Register of Government Borrowing
- 8 Information technology operations
- 9 Operational risk
- 10 Settlement operations
- 11 Agency financial performance
- 12 Cooperation with other debt managers
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 2011-12 and reports on AOFM performance against these functions.
Treasury Bond and Treasury Indexed Bond issuance
One objective of Treasury Bond and Treasury Indexed Bond issuance is to raise monies to fund the Australian Government Budget.
Another objective is to support the efficient ongoing operation of Australia’s financial system. This second 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; and
- the existence of active and efficient physical and futures markets for sovereign debt strengthens the robustness of the financial system and reduces its vulnerability to shocks.
Achieving the objective
2011-12 was another year of volatility in global financial markets. Investor faith in sovereign issuers, especially in Europe, continued to wane as attempts by officials to solve the Eurozone’s fiscal, debt and banking industry problems failed to convince investors that the situation could be stabilised. Hopes that public and financial sector balance sheets might be strengthened in the near-term by large-scale coordinated action were not met, as proponents of austerity and of fiscal stimulation proved unable to form agreement. Events in Europe contributed to a general slowing in the pace of the global economic recovery from the global financial crisis.
Australia as a sovereign issuer is well-positioned to satisfy its debt issuance requirements relative to most countries; this is in no small part because of its sovereign credit status as AAA (by all three major credit rating agencies) with a stable outlook.
In 2011-12 the RBA reduced the target cash rate by 100 basis points, while ten year Treasury Bond yields declined by over 200 basis points to historically low levels. Commonwealth Government Securities (CGS) outperformed other Australian dollar denominated debt securities, with the difference in yields between CGS and other debt securities at the end of the year being almost as wide as at the height of market dislocation in 2008-09.
Regular liaison with market-makers and investors was crucial to the efficient manner in which the financing task was completed during 2011-12. Investors remain comfortable with Australia’s creditworthiness (in part because it is a member of a shrinking group of AAA-rated sovereigns) and have been encouraged by relatively high yields.
Offshore demand for CGS remains strong. Non-resident holdings of CGS were around 75 per cent of the total outstanding during 2011-12. The proportion of CGS held by offshore investors has steadily increased during recent years, as illustrated in Chart 1.
Gross Treasury Bond issuance for the year totalled about $58 billion. The bulk of issuance was into existing bond lines in order to enhance their liquidity and in turn the attractiveness of the CGS market. This was particularly important to international investors.
Four new Treasury Bond lines were launched in 2011-12 as follows:
- new short-dated bond lines maturing in October 2015 and July 2017 were launched to allow issuance to be spread across a larger number of lines and to help limit the growth of the largest lines;
- a new bond line with a maturity date of April 2024 was opened in order to support the operation of the 10-year Treasury Bond futures contracts; and
- following a decision to extend the length of the yield curve to around 15 years, a new April 2027 bond line was issued.
In selecting the bond lines to issue each week, the AOFM took account of prevailing market conditions; information from financial market contacts about 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. Two tenders were held most weeks, typically comprising a tender of a long-dated bond line and the tender of a short-dated bond line, with the amount being offered at each tender usually being $700 million.
Lengthening the yield curve in a manner consistent with prudent sovereign debt management and market demand was announced in the 2011-12 Australian Government Budget. The April 2027 Treasury Bond was issued in October 2011 and it is planned for the length of the yield curve to be maintained at around 15 years as a matter of course.
Chart 2 shows the Treasury Bonds outstanding as at 30 June 2012 and issuance during the 2011-12 financial year.
During the year the total volume of Treasury Bonds on issue increased by around $44 billion, to $205 billion. At the end of the year there were 11 Treasury Bond lines with over $10 billion on issue.
Treasury Indexed Bonds
Treasury Indexed Bond issuance for the year totalled $2.14 billion.
Tenders for the issue of Treasury Indexed Bonds were generally conducted on a monthly basis. There was one syndicated offer of a new Treasury Indexed Bond maturing in February 2022.
The volume of each line outstanding, relative yields and other prevailing market conditions were all considered in the selection of which line to offer in any month.
Chart 3 shows the Treasury Indexed Bonds outstanding as at 30 June 2012 and issuance during the 2011-12 financial year.
Aussie Infrastructure Bonds
In April 2009 the Government announced that its investment in NBN Co, the builder and operator of the National Broadband Network, would be partly funded through issuance of Aussie Infrastructure Bonds (AIBs).
This funding is obtained through the issuance of CGS as part of the Government’s overall debt program. AIBs are not identified separately from other CGS at the time of issue, but amounts of AIB funding are reported separately in the Budget papers.
The entire $1.5 billion of the Government’s equity investment in the National Broadband Network in 2011-12 was financed through the AIB process.
Securities Exchange Trading of CGS
On 12 December 2010 the Government, as part of its Competitive and Sustainable Banking System package, announced that it would facilitate the trading of CGS on a retail exchange platform in Australia.
The trading of CGS on a securities exchange will help to provide retail investors with a more visible pricing benchmark for investments they may wish to make in corporate bonds issued by Australian businesses, as well as help to further encourage retail investors to consider diversifying their savings through investments into fixed-income assets, such as government and corporate bonds.
In November 2011, the AOFM issued a standing request for proposals for the delivery of services for the retail trading of Treasury Bonds and Treasury Indexed Bonds on securities exchanges. The AOFM is currently working with an exchange operator to implement the exchange trading of Treasury Bonds and Treasury Indexed Bonds.
During the year the AOFM also conducted a procurement process for registry services to replace the current service provided by the RBA. The registry services being procured will have the functionality to support the retail exchange trading of CGS.
Funding the Budget
The Government’s budget financing requirement in 2011-12 was fully met.
The budget underlying cash deficit for 2011-12 was higher than estimated at the time of the 2011-12 Australian Government Budget due to changes in economic circumstances reducing tax receipts, and both policy decisions and parameter changes that increased payments (as explained in the 2011-12 Australian Government Budget). The larger than expected budget financing task was managed primarily by increasing Treasury Bond issuance from the $46 billion planned at the beginning of the year to around $58 billion.
Market liquidity and efficiency
The Treasury Bond and Treasury Indexed Bond markets operated smoothly throughout 2011-12 with liquidity again being maintained throughout the year.
One indicator of liquidity is turnover in the secondary market. Charts 4 and 5 show the evolution of total secondary market turnover1 from July 2008 through to June 2012. Turnover steadily increased over the period and was around $250 billion per month in 2011-12 for Treasury Bonds (totalling 28 per cent higher turnover than in 2010-11) and $13 billion per month for Treasury Indexed Bonds (totalling 50 per cent higher than in 2010-11).
Source: Based on Austraclear data sourced from the RBA
Source: Based on Austraclear data sourced from the RBA
Turnover in the Treasury Bond futures market is significantly higher than in the underlying Treasury Bonds. Treasury Bond futures continued to display strong liquidity in 2011-12 with the turnover of 3-year Treasury Bond futures contracts increasing by 9 per cent over the previous year and turnover of the 10-year contracts increasing by 13 per cent. Turnover in recent years is illustrated in Chart 6. All Treasury Bond futures contract close-outs in 2011-12 occurred smoothly.
Source: Based on data sourced from the Australian Securities Exchange.
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 and reducing the risk of settlement failures.
Turbulent market conditions during times of the year resulted in more use of the securities lending facility than during the previous year. The facility was used 66 times for overnight borrowing in 2011-12 compared with 47 instances of use in 2010-11. The face value amount lent was around $1.5 billion compared to $1.3 billion in 2010-11.
Efficiency of issuance
The AOFM continued to use competitive tender and syndication as the only means by which issuance of Commonwealth Government Securities was undertaken in 2011-12.
Tenders held during 2011-12 were well supported. Table 1 summarises the results of Treasury Bond tenders conducted during the year. The results are shown as averages for each half-year and grouped by the maturity dates of the bonds offered.
|Period||Maturity||Face value amount allocated ($m)||Weighted average issue yield (%)||Average spread to secondary market yield (basis points)||Average times covered|
|July – December 2011||Up to 2017||16,250||3.9331||-0.21||3.26|
|January – June 2012||Up to 2017||7,700||3.3828||-0.35||3.69|
The average ratio of the volume of bids received to the amount of stock on offer was 3.02 for Treasury Bonds in 2011-12, a decrease from 3.91 in 2010-11. Six tenders had a coverage ratio less than two, compared to only one tender in 2010-11. Each of these tenders was for the issue of longer-dated bonds. Shorter-dated bond tenders generally received a greater volume of bids.
The strength of bidding at tenders was also reflected in the issue yield spreads to the secondary market. At most Treasury Bond tenders, the weighted average issue yields obtained were below prevailing secondary market yields.
The average ratio of the volume of bids received to the amount of stock on offer was 3.47 for Treasury Indexed Bonds in 2011-12, a decrease from 4.13 in 2010-11. At around half of the tenders the weighted average issue yields were below prevailing secondary market yields.
Full tender details are given in Part 5 of this annual report.
The AOFM manages the daily cash balances of the Australian Government in the Official Public Account (OPA).2 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 daily cash balances and to invest excess cash balances efficiently. In minimising cost the AOFM seeks to avoid any use of the overdraft facility provided by the RBA.3
Achieving the objective
Achieving the cash management objective involves undertaking appropriate short-term investments and debt issuance.
Cash balances not required immediately were invested outside the OPA for nominated periods of time, with the maturity dates set to coincide with financing large outlays. The types, magnitudes and tenors of the short-term investments were determined by the AOFM. Depending on market conditions and the duration of the cash surplus, investments were made in term deposits at the RBA and negotiable certificates of deposit (NCDs) issued by highly-rated Authorised Deposit-taking Institutions (ADIs). Investment other than with 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 negotiable certificates of deposit reflect prevailing market rates.
In the first half of 2011-12 a review of unsecured lending to financial institutions (via NCDs) was conducted. The finding of that review was that the additional returns on this lending relative to returns on deposits at the RBA were insufficient to justify the additional risk at that time. Investments in NCDs ceased: no new NCDs were purchased after July and all NCDs purchased prior to then matured by October 2011.
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 2011-12 with the aim of maintaining a liquid market.
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 7 shows the movement in the funding requirement in 2011-12.
The objective of meeting the Government’s financial obligations as and when they fall due was met without use of the overdraft facility provided by the RBA.
During 2011-12 the AOFM placed 348 term deposits with the RBA. The stock of term deposits fluctuated from a minimum of $2.2 billion in October 2011 to a maximum of $28.8 billion in June 2012.
- The average yield obtained on term deposits during 2011-12 was 4.22 per cent, compared with 4.68 per cent in 2010-11. The decrease in average yield reflects the lower average level of interest rates that prevailed during 2011-12.
The face value amount invested in NCDs peaked at $4 billion in July. The average additional return in 2011-12 from investing in NCDs compared with investing funds on deposit at the RBA was approximately 23 basis points. This is estimated to have generated additional investment earnings totalling around $1 million. Although the average return pickup on these investments was higher than the 16 basis points achieved in 2010-11, additional earnings were lower due to substantially less investment activity.
A total of $53.8 billion of Treasury Notes were issued in 2011-12 (in face value terms). The tenders were well supported with an average cover ratio of 4.58. Yields averaged around 32 basis points less than bank bill yields of corresponding maturities (compared to 17 basis points less than bank bill yields in 2010-11). Yields were on average the same as Overnight Indexed Swap rates for corresponding tenors. 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 2011-12 are shown in Chart 8.
In undertaking its cash management activities, the AOFM is required to maintain the 91-day moving average of the daily OPA cash balance within operational limits around a target level. In 2011-12 these limits were the same as applied in 2010-11, 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 9.
Minimising debt servicing costs subject to acceptable risk
In managing the government’s debt portfolio, the AOFM 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, while also managing the impact of its issuance on the CGS market.
In order to meet its objective, the AOFM uses cost and risk measures that appropriately reflect the costs and risks faced by a sovereign debt manager. The primary cost measure used is historic accrual debt service cost. This includes interest payments made on CGS, realised market value gains and losses, capital indexation of indexed debt and the amortisation of any issuance premiums and discounts. Total accrual debt service cost can be expressed as a percentage of the stock of debt outstanding, to provide the effective yield of the portfolio. This measure of cost is the most appropriate in circumstances where financial assets and liabilities are intended to be held, or in the AOFM’s case, to remain on issue until maturity. The use of an historical accrual debt service cost measure excludes unrealised market value gains and losses.
An alternative measure of cost is ‘fair value’, which takes account of unrealised gains and losses resulting from movements in the market value of physical debt and assets. Debt service cost outcomes are presented in the AOFM’s financial statements on this basis. 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, that is ‘re-measurements’. Fair value is useful in circumstances where it is possible that changes in market value may be realised in the future.
Variability in cost outcomes, or risk, can be measured in several ways. The AOFM calculates and compares several metrics to assess risk. In general, an acceptable level of risk can be characterised as an acceptable level of variation in cost outcomes over time. Abstracting from future financing tasks, debt issuance decisions made today will, by determining the maturity profile of the portfolio and hence the amount to be refinanced in any given year, impact on risk.
Achieving the objective
The AOFM influences the cost and risk profile of the portfolio primarily through its decision making on the composition, maturity and tender volume of the debt securities it issues. These decisions are framed through an annual debt issuance strategy approved by the Treasurer, which identifies the overall scale of the issuance task and its breakdown into different instrument classes. Within these broad strategy parameters approved by the Treasurer, the AOFM separately determines issuance weightings (specified as a range) applicable to different segments of the yield curve which are approved by the AOFM Chief Executive. Operational issuance decisions such as determining if, when, how much and what lines to issue each week, are made by the AOFM over the course of the year and are influenced by a range of factors including general market conditions, relative value considerations and feedback from investors.
To provide advice to the Treasurer and to inform strategic decision making, the AOFM is engaged in a constant process of research and review of alternative issuance strategies based on how they are likely to affect the longer term cost and risk profile of the Commonwealth’s debt portfolio. Decisions announced in the 2011-12 Budget to lengthen the CGS yield curve to around 15 years and to maintain around 10 to 15 per cent of total long-term CGS in Treasury Indexed Bonds were both informed by this research program. The same is true of the 2011-12 issuance strategy where the AOFM targeted a higher proportion of issuance into mid and longer maturity segments of the nominal curve than has been the case in recent years.
Chart 10 shows that the weighted average tenor of issuance in 2011-12 was around 7.7 years, compared to 6.3 years in 2010-11. This lengthening of issuance in 2011-12 boosted the average term to maturity of the nominal portfolio from around 5.0 years (30 June 2011) to 5.2 years (30 June 2012). Duration, which was boosted by falling bond yields in addition to the lengthening of issuance, increased from around 4.1 years (30 June 2011) to 4.4 years (30 June 2012)4. Looking forward to the next few years, the AOFM anticipates that both average term to maturity and duration will have slightly negative trajectories reflecting the relatively large weights in the portfolio of securities issued during and in the aftermath of the global financial crisis. At the time, the need to quickly ramp up issuance, combined with a general investor preference for shorter maturity lines, resulted in a number of relatively large bond lines being established in the front half of the yield curve. As these lines now approach maturity it is anticipated that the average term to maturity and duration of the portfolio will shorten in the near term. The AOFM’s strategy of lengthening issuance has ensured that this decline will be shallower than it would otherwise have been.
One of the key risk factors considered in the AOFM’s strategic deliberations is how different issuance strategies influence the maturity or refinancing profile of the debt portfolio. Indeed the refinancing risks implicit to the CGS portfolio structure that emerged post the global financial crisis contributed to the AOFM’s decision to lengthen issuance. Chart 11 highlights how the refinancing profile of the nominal portfolio has been gradually ‘flattening’ in recent years as a result of the AOFM’s strategy to boost issuance in the mid and longer segments of the curve. With a flatter, more evenly distributed maturity profile, debt servicing costs are generally less susceptible to adverse interest rate movements in any given period, while refinancing requirements are less concentrated and therefore more easily managed.
Chart 11 also highlights the extension of the nominal curve in 2011-12 with the establishment of a new 15 year benchmark. Extending the curve has provided the AOFM with more options for meeting the Government’s financing requirements year to year while enabling debt outstanding to be spread across a wider tenor range (which is beneficial for managing refinancing risks).
Another consideration in framing and executing the annual issuance strategy is the need to support the liquid and efficient operation of the Commonwealth Government yield curve. This requires, among other things, good communication with investors, transparency, regular supply and a spread of issuance across the curve. Communication with investors and operational transparency have always been important considerations for the AOFM. Chart 12 (showing cumulative issuance in 2011-12 set against the weighted average yield of each Treasury Bond tender) highlights that in executing its strategy, the AOFM issued bonds regularly and widely across the yield curve in 2011-12. The chart also shows how issuance yields (borrowing costs) steadily declined throughout the year.
In terms of the indexed debt portfolio, 2011-12 was the first year of a transition towards the 10 to 15 per cent indexed debt share target band announced by the Australian Government in the 2011-12 Budget. As at 30 June 2012, Treasury Indexed Bonds (measured on an accreted book value basis) accounted for 9.2 per cent of total longer term debt on issue.
Box A: The benefits of lengthening issuance
The information presented in this section compares the variability in expected cost outcomes of two hypothetical portfolios, namely a ‘long’ and a ‘short’ portfolio. In this example, the long portfolio allocates a greater proportion of future issuance to bond lines positioned in the mid to longer segments of the curve than the short portfolio. Both have a common starting point
Chart 13 below reveals the debt service cost performance of the two portfolios under a simulated interest rate path that sees interest rates oscillating between a simulation range of 2 per cent and 8.5 per cent, over a peak to trough business cycle of 6-7 years. The bounds of this simulation range are consistent with minimum and maximum 10 year yields observed since the mid 1990s.
Chart 13 shows that under the assumed yield curve path, the ‘long’ portfolio exhibits less variability in cost outcomes than the ‘short’ portfolio. By ‘locking in’ the cost of debt for longer periods of time, the ‘long’ portfolio rolls over less frequently and as a consequence requires the refinancing (or repricing) of less debt each year on average. As a result, the ‘long’ portfolio is generally less sensitive to changes in interest rates than is the short portfolio. This greater cost-stability of the long portfolio provides insulation against increases in debt service costs when interest rates are rising, but it also slows the rate at which the portfolio passes through the benefits of lower interest rates.
In recent years, the AOFM has been gradually lengthening the average tenor of its issuance (see Chart 10), a trend that will likely continue in 2012-13. With volatility and uncertainty continuing to be prominent features of global financial markets, the AOFM views such a strategy as providing the best fit with its core debt management objectives. It enables more stable cost outcomes to be delivered over time by locking in current interest rates, which are at historically low levels.
Reducing debt servicing cost at an acceptable level of risk
The debt servicing cost5 of gross debt managed by the AOFM in 2011-12 was $11.42 billion. This represented a cost of funds of 5.07 per cent for the period. Table 2 provides further details of the cost outcomes for the combined portfolio by instrument and portfolio for 2010-11 and 2011-12.
Debt servicing costs on gross CGS debt increased by $2.15 billion compared with the previous year. This was largely the result of an increase in the average volume of debt on issue by $47.31 billion to $225.07 billion in 2011-12. The return on gross assets for 2011-12 increased by $37 million; this was again driven by an increase in the average volume of gross assets (up $2.53 billion to $28.12 billion) which more than offset the return-dampening effect of lower short-term interest rates.
Expressed on an effective yield basis, funding costs in 2011-12 for gross CGS debt fell 15 basis points to 5.07 per cent. Improvements were broadly based across all funding sources and were principally driven by declining CGS yields on bonds and notes issued during the year. Falling rates also reduced yields on funds invested in term deposits from 4.68 to 4.24 per cent and RMBS investments from 6.07 to 5.80 per cent.
Taken together, the net servicing cost of the combined portfolio of debt and assets was $10.01 billion, with an effective yield of 5.08 per cent. The corresponding figures for 2010-11 were $7.90 billion and 5.19 per cent, respectively.
To summarise, an increase in the volume of debt generated a larger net interest cost in 2011-12 in dollar terms. However, the effective cost of funds on the gross debt portfolio decreased in percentage terms, due primarily to falling interest rates. The increase in returns on the gross asset balance, in dollar terms, provided an additional offset to the interest cost on the portfolio compared to the previous year. However, the return on gross assets fell below the cost of gross debt in percentage terms, leading to a slightly higher effective yield on the net debt portfolio than on the gross debt portfolio.
|Interest expense||Book volume||Effective yield|
|2010-11$ million||2011-12$ million||2010-11$ million||2011-12$ million||2010-11per cent
|Contribution by instrument|
|Treasury Indexed Bonds||(1,021)||(1,215)||(16,481)||(19,868)||6.19||6.12|
|Repurchase agreements (a)||(12)||–||(257)||–||4.75||0.00|
|Foreign loans (b)||(0)||(0)||(5)||(5)||7.98||8.49|
|Gross physical CGS debt||(9,272)||(11,421)||(177,760)||(225,072)||5.22||5.07|
|Term deposits with the RBA||391||587||8,372||13,842||4.68||4.24|
|Investments in bank paper||96||34||1,979||680||4.84||4.97|
|Term investments (c)||123||–||2,546||–||4.85||0.00|
|State Housing Advances||158||154||2,685||2,620||5.89||5.86|
|Net CGS debt||(7,896)||(10,009)||(152,173)||(196,952)||5.19||5.08|
|Contribution by portfolio|
|Long Term Debt Portfolio||(8,547)||(10,856)||(162,423)||(211,911)||5.26||5.12|
|Cash Management Portfolio||(114)||57||(2,440)||1,361||4.67||4.18|
|State Housing Portfolio||158||154||2,685||2,620||5.89||5.86|
|Total debt and assets||(7,896)||(10,009)||(152,173)||(196,952)||5.19||5.08|
|Total after re-measurements||(7,571)||(30,575)||(152,173)||(196,952)|
Note: Sub totals and totals are actual sum results, rounded to the nearest million dollars. Effective yields are based on actual results before rounding, rounded to two decimal places. Book volume is a through the year average.
- Repurchase agreements using investments in State and Territory government bonds as collateral.
- Interest expense and effective yield on foreign loans incorporates foreign exchange revaluation effects.
- Investments in State and Territory government bonds.
- Re-measurements refer to unrealised gains and losses from changes in the market valuation of financial assets and liabilities.
Falling interest rates had a large negative revaluation effect on the portfolio in 2011-12, with unrealised losses from re-measurements amounting to $20.57 billion. This comprised unrealised losses of $20,494 million on gross debt and $72 million on asset holdings. Because re-measurement items are highly volatile and will generally show losses/gains when borrowing costs are declining/increasing, they have no bearing on the AOFM’s debt issuance strategy. Indeed were the AOFM to adopt a strategy designed to minimise the ‘noise’ from re-measurements, issuance would be limited to only very short-term debt securities (Treasury Notes for instance) creating a portfolio structure that would maximise expected variability in debt servicing costs when measured in cash, accrual and public debt interest terms while also maximising exposure to refinancing risk.
Chart 14 below provides a closer examination of the two largest components of the gross CGS debt portfolio, by comparing the effective book yield of the Treasury Indexed Bond portfolio (in nominal terms incorporating capital indexation effects) with that of the Treasury Bond portfolio since June 2009. During this relatively short period, Indexed Bonds have generally been a more volatile and, at times, more expensive source of funding than nominal debt for the period shown. That being said, the AOFM recognises that indexed bonds offer funding diversification benefits for the Commonwealth and is committed to supporting liquidity and efficiency in this market by boosting the share of indexed debt to at least 10 per cent of the long-term debt portfolio (as announced in the 2011-12 Australian Government Budget — Budget Paper No. 1)6.
Chart 14 also demonstrates that despite lengthening issuance in recent years, the nominal portfolio has still benefited from falling interest rates, as evidenced by the decline in effective yields. The fact that the AOFM had run a relatively shorter duration profile7 entering into, during and in the period since the global financial crises has meant that the rate of ‘pass through’ from lower interest rates to lower debt servicing costs has been faster than it would otherwise have been. With bond yields reaching 60 year lows late in 2011-12 and with the continuing prospect for market conditions that support relatively low historic CGS yields, the AOFM sees benefits from lengthening the duration of new issuance and locking in historically low rates for an extended period. Notwithstanding downward pressure on the duration of the portfolio as shorter dated bonds approach maturity in the near term, this strategy will see the duration of the AOFM’s debt portfolio rise in the medium-term.
Residential mortgage-backed securities
The Australian residential mortgage-backed securities (RMBS) market is acknowledged as a critical source of funding for smaller mortgage lenders. The global financial crisis that started in 2007-08 reduced the availability of funding through the Australian RMBS market, which in turn limited mortgage lenders’ access to funding. In particular, RMBS margins 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 Australian RMBS. While conditions and investor sentiment improved at times, 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 market dislocation. In October 2008 the Treasurer directed the AOFM to invest up to $8 billion in eligible RMBS, of which up to $4 billion was to be invested in deals with sponsors that were not ADIs (Authorised Deposit-taking Institutions). In November 2009 the Treasurer extended the program by directing the AOFM to invest up to a further $8 billion in RMBS. This Direction also extended the objectives of the program to include supporting small business lending, through broadening the potential use of funds raised under the program.
In December 2010 the Treasurer announced, as part of the Competitive and Sustainable Banking System package, a further extension of the program. The subsequent Direction, issued in April 2011, directed the AOFM to invest up to an additional $4 billion and thus a cumulative total of up to $20 billion in RMBS. Importantly, this direction also identified the need to encourage a transition towards a market that is not reliant on Government support.
Achieving the objective
RMBS market conditions and developments in the program
In 2011-12, the AOFM invested a total of $1.93 billion across 11 RMBS transactions from 8 issuers. Since inception of the program, the AOFM has invested $15.3 billion across 60 transactions from 20 issuers. Through amortisation and sales, $4.1 billion has been repaid, and $11.2 billion remained outstanding by the end of this financial year. Table 3 details our investment activity.
|Total Investment||Outstanding||Number of deals|
|Torrens||Bendigo and Adelaide Bank||$1,922||12.6%||$1,523||13.6%||6|
|Reds||Bank of Queensland||$1,248||8.2%||$992||8.9%||3|
|Light Trust||People’s Choice Credit Union||$434||2.8%||$332||3.0%||2|
|WB||Wide Bay Australia||$404||2.6%||$302||2.7%||2|
|GBS||Greater Building Society||$190||1.2%||$127||1.1%||1|
|Pinnacle||Police & Nurses||$111||0.7%||$111||1.0%||1|
|Barton||Community CPS Australia||$91||0.6%||$91||0.8%||1|
Market conditions were volatile through the year. The Australian RMBS market continued to face challenges consistent with global credit markets. Concerns over Europe and credit in general, dampened issuance and widened margins. In addition, the debut of covered bonds resulted in further volatility and uncertainty in the Australian RMBS market in early 2012. Consequently, in line with reduced issuance, the AOFM’s pace of investment was slower through the year.
Consistent with a lower level of issuance and a slower pace of investment, the volume of transactions supported by the AOFM decreased from over $14.7 billion in 2010-11 to just under $8.5 billion this year, and likewise the volume of prime RMBS transactions that were not supported by the AOFM almost halved from nearly $9 billion to $4.75 billion. This brought total public prime RMBS activity to $13.2 billion in 2011-12 from $23.7 billion the year before. It is interesting to note that all the non-AOFM supported deals this year were sponsored by the Australian major banks and their subsidiaries.
Particularly in keeping with the AOFM’s objective of working towards a market that is not reliant on Government support, it is also worth noting that the participation of other investors was marginally higher again this year. Chart 15 shows the participation of AOFM and other investors in prime RMBS issues since the inception of the program. Participation from other investors averaged 23 per cent from inception until the end of June 2009, and has gradually grown from 81 per cent in 2009-10 to 82 per cent in 2010-11 and to 85 per cent of total market activity in 2011-128.
The net result of these activities is that the volume of Australian prime RMBS outstanding has now reduced to around $75 billion. The share of housing credit funded by securitisation also fell during 2011-12 to just below 8.5 per cent, according to the RBA.
In terms of margins, the typical benchmark of AAA rated senior tranche with a weighted average life of around three years progressively widened through the year, from around 100 basis points at the start of the financial year, to around 140-160 basis points by the end of the financial year. Similarly, margins widened for all tranches and accordingly, the cost of funding through RMBS and thus the net margin for investors was higher this year.
It was encouraging to see transactions tap pockets of demand where possible with the issuance of a variety of structures that included fixed rate bullet tranches aimed to attract index investors, and Yen and US dollar tranches aimed to attract offshore investors. Despite these efforts, the investor base for Australian RMBS did not deepen significantly over the year.
The AOFM continued to support structures designed to facilitate engagement with investors, by filling gaps in demand. For example, the AOFM continued to purchase some relatively small longer dated tranches, so as to facilitate the creation of RMBS securities with the weighted average life in demand. Likewise, the AOFM has been prepared to purchase tranches with a greater degree of sensitivity to mortgage prepayment rates so as to facilitate the creation of both bullet securities and scheduled amortisation tranches.
During the year, the AOFM also purchased, for the first time, a fixed rate bullet security. This was agreed in order to support the issuance of sufficient volume to enable this security to qualify for the UBS Composite Index which in turn would attract particular investors. In March 2012, and in spite of secondary markets implying otherwise, the AOFM was able to sell these securities at a tighter margin to swap than the equivalent margin at purchase.9
The funds raised by the RMBS issues supported by the AOFM have provided an important component of total lending for housing and small business since the inception of the program. Without this funding, new lending by the financial institutions supported, would have been lower and their ability to provide competition in the market, now and in the future, would have been curtailed. As such, the RMBS program has continued to positively contribute to mortgage competition again this year.
The investments made under the program continue to provide reasonable financial returns. Interest income in 2011-12 was $637 million, which represented an annualised return of 5.80 per cent on the average portfolio book value of $11.0 billion. This compares favourably with the AOFM’s funding costs, detailed in Table 2. The average margin over the one month bank bill rate, weighted by each of AOFM’s investments, for the book outstanding as at 30 June 2012 was around 133 basis points. In addition, capital repayments totalling $4.1 billion were received.10
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. Accordingly, the RMBS portfolio had an unrealised loss stand of $152.6 million (or 1.36 per cent of the portfolio book value) as at 30 June 2012.11 This represents a deterioration of $71.75 million for the financial year. Losses or gains in the mark-to-market value of the portfolio change with prevailing conditions and therefore vary at any particular point in time. They are not ‘realised’ losses or gains, but are referred to as ‘re-measurements’.
Further information on the AOFM’s investments in RMBS up to 30 June 2012 is given in Part 5 of this annual report.
Investor Relations activities again focused on supporting smooth debt issuance through regular and consistent communication with investors. This was done through a range of investor engagements such as one-on-one meetings, presentations and discussions with small groups of investors. Regular investor contact allows for new investors to become aware of and current investors to remain up-to-date on the Australian economy, the Government’s fiscal and debt positions underpinning its very strong stable sovereign credit status, and the benefits of the CGS market more generally.
One of AOFM’s main objectives has been to encourage diversity in the investor base via the entry of new investors with differing investment mandates, while maintaining relationships with strategically important investors. Diversity is obtained through a spread of investors over geography, sector, product and investment policies or mandates. A wide diversity of investors reduces the risk of very large moves in the demand for or sale of CGS, aiding in the maintenance of a liquid and orderly market and contributing to the AOFM achieving a lower cost of borrowing.
Investor Relations activity during 2011-12 involved the offshore markets sector, with visits to a similar number of countries and cities as the year before, and the domestic investor base. This year though, there was more direct investor contact. Sixteen more one-on-one meetings were held as well as a larger number of small group meetings or roundtable discussions. Fewer large conferences type presentations were attended in 2011-12 as the perceived benefit of these was not assessed as proportional to the preparation, effort and cost of international travel to attend them. For more information see Tables 4 and 5.
Although the AOFM participated in a smaller number of more targeted conferences, the ones which were attended were mainly held in Australia and usually had a more tightly selected audience, often with central bank investors as key attendees. Although AOFM participated in fewer conferences during 2011-12 than in the previous year, the nature of the selected conferences and roundtable discussions were highly relevant. On occasions the transcript of these discussions were later printed in financial magazines such as Asia Money or Kanga News, which have international investor reach through their subscription bases.
Good examples of the smaller discussion format were the domestic inflation linked roundtables, where AOFM provided updates to investors and received very useful direct feedback. These discussions were usually hosted by financial intermediaries (for example banks), as were most of the meetings and the conferences in which the AOFM participated. There are a number of benefits in having a financial intermediary arrange industry and investor related events and AOFM thanks all those institutions that have engaged with and provided assistance to the agency.
|Conferences, speaking engagements and investor meetings||16 events.|
|Approximate total audience size||550-650 attendees.|
|Individual meetings||96 investor meetings.|
|Hosted roundtable/small presentations||8 presentations with 46 investors.|
|Individual cities visited||25 cities.|
|Two AOFM staff members travel on each overseas trip||CEO, Head of Investor Relations, Director of Financial Risk, or a Senior Analyst from Investor Relations or Treasury Services.|
|Hosting banks||Bank of America Merrill Lynch (BoAML), Citi, Commonwealth Bank of Australia (CBA), Deutsche Bank (DB), Royal Bank of Canada, Royal Bank of Scotland, UBS, Westpac.|
|July 2011||Sydney: RBS Linker Roundtable – discussion with 7 domestic investors.|
|September 2011||USA: Euromoney Conference – CEO was keynote speaker, 18 investor meetings plus 8 investors met through 2 in-house bank hosted presentations.|
|November 2011||Tokyo: 20 Japanese investor meetings plus 11 investors met through a bank hosted luncheon.|
|February 2012||Sydney: BoAML Asian Central Bank and Sovereign Wealth conference – CEO presented to 50 investors, 7 individual meetings.|
|February/March 2012||Europe: 18 investor meetings plus 15 investors met through 2 bank hosted luncheons.|
|March 2012||Canberra: DB Investor Mission – CEO presentation to 40 investors.|
|June 2012||South East Asia: 11 investor meetings.|
In the first half of 2011-12, the AOFM undertook a small advertising campaign via print advertisement in Bloomberg Markets magazine and which directed interest to AOFM’s Bloomberg page. This was over a three month period and also allowed for an AOFM digital banner to be displayed on six days when users logged on to their Bloomberg terminals. The digital banner linked to the AOFM Bloomberg page, which in turn lead through to the AOFM website. The campaign coincided with a major investor trip to North America and both activities were aimed at increasing awareness amongst the large private sector US investor group. Evaluation of the campaign highlighted increased activity on both the AOFM Bloomberg page and AOFM website over the period of the campaign.
Investor Relations was also tasked during the year with rebuilding the AOFM website as it is a major portal of information for the public and investors in particular. This is a major project which aims to redesign and update the entire website.
Public Register of Government Borrowing
The Guarantee of State and Territory Borrowing Appropriation Act 2009 requires the AOFM to establish and publish a register recording the beneficial ownership, by country, of all Commonwealth Government Securities (CGS) and any Australian State or Territory government securities guaranteed by the Commonwealth.
The Act does not contain any mechanisms to compel the provision of information to the AOFM by the beneficial owners of these securities or persons holding these securities on their behalf. In the absence of a legal or regulatory compulsion to do so, nominee and custodial services firms have not provided information to AOFM due to their fiduciary and contractual obligations to their clients. Many investors wish for their holdings to remain confidential for valid commercial and other reasons.
This has severely limited the information available to the AOFM to form an opinion on the extent of beneficial ownership of the securities. Without information on the country of beneficial ownership information on the holdings of nominee/custodial firms alone provides a very limited indicator of ‘offshore’ CGS ownership.
During 2011-12, the AOFM published the register each quarter and following the latest update the register contains monthly data up to 30 June 2012. The register indicates that around $265.8 billion of CGS, together with State and Territory securities guaranteed by the Commonwealth, were on issue at year end. Country of ownership could be identified for $86.8 billion or 32.7 per cent, of which $38.7 billion was identified as Australian and $48.1 billion was offshore. Country of beneficial ownership could not be identified for around $179.0 billion or 67.3 per cent. Most of this unidentified component was held by nominee/custodial firms.
The Australian Bureau of Statistics (ABS) also collects and publishes information on the holdings of securities. The legal powers provided to the Australian Statistician enable the ABS to obtain information from nominee/custodial firms on security holdings, however, there are also set confidentiality requirements that can constrain how and to what extent the ABS publishes at a detailed country level.
The quarterly ABS publication 5302.0 Balance of Payments and International Investment Position, Australia indicates that around 76.1 per cent of Commonwealth Government Securities were held by non-residents as at June 201212.
The annual ABS publication 5352.0 International Investment Position, Australia provides information on the country of domicile for portfolio investment in debt securities. This information covers a broader range of debt securities, issued in Australia and overseas, than that covered by the AOFM register (that is State and Territory securities not guaranteed by the Commonwealth, as well as debt securities issued by financial intermediaries such as banks and those issued by companies).
The publication estimates that there was around $858.0 billion of this foreign portfolio investment in debt securities at 31 December 2011. The survey indicated the country of domicile breakdown as: the United States, $212.1 billion; United Kingdom, $172.6 billion; Japan, $58.0 billion; Luxembourg, $18.4 billion; Switzerland, $9.0 billion; Hong Kong, $7.8 billion; Singapore, $5.7 billion; New Zealand, $3.2 billion; Netherlands, $3.1 billion; France, $1.6 billion; Germany, $1.4 billion; and Ireland, $1.4 billion. The remainder of holdings were attributed to international bond markets, were unspecified, or were not published for confidentiality reasons.
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 AOFM is licensed to use its current system, Avantgard Quantum/Risk, until April 2014. The AOFM has an option (exercisable at its discretion) to extend its license for a further 2 years to April 2016.
During 2009-10 the AOFM commenced an open market testing and procurement process to identify a treasury system to replace the existing system. Given the central importance of the treasury system to the AOFM’s operations, the agency committed significant resources to conduct due diligence assessments of the technical, commercial and legal elements of proposals received. This included desktop reviews of expression of interest and tender responses, product demonstrations, proof-of-concept testing of products, financial viability assessments of vendors, costing of proposals and contract negotiations with vendors.
In February 2012 the AOFM terminated its selection process as no tender was assessed to represent a satisfactory value for money proposition to the AOFM due to technical, commercial and/or legal considerations.
The AOFM is re-evaluating its business case on how best to progress its treasury system requirements.
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 acceptably minimum levels. It maintains a culture of prudence awareness, together with 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. Responsibility for the design and monitoring of risk and compliance activities resides in the Enterprise Risk Management, Legal and Compliance (ERMLC) Group. A dedicated Enterprise Risk Management Unit maintains the currency and relevance of the AOFM’s risk framework and registers, while the Compliance Unit monitors compliance with external obligations and internal controls and procedures. The ERMLC Group reports to the Audit Committee on matters relevant to risk management, internal controls and compliance.
Operational risk activities undertaken in 2011-12 included:
- internal audits of the control effectiveness over the payroll and finance functions, general IT control environment, and the securities issuance and lending operations, as well as an assessment of the AML/CTF program governance framework;
- preparation of the Certificate of Compliance for the AOFM’s compliance with the financial management framework under the Financial Management and Accountability Act 1997; 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. In 2011-12, it settled around $82.5 billion of payments of interest, principal and redemptions on CGS and around $1,071.9 billion in financial asset acquisitions, including term deposits with the Reserve Bank of Australia, money market and residential mortgage-backed securities. The AOFM also ensures that administered receipts are settled promptly and correctly by its transaction counterparties.
In 2011-12, the AOFM was not late in settling any payment obligations. There was one instance where compensation was sought from a counterparty for failing to settle a payment obligation in line with its contractual obligations.
Agency financial performance
The AOFM recorded an operating surplus on agency activities of $3.14 million for 2011-12 financial year, comprising total revenue of $13.44 million and expenses of $10.30 million. The surplus in 2011-12 was due largely to lower than anticipated costs of undertaking additional issuance activity in response to the financial crisis.
As at 30 June 2012, the AOFM was in a sound net worth and liquidity position, reporting net assets of $24.25 million, represented by assets of $26.72 million and liabilities of $2.47 million.
As at 30 June 2012, the AOFM had unspent appropriations totalling $25.70 million of which $0.1 million was held in cash. Unspent appropriations are available to settle liabilities as and when they fall due and for future asset replacements and improvements.
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. One staff member is seconded 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 Brisbane in August 2011 to discuss their experience with debt management over the year and the development of management capabilities (including knowledge transfer).
During the year the AOFM also hosted visits by officials from Papua New Guinea and the Solomon Islands.
- Total turnover includes repurchase transactions based on Austraclear data sourced from the RBA. ↩
- 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. ↩
- Chart 10 focuses solely on Treasury Bonds in order to highlight changes to the issuance strategy in 2011-12. Were other instrument classes such as Treasury Indexed Bonds or RMBS holdings to be included, the average term to maturity and duration parameters would be higher. ↩
- 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 indexed debt share of the portfolio is calculated on an accreted book value basis. ↩
- Many of the AOFM’s contemporaries in sovereign debt management around the world have tended to run liability portfolios with longer durations. ↩
- Excluding transactions not supported by the AOFM reduces this proportion to 77 per cent (up from 70 per cent in 2010-11). ↩
- Further detail on this sale is available on the AOFM website. ↩
- This includes the RMBS investments sold for portfolio management purposes in March 2010 and March 2012 with a total face value of $123.79 million. The AOFM announced the details of these sales shortly after each completion. ↩
- The AOFM uses market bid rates for revaluation purposes supplied by a third party revaluation service provider. ↩
- Note this does not cover Commonwealth guaranteed securities issued by the State and Territory governments under the Act. ↩
Last updated: 5 February 2014