Review by the Chief Executive Officer
The AOFM’s core responsibilities continue to be managing the Government’s daily cash balances in the Official Public Account (OPA), meeting its financing requirements (through debt issuance), and managing the Australian Government Securities (AGS) portfolio. The annual term issuance program for 2015‑16 was $96.4 billion in gross terms — the highest in any financial year to date.
Once again it was a year during which global financial market conditions were at times volatile but, with a backdrop of the large ongoing quantitative easing programs of major central monetary authorities, the environment was largely supportive of sovereign fixed income assets. The AGS market remained attractive to global sovereign bond investors due to a range of factors including liquidity, relative credit quality, relative yields, transparency and regularity of issuance.
Since 2011, the AOFM has been gradually lengthening the AGS yield curve with a view to constructing a debt portfolio to meet a range of future scenarios, such as external shocks that could impact the fiscal position, prolonged volatility in interest rates, and heightened funding risk. The higher costs associated with issuing longer dated securities are justified by the benefits of lengthening portfolio duration. Other benefits include increased issuance options, and greater diversity in the AGS investor base. This is a long‑term strategy and it continues to be achieved at low cost by historical experience.
Although the proportion of AGS held by offshore investors has been steadily declining (and is now around 60 per cent compared with a peak of 76 per cent in 2012), global financial markets remain a significant influence on the AGS market. During the year there was continued speculation in financial markets about the likely pace of increases to the US federal funds rate given its ability to impact global bond markets. All other things equal, a rising US rate environment could see offshore demand for AGS ease and local bond yields increase. An offsetting factor, however, may be a continuation of extremely low (or even negative) yields on European and Japanese sovereign bonds. Attractive spreads to these markets may weigh in favour of continued demand for AGS in the year ahead.
Over 2015‑16 there was a marked decline in AGS yields and the yield curve flattened appreciably. Yields fell by around 60 basis points at the short end and over 100 basis points at the long end. The AOFM’s issuance and portfolio management strategy were appropriate given these moves.
The Treasury Bond issuance program was implemented through a combination of regular weekly competitive tenders, and syndications to establish new maturities. Consistency and transparency in the AOFM’s operations and communications with financial markets again provided a strong foundation for achieving the required issuance volume, while developing the AGS market.
In undertaking gross Treasury Bond issuance of $92.6 billion in 2015‑16, the AOFM was able to execute its planned portfolio strategy while also being responsive to a diverse investor base and providing continuing support for the 3 year, 10 year and 20 year futures contracts. Tender coverage ratios declined compared with the previous year, a reflection of the increase in primary issuance. The yield curve was again extended, with the establishment of a 2039 maturity. This new maturity consolidated the 20 year area of the curve and will support the 20 year Treasury Bond futures contract.
Gross issuance of Treasury Indexed Bonds for the year totalled $3.8 billion, most of which was issued via twice‑monthly competitive tenders. A new 2040 maturity was established to extend the indexed yield curve and support domestic investor demand for long dated inflation linked bonds.
The AGS market continues to attract a diverse range of investors and has retained strong ‘price making’ competition amongst a number of intermediary banks. While there has been some increased concentration in primary market participation through a reduced number of banks active in bond tenders, this effect has been less pronounced in Australia than in most other sovereign markets.
The interpretation of portfolio performance requires a strong element of judgment as changes to the structure of the portfolio can only be effected gradually and the core aims of minimising cost and reducing risk are often competing objectives. For example, the debt portfolio is de‑risked by issuing longer‑term debt; however, this will normally result in higher interest costs. Similarly, the cash management portfolio incurs increased carrying costs when cash balances are high; however, ample cash balances provide important cover for short‑term or unforseen Budget financing requirements and are necessary for funding large bond maturities.
Issuance undertaken in 2015‑16 further lengthened the average term to maturity of the portfolio. The lengthening strategy that has been in operation since 2011 has deferred the need to fund about $12 billion per year in maturities over the next five years. This is a considerable reduction in near‑term funding risk. Ongoing borrowing costs have continued to decline, in line with the lower interest rate environment. On average, the cost of new Treasury Bond issuance in 2015‑16 was 2.48 per cent, which compares with 3.79 per cent for the Treasury Bond portfolio as a whole.
The subdued inflation outlook resulted in relatively soft demand for Treasury Indexed Bonds, particularly during the second half of the year. The average cost of new issuance was 2.39 per cent, including the impact of inflation indexation, compared to 3.50 per cent for the indexed portfolio as a whole. Despite reduced investor appetite, the AOFM remains committed to supporting and developing the Treasury Indexed Bond market. Given that the indexed portfolio comprises only around 8.5 per cent of total long‑term debt on issue, there is flexibility in how this broad aim is achieved.
While lower interest rates reduce borrowing costs, they also reduced the return on investments and assets. The gross average return was 2.38 per cent for the year, compared with 2.82 per cent for the previous year.
In May 2015, the AOFM was issued a Direction to commence a program of regular divestment of the remaining residential mortgage backed securities (RMBS) portfolio. A program of monthly competitive auctions was developed and commenced in June 2015.
Four auctions were held between July and October 2015, before RMBS market conditions deteriorated to the point where the AOFM exercised its discretion to suspend the divestment process. As the Government is not a forced seller of the remaining portfolio, the AOFM (consistent with the intent of the Direction) favours holding the remaining, low risk portfolio over selling at a price that would incur a capital loss to the taxpayer. The suspension of auctions, and the AOFM’s intentions, have been communicated clearly to the market. By the end of the year the outlook for RMBS had not improved markedly. The auctions achieved sales totalling $297 million, and a modest gain was realised on disposal of the assets.
In addition to investor appetite for RMBS, credit market conditions generally will influence the AOFM in its deliberations regarding any resumption of the RMBS divestment process.
Over the past four to five years there has been much speculation about the outlook for global economic growth and inflation, changes to the conduct of monetary policy overseas, the increasing size of central bank balance sheets and the performance of sovereign bond markets. This speculation and uncertainty is likely to persist in the years ahead and the outlooks for each of these factors remain relevant to the AOFM’s deliberations.
The AOFM is mindful that amongst this challenging and uncertain backdrop, issuance programs are projected to remain elevated. These factors have been taken into account in determining an appropriate long‑term structure of the debt portfolio and the issuance strategy required to achieve it.
The AOFM remains focused on portfolio management objectives but does so with consideration of a number of market‑related factors. These factors relate to maintaining an efficient and effective sovereign bond market to support domestic financial market operations more generally.
Given the heightened uncertainty around future global financial market conditions, the AOFM has identified a need to dedicate more resources to understanding, anticipating, and responding to the associated sources of risk. This will be achieved through continuing discussions with investors, leveraging the research capability of domestic and international institutions, and directing some internal resources to longer range issues.
Chief Executive Officer
Last updated: 27 October 2016