Review by the Chief Executive Officer

Context

The growing interest in Commonwealth Government Securities (CGS) continued throughout 2011-12. Against a backdrop of persistent economic uncertainty and financial market volatility, mainly deriving from the situation in Europe, investors have been increasingly attracted towards what has become generally known as either the ‘diversification play’ or ‘safe haven switch’ — both of which reflect a general shift of investment focus away from the European region and equity markets.

The heightened scrutiny applied by investors to differentiating between the credit ratings of sovereigns has also continued throughout the year. Just over 18 months ago Australia was one of 15 AAA rated sovereigns with a stable outlook, as rated by the three largest rating agencies. This group has now been reduced to just seven. This has increasingly brought the CGS market into a positive light and for most of the year all existing nominal bond lines have been issued into a market that reflects a very strong demand for CGS. This has reduced the borrowing costs to the Australian community (through new issuance with lower yields) and ensured that issuance of CGS has been smooth and readily absorbed into the market. Furthermore, the AOFM’s commitment to transparency in its operations, together with the importance it places on using market feedback and its engagement with investors, underlie broad confidence in a resilient and well-functioning sovereign bond market for Australia.

The CGS issuance program will have peaked this last year given the Government’s announcements that it will return the Budget to surplus in 2012-13. The AOFM remains conscious of the need to keep investors informed as to CGS market developments and we have done that throughout the year by advising investors and market intermediaries as to the slowing growth in the size of the market, which will arise from the reduced issuance programs planned for the years ahead. This will help to ensure that market expectations remain consistent with Government fiscal and debt portfolio policy intentions. The Government has highlighted its commitment in the last two Budgets to maintaining a liquid CGS market and it will continue to monitor the size of the market in relation to liquidity considerations. The AOFM continued to track market conditions throughout the year so as to gauge maintenance of this policy objective.

Through their investment decisions, investors continued throughout the year to acknowledge the strong positive trade links between Australia and the high-growth Asian region. This reflects a widespread acceptance that Australia is well-placed to benefit from the underlying medium to longer-term growth trend in Asia, despite its exposure to volatility in the performance of its largest trading partners in the short-term.

Bond issuance

During 2011-12, gross Treasury Bond issuance was approximately $58 billion. During the past year, ten year Treasury Bond yields declined over 200 basis points, while CGS continued to outperform other Australian dollar denominated debt securities.

The issuance program was less challenging throughout much of the year when compared with the past three years. The ongoing entry of new investors to the market and the prevailing conditions for strong demand for bonds more generally underpinned another successful issuance program. The presence of investors with a wider spectrum of investment mandates than previously experienced in the market for CGS has also contributed to CGS issuance being readily absorbed into the market.

Although CGS yields have declined substantially over the last year, they are still attractive on a global relative value basis, which has been an important factor in retaining investor interest in the Australian sovereign bond market.

Once again, the bulk of issuance was achieved by ‘tapping’ existing bond lines. This helps to reduce the cost of issuance while enhancing the liquidity and attractiveness of the bond portfolio. However, consistent with prudent overall portfolio management, opportunities were taken to launch four new Treasury Bond lines during 2011-12. The new lines were for maturity in October 2015 and July 2017 (to meet demand for short dated maturities); April 2024 (to support the operation of the 10 year Treasury Bond futures contracts); and April 2027 (to extend the yield curve to around 15 years).

Once again the AOFM pursued an issuance strategy that took into account areas of strongest demand. This helped to ensure the Government’s financing task could be most efficiently met. The AOFM continues to recognise the need to retain flexibility in determining detail of the issuance task throughout the year. Therefore, prevailing market conditions, information based on market advice, relative value considerations, the aim of increasing liquidity in CGS generally, and the need to manage the maturity structure to limit refinancing risk all remained key considerations in developing the issuance program. This has highlighted the need for market vigilance and regular reappraisal of overall portfolio management strategies.

The practice of generally conducting two tenders per week, typically targeting a long dated bond line and a short dated bond line, was continued for the most part of 2011-12. Net new issuance of around $44 billion brought the outstanding stock of Treasury Bonds at 30 June 2012 to $205 billion. At year-end there were 18 Treasury Bond lines of which 11 have over $10 billion on issue.

In 2011-12 the market for Treasury Indexed Bonds remained similar in terms of demand, performance and outlook compared with the previous year. Issuance for the year totalled $2.14 billion, including a syndicated offer for a new Treasury Indexed Bond maturing in February 2022. This brought outstanding stock (in face value terms) to $16.07 billion. The volume of each line outstanding, relative yields and other prevailing market conditions were all considered in the selection of which indexed bond line to offer in any month.

Investor feedback remains positive regarding the Government’s commitment 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 in the secondary market for Treasury Bonds and Treasury Indexed Bonds continued to grow broadly in line with increasing volumes on issue. A number of factors have contributed, amongst them were: 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 2011-12 was fully met.

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 that have tended to result in a greater proportion of cash required in the first half of the year.

Improved demand dynamics have enabled the AOFM to actively target a longer average term to maturity for its issuance in 2011-12. This aims to reduce refinancing risk. In 2010-11 the nominal bond issuance program had a weighted average term to maturity of 6.29 years, while in 2011-12 this was raised to 7.68 years.

The average cost of funds for gross debt in 2011-12 was 5.07 per cent, representing a decrease on the previous year (which was 5.22 per cent). The average return on gross assets in 2011-12 was 5.02 per cent. Taken together, the net servicing cost of the combined portfolio of debt and assets for 2011-12 was $10.01 billion, which represented an 11 basis points reduction in effective yield, to 5.08 per cent (compared with 5.19 per cent last year). This represents the average outcome for 2011-12. The extent to which this result reflects a very strong pickup in demand for CGS in the second half of the year needs to take account of the fact that only new issuance for the year has attracted the low yields resulting from a strong rally in the CGS market. It is also important to note that the CGS market has continued to exhibit the characteristics of a highly resilient and well functioning market regardless of the movements in yields.

Residential mortgage-backed securities

Commencing with the Government’s Competitive and Sustainable Banking System package the AOFM has been directed to invest up to $20 billion in residential mortgage backed securities (RMBS). The RMBS investment program was launched in 2008 due to the dislocation resulting from the global financial crisis. The Government has since announced its intention that the program be part of encouraging a transition towards a market that is not reliant on Government financial support. This has broadened the objective of the program beyond the initial aim of supporting competition from a diverse range of providers in the Australian market for residential and small business lending.

Throughout 2011-12 the AOFM’s RMBS investment pricing has continued to balance the objective of maintaining a competitive flow of funds for new lending with the objective of attracting additional investors. A growing presence of other investors alongside the AOFM is taken to indicate that conditions in the Australian securitisation market are improving.

During the first half of 2011-12 RMBS market conditions continued to improve over the performance of the previous year. However, early 2012 revealed that the Australian securitisation market still faces challenges consistent with global credit concerns.

The AOFM continues to work closely with market participants in support of the Government’s objectives, with an increasing focus on the need to encourage a transition towards a sustainable and innovative securitisation market that is not reliant on Government financial support.

Looking ahead

While the general impact of the global financial crisis continues to be felt around the world, the performance of the Australian economy relative to most other advanced nations and fiscal policy decisions have led to a substantially reduced outlook for net new issuance. Therefore, supporting liquidity in the CGS market will once again become a lead factor in AOFM thinking and operations. Further diversification of the CGS investor base will also remain an important consideration.

Consolidation of the yield curve extension to 15 years and delivering on previously announced commitments to maintain a mix of Treasury Indexed Bonds and nominal bonds as part of the overall portfolio will continue to be key tasks for the AOFM to manage. Volatility in international financial markets has continued through the past year and there would appear to be little prospect for an appreciable change to this situation in the near to medium-term.

Rob Nicholl
Chief Executive Officer

Last updated: 8 November 2013