Review by the Chief Executive Officer

Context

Core to the Australian Office of Financial Management’s (AOFM) responsibilities are financing the Government’s budget requirements (through debt issuance), managing its daily cash balances in the Official Public Account (OPA) and managing the Australian Government Securities (AGS) portfolio. While global financial market conditions were volatile at times throughout the year, the overall circumstances were conducive to readily achieving the 2014‑15 issuance task. On balance, AGS yields were appreciably lower towards the end of 2014‑15 than at year commencement, with most of the bond market rally occurring in the latter part of 2014 and early part of calendar 2015. While lower than the previous year, the issuance programme for 2014‑15 was still substantial at $78 billion in gross terms.

The issuance strategy for the year focused on further developing the ‘long and very long‑end’ of the yield curve. This is consistent with the AOFM having gradually weighted new issuance into longer maturities, the purpose of which is to reduce the Government’s medium to long‑term exposure to interest rate volatility (through reducing the amount of funding it needs to raise overtime) and to ‘smooth’ the maturity profile of the outstanding stock of debt over a longer period. The average term to maturity of new issuance during 2014‑15 was over 10 years. With interest rates very low compared to historical experience, the long issuance bias remains an appropriate strategy for managing the costs and risks of the growing AGS portfolio

While market conditions have proved conducive the AOFM has been steadily lengthening the yield curve. Consistent with this and the AOFM’s stated aim of establishing a number of maturities around 20‑years, two new maturities were introduced in the ‘very long‑end’ during the year.

The United States (US) Federal Reserve began a wind‑down of its asset buying programme in December of 2013 and since then there has been considerable speculation as to when it would begin to raise the Federal Funds rate. As AGS yields tend to track changes in US Treasury bond yields, broad financial market expectations imply that there will be an increase in AGS yields following the commencement of such action on the part of the US Federal Reserve; but by year end this action had not commenced. At the same time, further uncertainty in Europe related to the possible widespread implications of a sovereign default within the European Union, and continuing low interest rate settings in Japan, have created some countervailing influences on bond yields.

Issuance to support the financing task

The Government’s budget financing requirement in 2014‑15 was fully met through regular competitive tenders and the use of syndications to establish a number of new maturities for the Treasury Bond yield curve. The regular supply of bonds to the market is recognised as an important role of sovereign issuers, as is the transparent and predictable delivery of issuance programs while maintaining sensible operational flexibility to manage periods of heightened market volatility.

Gross Treasury Bond issuance for the year totalled approximately $74 billion. Favourable market opportunities were used to establish four new Treasury Bond lines. In the ‘short‑end’ there were October 2019 and November 2020 maturities (to support the 3‑year futures contracts; to assist with reducing growth in the amount outstanding in future years in surrounding bond lines; and to reduce future within year funding requirement peaks). The 10‑year futures contract was supported by continuing issuance into existing maturities. In the ‘very long‑end’ new bond lines with maturity dates in April 2037 and June 2035 were established.

The AGS market continues to exhibit a diversity of investor types (with a wide geographic spread) and has retained strong ‘price making’ competition amongst a number of (intermediary) banks. The proportion of outstanding AGS owned by non‑resident investors appears to have peaked several years ago and the number of new central banks and sovereign wealth funds entering the market has diminished markedly. Domestic and non‑resident investor interest in ‘long’ and ‘very long’ dated maturities continued to emerge though 2014‑15 and this assisted in achieving a ‘long‑end’ issuance bias.

For Treasury Indexed Bonds, gross issuance for the year totalled approximately $4 billion. No new maturities were established during the year, but a programme of regular bi‑monthly competitive tenders was completed as planned. The Treasury Indexed Bond market for AGS continued to be dominated by domestic investor interest.

Once again the AOFM continued its programme of regular engagement with the market (both domestically and internationally). It also maintained its established practice of taking account of prevailing market conditions and feedback from financial market contacts about investor demand when selecting the bond lines to issue each week.

Portfolio management and outcomes

Throughout 2014‑15 the AOFM continued with its aim of increasing the average term to maturity (and duration) of the debt portfolio. The weighted average term to maturity of the stock of Treasury Bonds outstanding at the end of the year was 6.5 years, which has been increasing steadily from around 4.8 years at the end of 2009‑10.

Once again, sufficient periods of favourable market conditions and steadily growing interest by investors for longer dated AGS combined to allow for the overall portfolio objective to be further progressed. As noted above, this reduces the exposure of the Government to volatility in interest rates (and more specifically delays the impact on debt servicing costs of a future prolonged increase in the cost of borrowing). The issuance of Treasury Bonds with relatively long terms to maturity in a historically low interest rate environment remains a cost‑effective means of achieving this aim. As an example, issuing $1 billion in 20‑year bonds in a particular year avoids the need to issue and re‑issue $4 billion in five‑year bonds over the same period.

Residential mortgage‑backed securities

Although the AOFM has ceased investment in new residential mortgage-backed securities (RMBS), it continues to manage the existing portfolio to maturity.

In May 2015 the Treasurer issued a Direction that instructed the AOFM to commence a regular programme of divestment of the remaining RMBS portfolio. A programme of monthly competitive auctions was developed and commenced in late June 2015. The rate at which the divestment programme can be achieved will be dependent on a number of factors. One noticeable factor is investor demand for RMBS via the secondary market as compared with new primary market issuance as it becomes available. Another influencing factor will be credit market conditions generally, which will have an impact on the prices investors are willing to pay for RMBS notes offered at the regular auctions.

Looking ahead

The AOFM remains mindful of the need to consider further AGS market developments. While driven in large part by portfolio management objectives, these considerations will also be influenced by a number of related factors and will cover options for further yield curve extensions and the establishment of new maturities (issuance points) within the existing yield curve structures. Issuing new maturities in support of the three‑year and 10‑year futures market contracts remains a priority, as is further consolidation of a 20‑year benchmark. The establishment of a 20‑year futures contract by the ASX is an important market development which the AOFM views as complementary to its ‘long’ strategic issuance bias. The AOFM will also continue to monitor liquidity and how that may be affected by the outstanding size of individual bond lines; the structure of the market; and further regulatory developments that may impact sovereign bond market liquidity.

 

Rob Nicholl

Chief Executive Officer

 

Last updated: 28 January 2016