Part 2: Performance and Outcomes
- 1 Performance and Outcomes
- 1.1 Introduction
- 1.2 Section 1: Annual Performance Statement
- 1.3 Section 2: Outcomes
- 1.4 Bond Issuance
- 1.4.1 Aims
- 1.4.2 Approach to achieving these aims and market influences
- 1.4.3 Outcomes
- 1.5 Debt portfolio management
- 1.6 Cash management
- 1.7 Residential mortgage‑backed securities
- 1.8 Market engagement
Performance and Outcomes
The role of the AOFM encompasses a number of principal functions that serve three key objectives. These key objectives are to: (1) meet the Budget financing task in a cost‑effective manner subject to acceptable risk; (2) facilitate the Government’s cash outlay requirements as and when they fall due; and (3) be a credible custodian of the AGS market and other portfolio responsibilities.
This part of the annual report is presented in two sections: Section 1 is focused on the PGPA Act requirement to provide an Annual Performance Statement; and Section 2 gives context to the outcomes achieved through the AOFM’s operations to support its principal functions and discusses relevant market aspects of the environment in which the AOFM operates.
The principal functions of the AOFM are:
- issuing AGS in accordance with Government policy objectives (such as promoting sovereign bond market liquidity);
- managing the aggregate daily cash balances in the Government’s Official Public Account (OPA);
- managing financial assets (including Australian Residential Mortgage‑Backed Securities (RMBS)) according to policy directives, or as part of broader portfolio management;
- the settlement and payment of Commonwealth financial obligations on AGS;
- developing risk assessments to undertake cost effective management of the debt and asset portfolios; and
- where appropriate, supporting the efficient operation of the Australian financial system.
The purpose of the AOFM is achieved through three key objectives (above). Table 1 presents the Annual Performance Statement, outlines these objectives, and provides a summary of key performance indicators and results for the year. The statement of results refers to detailed context in Section 2 of this part, which provides a comprehensive explanation of a range of outcomes important to the AOFM’s achievement of annual and longer‑term aims.
The Annual Performance Statement is prepared in accordance with paragraph 39(1)(a) of the PGPA Act.
Table 1: Annual Performance Statement 2016‑17
|Key performance indicator||Measure||Result|
|Objective: Meet the Budget financing task in a cost‑effective manner subject to acceptable risk|
|Term issuance||Shortfall in volume ($) between actual Treasury Bond issuance and planned issuance announced at the Budget and subsequent releases||
The shortfall in issuance was zero, with the financing task for 2016‑17 fully met through sufficient issuance ($106.25 billion)
Discussion from page 12
|Financing cost||The cost of the long‑term debt portfolio compared to the 10 year average of the 10‑year bond rate||
Debt issuance in 2016‑17 was cost effective, and consistent with the AOFM strategy of lengthening the average term to maturity of the nominal portfolio to reduce refinancing risk and variability in interest costs. The effective yield of the long‑term debt portfolio for 2016‑17 was 3.42 per cent (2015‑16: 3.76 per cent). This is below the 10 year average of the 10‑year bond rate of 4.15 per cent.
The average yield of Treasury Bond issuance (accounting for 97 per cent of all long term issuance) for 2016‑17 was 2.38 per cent (2015‑16: 2.48 per cent). This is below the 2016‑17 average of the 10‑year bond rate of 2.62 per cent (2015‑16: 2.61 per cent). The average term to maturity of the Treasury Bond portfolio was 7.13 years as at 30 June 2017 (2015‑16: 6.97 years). The average term of new issuance in 2016‑17 was 10.29 years (2015‑16: 9.41 years).
Discussion from pages 15 and 25‑28
|Objective: Meet the Budget financing task in a cost‑effective manner subject to acceptable risk (continued)|
|New issuance yields||Weighted average issue yield at Treasury Bond and Treasury Indexed Bond tenders less prevailing mid‑market secondary yields||
The weekly selection of bond maturities and issuance volumes for tenders facilitated continual efficient functioning of the primary market. This is reflected by average tender yields being below secondary market yields for Treasury
Bonds (‑0.40 basis points), and Treasury Indexed Bonds (‑0.79 basis points).
Discussion from page 18
|Objective: Facilitate the government’s cash outlay requirements as and when they fall due|
|Use of the overdraft facility||Number of instances the RBA overdraft facility was utilised to the extent that it required Ministerial approval during the assessment period||
Sufficient cash was available at all times to meet the government’s outlays such that there was no requirement during the year to use the RBA overdraft facility.
Discussion from page 30
|Objective: AOFM is a credible custodian of the AGS market and other portfolio responsibilities|
|A liquid and efficient secondary market||Annual turnover in the secondary market for Treasury Bonds and Treasury Indexed Bonds||
Annual secondary market turnover for Treasury Bonds was $1.1 trillion and for Treasury Indexed Bonds $42 billion in 2016‑17. This is adequate for the market to function effectively.
Discussion from page 19
|Number of times the AOFM securities lending facility was accessed and the aggregate face value amount of stock lent (excluding intraday borrowings)||
The securities lending facility was used 51 times (excluding intra‑day uses), but only for small volumes and generally for short periods.
Discussion from page 20
|Market commitments||Number of times the AOFM failed to undertake actions consistent with public announcements||All commitments were met.|
This section outlines AOFM operations undertaken in achieving its principal functions, and reports on the aims underpinning these operations and how these principal functions were achieved. It is presented according to five primary operational considerations: bond issuance; debt portfolio management; cash portfolio management; RMBS portfolio management; and market engagement. The discussion of each refers to underlying aims, how they are achieved and outcomes.
The AOFM currently has two term debt instrument choices — nominal Treasury Bonds and Treasury Indexed Bonds, the latter for which the capital value is adjusted over time according to inflation outcomes. During times of Australian Government Budget deficits the main aim of Treasury Bond and Treasury Indexed Bond issuance is to meet the budget financing task; however the issuance program is also determined such that it will assist with meeting overall debt portfolio aims (such as increasing the average term to maturity of the portfolio). The AOFM plans its programs each year to undertake issuance in a cost effective manner.
The AOFM also aims to support the efficient operation of Australia’s financial markets by being a credible custodian of the AGS market. This takes account of the following financial market activities:
- 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.
Another element of market efficiency that is important to issuers, intermediaries and investors is market liquidity. Bond market liquidity is broadly accepted to mean the ability to trade bonds at short notice and at low cost without materially moving prices. Strong liquidity is attractive to investors and reflects favourably on a sovereign bond market. There is no single measure of liquidity; it is an assessment by individuals (and institutions) based on a number of considerations. These considerations include, but are not restricted to, turnover in secondary markets, the frequency of primary market activity, bid‑offer spreads, and the time it takes to execute ‘large’ transactions (something in itself that has a different meaning to different parties).
Treasury bond buybacks
The AOFM repurchases Treasury Bonds before their maturity with several aims in mind: to increase the duration of the debt portfolio; reduce refinancing risk; assist in the cash management task around the time of bond maturities; enhance the operation of the secondary market; and assist the RBA in its liquidity management task on days of very large maturities.
Approach to achieving these aims and market influences
The AOFM only uses competitive tenders and syndications to conduct bond issuance. The use of competitive tenders remains the mainstay of AOFM’s issuance operations; 102 Treasury Bond tenders and 17 Treasury Indexed Bond tenders were conducted during the year. Three new Treasury Bond lines were launched via syndication. The first ‘syndicated tap’ of an existing bond maturity was held and this was for the 2040 Treasury Indexed Bond.
Buybacks of short‑dated Treasury Bonds were conducted via tenders, in conjunction with syndicated issues, and via bilateral transactions with the RBA.
Implementing the government’s largest ever term funding program while pursuing a strategy designed to lengthen the average term to maturity of the portfolio proved challenging, particularly during the latter part of 2016. Elevated weekly issuance volumes, low yields and constrained market‑maker balance sheets were reflected through higher repo rates, cheaper physical Treasury Bonds relative to futures, and lower coverage ratios at tenders.
The proportion of outstanding AGS held by offshore investors continued to fall over 2016‑17, as illustrated in Chart 1. This reflects a continued increase in the absolute level of non‑resident investment but not at a rate to match that at which the size of the market has increased. Australian‑domiciled investors, particularly bank balances sheets facing increased requirements to hold high quality liquid assets under Basel III, were a strong presence in the market in 2016‑17.
Strong offshore interest in long‑dated AGS was demonstrated in the syndicated issue of the 30‑year Treasury Bond, 65 per cent of which was allocated to non‑resident investors.
Chart 1: Non‑resident holdings of Australian Government Securities
Source: Australian Bureau of Statistics and the AOFM
Treasury bond buybacks
In May 2016 the AOFM announced its intention to begin a program of Treasury Bond ‘conversions’, seeking feedback on how this could best be implemented. Feedback indicated broad support for the plan, with clear understanding of and appreciation for the AOFM’s objectives; a preference for separate buyback and issuance transactions (rather than single transaction conversion tenders); simple, market‑based, transparent and competitive operations; and that Treasury Bonds shorter than those comprising the three‑year futures basket should be targeted.
A program of regular competitive buyback tenders commenced in September 2016. These operations are funded by separate tenders for issuance of longer‑dated Treasury Bonds. The AOFM expects that buyback tenders will add to its operational flexibility and become an accepted and enduring feature of the market.
There are two other ways in which the AOFM can repurchase bonds prior to maturity: switches or buybacks can be accommodated in conjunction with syndicated issues; and via transactions with the RBA, which purchases short‑dated Treasury Bonds in its liquidity operations.
Meeting the Budget financing task
The financing task for 2016‑17 was fully met. A total of $106.25 billion of term debt was issued during the year.
At the time of the 2016‑17 Budget, Treasury Bond and Treasury Indexed Bond issuance for the year was expected to total around $93 billion in face value terms. This volume was revised over the course of the year to meet the government’s increased financing requirement and to increase the cash balances managed by the AOFM as part of its assessment of liquidity risk.
Treasury Bond issuance
Gross Treasury Bond issuance for the year totalled $103 billion. This was the highest issuance program the AOFM has achieved to date. The bulk of this issuance was into existing bond lines in order to enhance market liquidity. In addition, three new Treasury Bond lines were launched in 2016‑17:
- a new bond line maturing in December 2021 was issued to support the operation of the three‑year Treasury Bond futures contract;
- a new bond line maturing in November 2028 was issued to support the operation of the 10‑year Treasury Bond futures contract and to reduce growth in the amount outstanding in surrounding bond lines, which will make it easier to manage maturity of those bonds lines; and
- a new bond line maturing in March 2047 was issued to lengthen the yield curve to include a 30‑year benchmark.
In selecting the bond lines to issue each week, the AOFM took account of its debt issuance strategy; prevailing market conditions; information from financial market contacts about investor demand; relative value considerations; scope for increasing the liquidity of outstanding bond lines; and the need to manage the maturity structure to limit funding risk. Two tenders were held during most weeks, typically comprising a tender of a long‑dated bond line and another of a short‑dated bond line. To facilitate tenders of ultra‑long‑dated (around 20‑year tenor) Treasury Bonds, three tenders were held in some weeks. The amount offered at each tender ranged from $300 million to $1 billion.
Large issuance volumes were achieved via the syndicated issues of new Treasury Bonds. The March 2047 ($7.6 billion), December 2021 ($9.3 billion) and November 2028 ($11 billion) issues were each the largest issue on record when they were held. This allowed a reduction in weekly tender issuance volumes from April 2017.
At the end of the year, there were 24 Treasury Bond lines, with 12 of these lines having over $20 billion on issue and 21 having over $10 billion on issue. Chart 2 shows Treasury Bonds outstanding as at 30 June 2017 and the allocation of issuance across bond lines during 2016‑17.
Chart 2: Treasury Bonds outstanding as at 30 June 2017 and issuance in 2016‑17
Extension of the Treasury Bond yield curve
Yield curve extension has been an integral component of the AOFM’s debt strategy for a number of years. The achievement of this strategy has added to the depth and diversity of the AGS investor base by appealing to longer duration investors while simultaneously providing the AOFM with greater flexibility in how it meets government financing requirements through time. Chart 3 demonstrates that 2016‑17 was the sixth consecutive year of yield curve extension and with the establishment of a 30‑year benchmark occurring in October 2016. Curve extensions have both facilitated and contributed to the AOFM’s lengthening strategy as reflected by an uplift in the average term to maturity of issuance and of the broader portfolio since 2010‑11, while also being central to the AOFM’s approach to managing risk and accommodating appreciable growth in the AGS market since the global financial crisis
Chart 3: Treasury Bond average term to maturity and length of yield curve (years)
Treasury Bond buybacks
A total of $12.3 billion of Treasury Bonds were repurchased ahead of maturity in 2016‑17:
- eleven Treasury Bond buyback tenders were conducted, at which $4.9 billion of bonds were repurchased;
- the AOFM repurchased $3.1 billion of bonds in conjunction with the syndicated issue of the new 21 December 2021 Treasury Bond;
- $4.4 billion of bonds were repurchased from the RBA; and
- a small amount of bonds were repurchased from retail investors who sold their holdings via the Australian Government Securities Buyback Facility.
- Buyback tenders are effectively a reverse of normal competitive issuance tenders. The AOFM sets the total volume of bonds it is prepared to buy back and offers from intermediaries are accepted from the highest yield (lowest price) in descending order until the total volume is reached. All buybacks other than those from retail investors were of Treasury Bond lines shorter than the three‑year futures basket.
The volume outstanding in short‑dated Treasury Bonds was reduced as illustrated in Chart 4.
Chart 4: Volume outstanding in short‑dated Treasury Bonds as at 30 June 2016 and 30 June 2017
Treasury Indexed Bond issuance
The AOFM’s alternative long‑term funding instrument to Treasury Bonds is Treasury Indexed Bonds, the capital values of which are adjusted with changes in the CPI. The issuance of these bonds typically attracts a different (and predominantly domestic) class of investor to Treasury Bonds and thus provides a source of diversification in the funding base. The regular issuance of Treasury Indexed Bonds re‑commenced in 2009‑10 following an extended absence from this market. While the indexed bond portfolio has declined marginally as a share of the long term funding, the total stock of indexed bonds has continued to grow steadily (as shown in Chart 5).
Chart 5: Treasury Indexed Bonds — average term to maturity and share of the long‑term funding base
Treasury Indexed Bond issuance for the year totalled $3.25 billion. Two tenders for the issue of Treasury Indexed Bonds were conducted in most months. The volume of each line outstanding, relative yields and other prevailing market conditions were considered in the selection of which line to offer. Complementing regular tenders, liquidity in the ultra‑long part of the TIB curve was assisted by a ‘syndicated tap’ of the August 2040 line. $700 million was issued in the tap, with the majority of demand from domestic fund managers.
Chart 6 shows the amount outstanding in each of the seven Treasury Indexed Bond lines as at 30 June 2017, and the allocation of issuance during the 2016‑17 year.
Chart 6: Treasury Indexed Bonds outstanding as at 30 June 2017 and issuance in 2016‑17
Efficiency of issuance
Table 2 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.
Table 2: Summary of Treasury Bond tender results
Despite the pronounced market congestion experienced at times in the latter half of 2016, the average coverage ratio for all Treasury Bond tenders in 2016‑17 was 3.41, an increase from 2.99 in 2015‑16. The average tender size of $736 million was lower than in 2015‑16 despite the higher issuance program. This was due to the large volumes of issuance achieved via syndication and more tenders of ultra‑long bonds, which tended to be for smaller volumes. Shorter‑dated bond tenders generally received a greater volume of bids (higher than average coverage ratios), which reflected core investor base interest.
The strength of bidding at tenders was also reflected in competitive issue yield spreads to secondary market yields. At most Treasury Bond tenders the weighted average issue yields were below prevailing secondary market yields.
The average coverage ratio was 3.14 for Treasury Indexed Bond tenders, a decrease from 3.69 in 2015‑16. At most tenders, the weighted average issue yields were below prevailing secondary market yields.
Full tender details are available in Part 5 of this annual report.
Market liquidity and efficiency
The Treasury Bond market operated smoothly during 2016‑17 with liquidity and efficient price discovery being maintained throughout the year. However, there were times during the second half of 2016 when repo rates were elevated and Treasury Bonds traded at cheap levels relative to bond futures.
In previous years, data on secondary market turnover in Treasury Bonds has been obtained from the Australian Financial Markets Association (AFMA). With changes in the AFMA data collection methodology and in order to have a clearer understanding of turnover in AGS, the AOFM began collecting secondary market turnover data from market‑makers from July 2016. Total secondary market turnover of Treasury Bonds in 2016‑17 amounted to $1.1 trillion.
Although liquidity in Treasury Indexed Bonds remains good compared to global inflation‑linked debt markets, it has continued to prove noticeably more challenging than for Treasury Bonds. This is consistent with the relative liquidity of nominal and inflation‑linked securities in other sovereign debt markets. Market participants reported that large trades may have to be executed carefully and over time, and larger transactions can at times move market prices. Treasury Indexed Bond turnover in 2016‑17 was around $42 billion.
There was tightness in the August 2040 TIB for several months, requiring some market participants to borrow that line from the securities lending facility. To assist the operation of the TIB market and build liquidity, the first syndicated tap of an existing indexed bond (the August 2040 TIB) was conducted in February 2017.
Turnover in the Treasury Bond futures market is significantly higher than in the underlying Treasury Bonds. The three and 10‑year Treasury Bond futures contracts are highly liquid: over 53 million three‑year contracts (representing $5.3 trillion face value of bonds) and over 42 million 10‑year contracts ($4.2 trillion face value of bonds) were traded in 2016‑17. Turnover in the 20‑year contract is considerably lower: 545 thousand contracts ($27 billion face value of bonds) were traded. All contract close‑outs in 2016‑17 occurred smoothly.
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 in the secondary market. This enhances the efficiency of the market by improving the capacity of intermediaries to continuously make two‑way prices, reduces the risk of settlement failures and supports market liquidity. The facility was used 51 times for overnight borrowing in 2016‑17 compared with 29 times during 2015‑16. However, the volumes borrowed tended to be small, with the total face value amount lent in 2016‑17 being $388 million, an increase from $261 million in the previous year.
In managing the Commonwealth’s debt portfolio and meeting the Government’s financing requirements, 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.
To meet these aims the AOFM endeavours to execute a debt issuance strategy that appropriately accounts for the trade‑offs between cost and risk while simultaneously providing effective and transparent stewardship of the AGS market in order to underpin confidence and promote participation in the market. Through its strategy and operations the AOFM contributes to an efficient and resilient market while providing continuity of access to financial markets for the Australian Government.
The AOFM uses 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 AGS, 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. The use of an historic 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. Fair value is useful in circumstances where it is possible that changes in market value may be realised in the future.
Approach to achieving the aims
Variability in portfolio outcomes 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 interest cost outcomes over time. Debt issuance decisions made today impact the variability of future interest cost outcomes because of their influence on the maturity profile of the portfolio and hence the amount of debt that needs to be refinanced (and ‘re‑priced’) through time.
The AOFM influences the cost and risk profile of the portfolio primarily through the maturity structure of the debt securities it issues (and to a lesser extent, the mix between nominal and inflation linked securities). Issuing longer‑term securities will typically involve paying higher debt service costs (in the presence of a positive term premium) although this is compensated by reduced variability in future interest cost outcomes and lower exposure to refinancing or rollover risk. Issuing shorter term debt securities by contrast will typically be cheaper (avoiding a term premium) but result in higher variability in cost outcomes through time and a greater debt refinancing task. Striking the right balance between these cost and risk considerations is the debt manager’s ongoing challenge.
Strategic decision making around the portfolio is informed by an ongoing research program focussed on exploring the cost and risk characteristics of alternative portfolio structures and issuance strategies. This is done in light of prevailing fiscal and economic circumstances. Drawing on this research, a strategy for the structure and composition of issuance for the financial year was formulated and ultimately approved by the Treasurer. Separately, a range of complementary limits, thresholds, guidelines and targets governing the AOFM’s operations were submitted to the Secretary to the Treasury for approval through an Annual Remit. Implementing the strategy requires weekly operational issuance decisions such as determining how much and which lines to issue or when a new maturity should be established. These operational decisions were influenced by several factors including general market conditions, relative value considerations and feedback from investors. The ongoing suitability of any issuance and portfolio strategy is constantly under review.
During the year, the total volume of Treasury Bonds outstanding increased by around $79 billion, to $464 billion.
Portfolio risk management
The AOFM’s strategy in 2016‑17 followed a similar theme to recent years. This involved focussing on lengthening the maturity structure of the overall debt portfolio in order to accommodate growth in outstanding debt levels while limiting growth in the volume of maturities to be re‑financed each year. The strategy also aimed to increase the diversity of issuance options available to the AOFM and to facilitate further diversification of the investor base. The strategy was influenced by a range of factors including a continuation of low outright bond yields, below average term premium (which increases the cost‑effectiveness of longer term issuance), an elevated financing task in 2016‑17 and an external environment characterised by a number of political and geopolitical events with the potential to generate uncertainty in markets. A bias towards issuance of longer maturity bonds and yield curve extension continued to form the backbone of the AOFM’s portfolio management strategy, although, this was complemented for the first time by a regular program of bond buyback tenders (introduced from September 2016 onwards) to aid in the management of refinancing risks around near maturity lines and contribute to the efficient operation of the AGS market.
Chart 7 demonstrates the lengthening bias implicit to the AOFM’s strategy with the average Treasury Bond issued in 2016‑17 having a term to maturity of 10.29 years. The issuance program continued to benefit from low interest rates and was delivered cost effectively, with an average yield on issuance of 2.38 per cent which is lower than the average 10‑year bond yield over the course of the financial year of 2.43 per cent.
Chart 7: Treasury Bond issuance — average yield, term to maturity and 10‑year bond yield
Chart 8 shows that the average term to maturity of the Treasury Bond portfolio as a whole lengthened by 0.16 years to 7.13 years over 2016‑2017. Duration was slightly lower due to a combination of bond yields moving higher over the year and the proximity of the July 2017 maturity to financial year end. The effective cost of funds or yield on the Treasury Bond portfolio fell from 3.50 to 3.22 per cent over the same period.
Chart 8: Treasury Bond portfolio — modified duration, average term to maturity and cost of funds
The reduced risk levels of the portfolio flowing from the lengthening strategy are demonstrated in Chart 9 below. The chart shows a steady decline in the short to medium term Treasury Bond refinancing task, measured as the proportion of the stock of Treasury Bonds on issue through time. At 30 June 2010 the structure of the portfolio was such that 43 per cent and 65 per cent of bonds required refinancing over the next three and five year periods respectively; this has now fallen to 26 per cent and 41 per cent. These reductions translate directly into lower medium‑term gross borrowing programs. The AOFM estimates that annual Treasury Bond issuance is about $15 billion per annum lower on average over the next five years as a result of the lengthening strategy. This provides the AOFM with greater operational flexibility around how it meets future government financing requirements while also reducing the impact of future movements in interest rates on debt servicing costs.
Chart 9: Treasury Bond maturity profile
The debt servicing cost of the net AGS portfolio managed by the AOFM in 2016‑17 was $15.69 billion on an average book volume of $445.27 billion, representing a net cost of funds of 3.52 per cent for the financial year. The largest component of net AGS debt is the Long Term Debt Portfolio (LTDP), comprised primarily of Treasury Bonds and Treasury Indexed Bonds, which incurred debt servicing costs of $16.37 billion on an average book volume of $478.38 billion, implying a cost of funds of 3.42 per cent. The difference between net AGS debt and the LTDP is attributable to the short term assets and liabilities the AOFM uses for liquidity management purposes (term deposits and Treasury Notes) and other residual assets (such as RMBS).
Chart 10: Net AGS debt and Long Term Debt Portfolio cost of funds analysis (per cent)
Chart 10 shows the funding cost profile of the net AGS debt portfolio and the LTDP back to 2007‑08. These profiles are contrasted with the cash rate and the 10‑year moving average of the 10‑year bond yield. With interest rates trending down, funding costs on the net debt portfolio and the LTDP have declined by 167 and 185 basis points respectively since 2010‑11. This compares to declines of 325 basis points in the cash rate and 141 basis points in the 10‑year bond yield moving average over the same period. Given the largely fixed cost structure of the net debt portfolio and the LTDP, changes in funding cost will always lag changes in the overnight cash rate (changing only when existing debt securities or assets mature or new securities are issued/investments placed). In a comparison with the 10‑year bond yield moving average, funding costs have fallen further because of the relative ‘over‑representation’ of recently issued debt in the portfolio through a period where issuance yields have been declining.
Table 3 provides further details of the cost outcomes for the portfolio of debt and assets administered by the AOFM broken down by instrument and portfolio for 2015‑16 and 2016‑17.
Table 3: Commonwealth debt and assets administered by the AOFM
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.
(a) Interest expense and effective yield on foreign loans incorporates foreign exchange revaluation effects.
(b) Re‑measurements refer to unrealised gains and losses from changes in the market valuation of financial assets and liabilities.
The cost of gross debt increased in dollar terms by $828 million compared to the previous year. This was primarily due to an increase in the average volume of debt on issue from $417.85 billion in 2015‑16 to $482.73 billion in 2016‑17. In percentage terms however, the funding cost of gross debt declined by 33 basis points (from 3.74 per cent to 3.41 per cent). This improvement was driven by the issuance of new bonds through the year at yields that were below the average of pre‑existing (and maturing) debt. Low rates also reduced the yield on funds invested in term deposits from 2.01 to 1.72 per cent and RMBS investments from 3.37 to 2.93 per cent.
The return on gross assets in dollar terms for the period was $754 million, a decrease of $12 million compared to 2015‑16. This was driven by a $42 million reduction in income from RMBS (resulting from the maturity of existing investments and lower interest rates) which was partially offset by a $33 million increase in income from term deposits resulting from holding higher balances through the year.
The net servicing cost of the combined portfolio of debt and assets was $15.69 billion. This was higher in dollar terms compared to 2015‑16, due to the volume of debt on issue being higher than the previous year. As a percentage of net debt, servicing costs fell from 3.85 per cent to 3.52 per cent, a product of more expensive historically issued debt maturing and continued issuance over the year into a low interest rate environment.
Movements in market interest rates had a favourable impact on the market value of the portfolio in 2016‑17. Unrealised gains from re‑measurements amounted to $19.40 billion. This compares to an unrealised loss of $17.63 billion in the previous year. About 94 per cent of re‑measurement gains are attributable to the lower market value of Treasury Bonds. Re‑measurement items are highly volatile from one year to the next and 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, for example Treasury Notes and near maturity bonds, 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 and funding risk. In practice, the AOFM has been seeking to reduce these risks, through allocating a greater proportion of issuance to long dated lines.
The AOFM manages the daily cash balances of the Australian Government in the OPA. This is undertaken in a manner that ensures the government is able to meet its financial obligations as and when they fall due. Other objectives are to minimise the cost of funding and the carrying cost of holding cash balances (which centres on holding only balances assessed as prudent to cover forecast needs and contingencies, while investing excess balances but at low or minimal risk). In minimising cost, the AOFM seeks to avoid use of the overdraft facility provided by the RBA.
Approach to achieving the aims
Achieving the cash management objective involves formulating forecasts of government cash flows, and developing and implementing appropriate strategies for short‑term investments and debt issuance.
A precautionary asset balance is maintained to manage the forecasting risk associated with potentially large unexpected cash requirements (or shortfalls in revenue collections) and the funding risk associated with market constraints.
Cash balances not required immediately were invested in term deposits at the RBA, with the magnitudes and tenors of the term deposits determined by the AOFM. Maturity dates of term deposits were selected to most efficiently finance net outflows. Interest rates for term deposits at the RBA reflect the rates earned by the RBA in its open market operations.
Treasury Notes are issued to assist with management of the within‑year funding requirement. The volume of Treasury Notes on issue ranged from $3 billion to $6.5 billion during 2016‑17.
The size and volatility of the within‑year funding requirement are reflected in changes in the short‑term financial asset holdings managed by the AOFM, after deducting Treasury Notes on issue. Chart 11 shows movement in the funding requirement over the year.
Chart 11: Within‑year funding requirement 2016‑17
The task of meeting the government’s financial obligations as and when they fall due was fully met, without use of the overdraft facility provided by the RBA.
During 2016‑17, the AOFM placed 424 term deposits with the RBA. The stock of term deposits fluctuated according to a range of factors influencing the AOFM’s cash portfolio management needs and decisions. The balance of term deposits ranged from a minimum of $14.6 billion in February 2017 to a maximum of $66.4 billion in June 2017.
The average yield obtained on term deposits during 2016‑17 was 1.72 per cent, compared with 2.01 per cent in 2015‑16. The decrease in average yield reflects the lower average level of interest rates that prevailed during 2016‑17.
A total of $13 billion of Treasury Notes were issued in 2016‑17 (in face value terms). The average coverage ratio at tenders was 3.35, an increase from 3.19 in 2015‑16. Yields were on average around 10 basis points higher than Overnight Indexed Swap (OIS) rates for corresponding tenors (compared to around eight basis points higher than OIS rates in 2015‑16). Details are available in Part 5 of this annual report.
The movement in total short‑term financial asset holdings managed by the AOFM (OPA cash balance plus term deposits with the RBA), together with the volume of Treasury Notes on issue during 2016‑17 are shown in Chart 12.
Chart 12: Short‑term financial asset holdings and Treasury Notes on issue 2016‑17
In undertaking its cash management activities, the AOFM was required to maintain a 91‑day moving average of the daily OPA cash balance below the Ministerially approved upper limit of $1.5 billion. Given the significant increases in government cash flows since the limit was agreed, the Minister for Finance and the Treasurer agreed to remove the limit in February 2017. The limit was replaced by a set of cash management principles which require that balances in the OPA be sufficient to meet the Commonwealth’s operational needs without being excessive, with use of the overdraft facility expected to be infrequent and in general only to cover unexpected events (due to timing or quantum or both) . The AOFM has developed an operational framework to adhere to the principles.
Movements in the 91‑day rolling average OPA cash balance over the year are shown in Chart 13.
Chart 13: 91‑day moving average cash balance 2016‑17
During the period October 2008 to April 2013, the AOFM was directed to invest up to $20 billion in eligible RMBS to support competition in mortgage lending. In total, just under $15.5 billion was invested. On 5 May 2015, the Treasurer issued a new Direction under the PGPA Act to divest the Government’s RMBS portfolio through a regular competitive process.
The Treasurer’s Direction requires that sales must not exceed $500 million per month and that the AOFM should exercise its discretion on timing and sales volume to minimise potential market disruptions. The Direction also provides the AOFM with discretion to cancel a sale or suspend the auction process when RMBS sales cannot occur at a price level that the AOFM considers to be acceptable.
Approach to achieving the aim and market influences
Consistent with the Treasurer’s Direction, the AOFM commenced a competitive sales process for the Government’s RMBS portfolio in June 2015. Under the current Direction, five auctions were held in which RMBS with an amortised value of around $458 million were sold. Conditions affecting the Australian RMBS market deteriorated during 2015 such that in November 2015 the AOFM exercised its operational discretion to suspend RMBS auctions until further notice.
The RMBS auction process remained suspended throughout the 2016‑17 financial year. While credit markets improved for much of the year, the AOFM considered that market conditions were not conducive to achieving satisfactory prices for the taxpayer.
Chart 14 plots the amortised book value of the AOFM’s RMBS portfolio through time on the left axis. The histogram component of the chart decomposes quarterly movements in this (stock) series into volumes purchased and sold by the AOFM and the portfolio’s natural amortisation that has occurred as mortgage principal repayments have been passed through to investors. Also included within the histogram are quarterly issuance volumes within the primary RMBS market beyond those volumes purchased by the AOFM. RMBS revaluation spreads, based on trading margins above BBSW observed in the secondary market, are plotted on the right axis. These highlight that while trading margins improved throughout 2016‑17, they finished the year slightly above the levels seen in late 2015 when auctions were suspended, and around 30 basis points per annum higher than the post‑crisis lows of mid‑2014.
Chart 14 also highlights that the RMBS market achieved quarterly primary issuance volumes of greater than $7 billion in all but the first quarter of the 2016‑17 financial year. Furthermore, the second and fourth quarter of the financial year ranked in the top five quarters since the global financial crisis in terms of primary issuance volumes.
The chart also demonstrates that the reduction in the stock of outstanding RMBS investments held by the AOFM has been driven by amortisation to a much greater extent than by sales. Of the total of just under $15.5 billion in RMBS purchased, around three quarters had been returned via amortisation, slightly over an eighth had been realised through sales and slightly under an eighth remained outstanding as at 30 June 2017. While divestments have accounted for a modest share of capital returned to date, they have had a noticeable impact on the rate of decline of the portfolio’s outstanding balance through most of the period between early 2013 and mid‑2014 and again in the second half of 2015.
Chart 14 also illustrates that of total divestments of just under $2 billion made since March 2010, just over three quarters were achieved on a reverse enquiry basis prior to 30 June 2014, including around 60 per cent between May 2013 and June 2014. Less than a quarter of sales have been achieved under the competitive auction process that commenced in 2015.
Chart 14: RMBS investments, amortisation and divestments
Source: AOFM, Macquarie Debt Markets Analysis
Turning to the financial performance of the RMBS portfolio, the weighted average margin over the one month bank bill rate of the AOFM’s RMBS book remained stable over the financial year at around 127 basis points per annum. Accrual interest income in 2016‑17 was approximately $70 million. This represented an annualised accrual return of 2.93 per cent on the portfolio’s average book value of $2.379 billion. This is lower than the corresponding rate of return in 2015‑16, due largely to lower prevailing short term interest rates.
Losses or gains in the market value of the portfolio change with prevailing conditions and therefore vary at any particular point in time. These are not realised returns and so are excluded from the accrual measure, but are included as re‑measurements within the AOFM’s comprehensive income statement treatment.
The RMBS securities held by the AOFM are valued using indicative ‘bid’ margins in secondary markets as estimated by an independent valuation service provider. The cumulative unrealised profit on the portfolio was $5 million as at the end of the financial year, a gain in value of around $15 million versus the year before. This improvement was due to the compression of revaluation spreads illustrated in Chart 14. The total return on the RMBS portfolio for 2016‑17, including re‑measurements, was thus around $85 million, or approximately 3.56 per cent of the portfolio’s average book value.
In order to achieve its core objectives the AOFM needs to maintain a comprehensive understanding of market related issues including major announcements and events, impacts on the global flow of capital, changing investor preferences, and the performance of banks that play the role of intermediaries — particularly in the primary AGS market, on which the AOFM relies exclusively for access to end investors. While this latter aim can in part be served by assessing announced regulatory changes there remains the need for a heavy emphasis on maintaining strong lines of communication directly with intermediaries and (both directly and indirectly through intermediaries) with end investors. Communication with intermediaries is frequent and with investors it is based on an investor relations program. The program is underpinned by an investor relations strategy that is reviewed annually, in response to changes in market conditions, investor activity and changes in the key investor base and/or the AOFM’s planned issuance strategy.
Achieving the Aims
The Investor Relations strategy in 2016‑17 focused on identifying opportunities to promote further diversity in the AGS investor base while maintaining and managing engagement with current key investors.
There were four parts to the investor relations strategy:
- targeted direct engagement with investors in specific geographic regions (in particular Europe, Asia and Japan), and the current key investor base, together with monitoring emerging interest from new and potential investors;
- a regular use of face‑to‑face investor meetings (both within Australia and offshore);
- increased use of opportunities to present to conferences or speaking events to groups of investors; and
- use of the AOFM website to provide updates for investors.
Of greatest interest to investors throughout the year were discussions about AGS market conditions, AOFM plans for issuance and further market development (with particular interest around yield curve extensions), and AOFM assessments on the changing composition of the AGS investor base.
With investors in the AGS market growing in number and geographic diversity, the ability to engage and/or meet with them regularly is becoming increasingly challenging. Domestic investors are easily accessible and therefore this part of the task is relatively straightforward and occurs with established regularity. The range and geographic locations of the non‑resident investor base means that the AOFM will not have direct contact with most of these investors throughout the year. At the same time as new institutions such as fund managers, banks and hedge funds enter the market for the first time and current investor holdings and their activities within the market increase, the number of key AGS investors has also grown. Managing the choice between how, when, where and who to engage with during the year, remains a key priority and judgement.
A significant part of the investor engagement task over the last five to six years has involved understanding the potential demand for ultra‑long AGS and explaining the AOFM’s planned issuance and yield curve extension strategy. Experience has shown that issuer transparency and reputational credibility are important factors for investors. With the issuance of a 30‑year benchmark bond in October 2016, this signalled completion of the yield curve extension strategy, however some effort went in to updating investors on the AOFM’s ongoing issuance into the long end of the curve.
With this in mind, many of the 131 individual meetings (up from 116 last year) conducted throughout the year, were with investors focusing on long dated (ultra‑long) AGS. Of the total number of meetings 29 were with new investors. Most of these new investors were offshore (i.e. non‑resident) and these included bank balance sheets and fund managers.
The investor engagement strategy has proved useful in achieving the aims of enhancing the AOFM’s understanding of the investor base and explaining its market development and issuance strategies. However, in the latter half of the year investors have been advised that as the AOFM has completed its yield curve extensions and its issuance pattern is now familiar and broadly predictable the frequency of engagement will abate.
A continued focus for the year was on the Asian region (with two roadshows, one each at the start and end of the year). This series of meetings involved a number of new investors in the region. London also provided opportunity to engage with a number of investors not previously met, as well as meetings with many of the key well‑known investors. Certain European countries, particularly those with large defined benefit pensions and growing funds management industries, are showing emerging interest for AGS.
Although no face‑to‑face meetings were organised in Japan in 2016‑17, the AOFM conducted its 3rd Australian Government Fixed Income Forum (AGFIF); this was in October 2016. This AGFIF was the largest hosted by the AOFM so far. The Treasury Secretary provided the key note address while the AOFMs CEO and the CEOs of the four largest state borrowing authorities also spoke. Along with the individual presentations, two panel discussions were held, with senior officials from the domestic funds management and securitisation industries speaking.
Chief Executive Officer Rob Nicholl presents to Australian Government Fixed Income Forum in Tokyo, Japan
A total of 70 individual investors from 51 different institutions attended the AGFIF. Based on direct and indirect feedback from financial market participants the AGFIF is deemed to offer an efficient way to provide a general issuance update to the Tokyo investor community (which is now the single largest concentration of investors for the AOFM).
Australian based investors continued to grow in importance, particularly in the banking sector. Not only were the larger Australian banks more active in in AGS but an increasing number of medium sized and smaller ADIs were also active. Domestic fund managers continued to remain key investors and their importance was prominent, particularly in their participation of new long bond syndications. The domestic support for AGS issuance was obvious from the continued decline in non‑resident holdings through the year, with the proportion of AGS held by non‑resident investors falling to around 55 per cent in the June 2017 quarter. However the absolute holdings by non‑residents continued to rise but the rate of increase has not matched the rate of increases in AOFM issuance (the difference being absorbed by the domestic investor base).
The AOFM continued to participate in third party sponsored conferences and events. These engagements provide a useful platform to reach a greater audience per day of effort. While these events do not substitute for the benefits derived from face‑to‑face meetings, they do offer opportunity to offer useful updates to investors and usually offer opportunity for short face‑to‑face meetings with some attendees.
As well as face‑to‑face meetings and presentations, the AOFM again conducted a number of phone meetings with international and domestic investors throughout the year. Regular fortnightly calls with ten domestic Treasury Indexed Bond investors have assisted in the selection of individual lines to tender and were useful in gauging demand for Treasury Indexed Bonds in general.
Table 4: Summary of investor relations activities in 2016-17
|Conferences, speaking engagements and investor roadshows||16 events|
|Presentations: large engagements/ roundtables||7 presentations|
|Approximate total audience size: large presentations||315 attendees|
|Individual meetings||131 investor meetings|
|Individual cities visited||19 cities|
|AOFM staff participating in investor relation activities||CEO, Head of Investor Relations, Head of Funding and Liquidity, Senior Strategist Investor Relations, Acting Communications Officer Investor Relations, Analyst Funding and Liquidity|
|Hosting banks: Investor roadshows, conferences, roundtable discussions||ANZ, Commonwealth Bank, Deutsche Bank, UBS, Westpac|
 The term premium is the additional yield demanded by investors in order to hold a long‑term bond instead of a series of shorter‑term bonds.
 Refinancing risk, also referred to as rollover risk, is the inability to renew maturing debt by further borrowing.
 The profile of modified duration over any span of time is rarely smooth. In particular it will tend to jump when bond lines mature or when the AOFM executes very large issuance transactions. It is also inversely correlated with movements in bond yields.
 These are point in time measures as at 30 June each year, in contrast to the debt servicing cost incurred throughout the year captured in Table 3. Figures are calculated by weighting Treasury Bond issuance yields by book volume.
 In absolute dollar terms, the quantum of three and five year maturities in the portfolio has still grown although this has occurred at a considerably slower pace compared to growth in the overall stock of Treasury Bonds.
 Debt servicing cost includes net interest expense (measured on an accruals basis and includes realised gains and losses on the disposal of assets or liabilities) plus foreign exchange revaluation gains and losses (now minimal). Unrealised changes in the market valuation of domestic debt and assets are not part of this measure.
 Bond issuance over the past four financial years for instance accounts for around ¾ of the LTDP as at 30 June 2017. Bond yields over this period were on average significantly lower than the preceding years which largely explains why portfolio funding costs have fallen by more than the 10‑year bond yield moving average.
 The 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.
 Copies of each Direction are available on the AOFM website.
 The Directions that provided for sales to be made on a reverse inquiry basis were issued under the FMA Act and ceased with its repeal in June 2014. The Direction issued in May 2015 was issued under the PGPA Act.
 Information on the realised gains made on the sale of RMBS for each financial year since 2009‑10 can be found in the AOFM’s 2015‑16 Annual Report.
Last updated: 2 November 2017