CEO presentation at the 3rd Australian Government Fixed Income Forum, Tokyo
21 October 2016
The importance of the Australian-Japanese fixed income relation and an update on the AGS funding task for 2016-17 – Rob Nicholl, CEO.
Good afternoon ladies and gentlemen and welcome to you all.
The AOFM again takes pleasure in hosting this – the 3rd Australian Government Fixed Income Forum. Since our first event in December 2013 it has attracted increasingly wider interest from the Japanese investor community.
This year we have with us over 90 people from 62 different Japanese investment businesses representing a diverse array of institutions.
For the forum to remain relevant, it is important to increase the diversity of the audience it attracts. To this end over 30 Japanese institutions new to the forum were invited; this including regional banks and agricultural cooperatives. Nine of these types of institutions are attending today. We also have representatives from another 13 institutions that have not attended before.
In hosting the forum it is not our expectation that everyone will be looking to invest in Australian Government bonds – although we wouldn’t want to discourage that. The point of it is to provide you an overview of and update on the Australian fixed income market and its various components.
But what I will do in this session is cover four aspects:
- an overview of the fiscal relationship between the national and semi-governments –which will be familiar to some but not all of you;
- an overview of the key features of the sovereign market – for which the AOFM has responsibility;
- an update on our issuance program and market development; and
- I will finish with some comments on the investor base – highlighting the importance of Japanese investors to the overall Australian fixed income market.
Australian Fixed Income Market
However, before doing that let me give you a picture of the overall size and composition of the Australian market.
This chart maps growth in the various fixed income asset classes over the last decade, with the total issuance outstanding now around $1.4 trillion.
CHART 1: THE AUD DEBT MARKET – Debt stock outstanding
Note: Data on asset-backed securities excludes self-securitisations of residential mortgages by ADIs. Source is Australian Bureau of Statistics and the Reserve Bank of Australia.
The things to note are that total government sector debt (which includes the Australian Government and the semi-governments) has grown appreciably since the global financial crisis – it was about 10% in 2008 but as at December last year it represented just under half of the total market. You can also see the increased presence of the (mainly European) SSA sector issuing in AUD – which lends further support to the growing importance of the Australian currency.
The size of the Australian domestic financial sector was beginning to expand rapidly in the lead-up to the global financial crisis, but its share of the non‑government sector, as you can see, has since remained steady.
Today we will specifically be covering the Australian sovereign bond market; the main semi-governments and the asset backed sector (which in this chart is the light blue section – but which excludes self-securitised residential mortgages). You will also hear some perspectives from Australian fund managers.
One of the reasons why Japanese fixed income investors view AUD fixed income favourably is because there is a variety of securities with differing yields, credits and duration – and they are available in reasonable volumes. Japanese investors have occasionally said to me, that they would buy more AUD fixed income securities if there were more on issue and there were a greater variety of issuers and credits available. I would argue that for better or worse, the volume continues to grow, yields remain relatively attractive, and with development of the sovereign market as a benchmark there is opportunity for other AUD issuers to develop their yield curves.
Commonwealth-State Financial Relations
Let me turn briefly to an overview of the main financial relationships between the Australian Government and the semi-governments.
The reason this is important is because the semi-governments are heavily reliant on the national government as a source of budget revenues and this gives context to the presentations by each of the semi-government chief executives later in the program.
The Australian Government currently raises about three quarters of total public sector revenues, the greatest proportion of this being through income taxes.
Because the semi-governments collectively raise only 25 per cent of total public sector revenue, but have responsibility for around 40 per cent of national expenditure – a system of fiscal transfers between the two levels of government is required to rebalance this situation.
This chart shows that on average the semi-governments, therefore, rely on the Australian Government for about 45 per cent of their budget revenues.
CHART 2: COMMONWEALTH-STATE FISCAL TRANSFERS
You can also see the relative importance for each of the semi-governments own tax bases, and in turn their reliance on the intergovernmental fiscal transfer system (the two top-shaded areas of each bar). The chart shows that Northern Territory and Tasmania are most reliant on fiscal transfers.
The two most important mechanisms by which the Australian Government makes revenue transfers to the semi-governments are ‘General Purpose Payments’ and Specific Purpose Payments’. The first can be spent by semi-governments however they choose – the second are payments made by the Australian Government conditional on semi-governments using the revenue toward pre-determined activities.
‘General Purpose Payments’ involve a formal agreement for the Australian Government to transfer in full the collection of a national Goods and Services Tax (the GST). The relative importance of GST transfers is represented by the middle grey part of each bar.
GST transfers are distributed between semi-governments on an adjusted per capita basis, taking into account their inherent revenue raising and expenditure challenges relative to the average experience across them collectively.
This means that semi-governments with relatively stronger economic performances and lower costs of providing public services will receive a lower per capita share than other jurisdictions. Western Australia has been a notable example of this in recent years with strong commodity royalties resulting in it receiving lower GST allocations.
The so-called Specific Purpose Payments (the light blue sections at the top of each bar) are fairly broad in nature, but in most part go to supporting the semi-governments in providing key services, such as health and education. On average these conditional payments provide about 20% of semi-government revenue. Unlike the GST arrangement, these transfers are not made from a dedicated tax base.
The important thing to note, however, is that national economic performance acts in a way like a safety net for the relative revenue performance of individual semi-governments.
Australian Government Securities Market
Turning to the second broad aspect of this session, the following are fundamental specifics of the sovereign bond market, for which the AOFM is responsible.
The AOFM issues three forms of government securities –each only issued in AUD. There are two types of long-term issuance that are used to fund the Australian Government budget – these are: Treasury Bonds (or nominal bonds, which comprise over 90% of our long-term debt portfolio); and Treasury Indexed Bonds (for which the capital value is adjusted over time according to inflation outcomes).
A third instrument is our equivalent of US Treasury Bills – a cash instrument called Treasury Notes. They range in maturity up to 12 months and are issued at a face value discount to reflect the absence of a coupon payment. The Treasury Note market is relatively small and we issue them primarily to help with management of the Australian Government’s cash portfolio. We issue relatively small volumes on a regular basis, but there is no pre-determined program in any year.
CHART 3: TREASURY BOND PORTFOLIO
This chart shows the maturities and volumes outstanding for the Treasury Bond market – the light coloured segments reflect face value amounts that were outstanding as at June 2012 – with the white bars showing maturities and re-purchases since then. The dark segments show issuance between July 2012 and June this year; and the green bars show issuance since July this year.
There are several things to note:
- the yield curve has been progressively extended – from around 12 years in 2011 to 30 years as of last week;
- while the number of individual bond lines has increased, issuance has still been concentrated into what is a relatively small overall number of lines – this is our way of supporting liquidity;
- we issue across the yield curve in recognition of a range of investor interest and also to facilitate 3-year, 10-year and 20-year futures contracts; and
- we have concentrated issuance into long and ultra-long bonds so as to build this part of the market and attract a different type of investor.
Our development strategy for this market has resulted in increased issuance options, an increased diversity of the investor base, and it has reduced the Government’s funding risk by spreading the maturity profile of the portfolio over a longer period. We expect to continue with this lengthening strategy for the foreseeable future.
CHART 4: NEW TREASURY BOND 30-YEAR MATURITY
Note:*Fund Manager includes asset managers, insurers and pension funds. Source: AOFM
Last week we syndicated a new 30-year Treasury Bond to complete the yield curve extensions. It was issued at a yield of 3.27 per cent and we printed a record volume of $7.6 billion, from a record book of $13.8 billion, from a record 107 participating investors. This chart shows the breakdown of the final allocation by investor type, domestic and offshore, and by offshore region.
Apart from the very large response from domestic and offshore investors, we were surprised by the number of new investors, and the noticeably large participation from Japanese investors – whom typically do not participate in our primary market. Japanese investors took over 6 per cent when in the past this has usually been around 2 per cent or less.
This bond has opened up a new part of the market for us and we were encouraged by the absence of volatility during and immediately after the transaction – suggesting a healthy market resilience given that we were able to increase the total size of the market by just around 2 per cent with that sort of duration, and in a single transaction.
Wide ranging feedback from investors indicates that liquidity continues to be good – although it varies across the yield curve – being strongest in the short-to-medium part of the curve and around the 3 and 10-year futures contracts. In terms of outright bond trading volume, annual turnover is now multiples of the outright size of the market at around $1.2 trillion last year. Favourable liquidity will in part be due to the increasing size of our issuance programs, but it is also reflects the growing number of investors and competitive pricing out of Sydney and London.
CHART 5: A LIQUID FUTURES MARKET
3 month moving average
Note: A 20 year futures contract was launched on 21 September 2015. Source: Australian Securities Exchange (ASX).
This chart shows the 3-month moving average for the 3-year and 10-year futures contracts, which are amongst the most liquid futures markets in the world. They offer a useful hedging tool, while also adding an additional trading dimension. This is a positive element to the overall market and is why the AOFM focuses on providing sufficient bond line volumes to support the futures contracts. You will find more information on the futures contracts in the conference book, including on the 20-year futures contract that was launched just a year ago.
Although our inflation indexed bonds comprise a relatively small part of the overall portfolio, this is a segment to which we have devoted a lot of development attention over the past 4-5 years. The market is now just over $30 billion outstanding and there are 7 Treasury Indexed Bond lines – the longest maturity which is 2040. This is a market that has a strong following by domestic investors, but also has an established offshore investor base whom has participated for several years.
Issuance Program for this year
This fiscal year (which commenced on 1 July) our total planned Treasury Bond issuance is $90 billion – of that just under one quarter will be used to fund maturities and the remaining $69 billion will represent net new issuance. In addition to the new 2047 maturity launched last week, we will also be establishing a new 5-year maturity and a new 12-year maturity – both by syndication and both of which will support the respective futures contracts.
The Treasury Indexed Bond program is planned to be $3 billion, with all of that reflecting net new issuance as there are no maturities in 2016-17.
CHART 6: ANNUAL AOFM ISSUANCE BY YEAR
This chart shows the AOFM’s annual issuance programs back to the late 1980s. It is clear that the period since the global financial crisis has required long-term issuance at a rate that is unprecedented for Australia. The dark bars represent Treasury Bond issuance and the small light bars represent Treasury Indexed Bond issuance. You can see that for the last 3 years issuance programs have been over $80 billion, with the program last year being $97 billion. Current Budget forecasts suggest that issuance will remain around current levels for the next 2-3 years.
You can also see the lower reliance we have placed on issuing Treasury Notes – this is because we have reduced the Government’s exposure to short-term refinancing risk while at the same time carrying larger cash balances on average throughout the year. The use of Treasury Notes throughout the 1990s was much stronger because bond issuance was very low and there was limited opportunity to build cash portfolio balances using these instruments.
The Australian Government Market Investor Base
Many of you would be aware that the Australian bond market stands out for its high level of offshore ownership. We as the issuer do not take a view as to whether it is too high or too low; it is simply the result of market outcomes; and in fact we believe that the risks and benefits of this outcome are balanced. In any case there are no regulations or requirements of the Australian Government that either advantage or disadvantage foreign ownership.
The Australian Government bond market investor base has, however, been changing gradually over the last few years. The domestic component was less prominent in the past because of a bias from Australian fund managers towards property and equities. The domestic bank balance sheets have typically favoured semi-government bonds over Australian Government bonds because of the yield pick-up. Furthermore, six or seven years ago there probably wasn’t even that much difference in the liquidity between these markets.
However, for offshore investors Australian sovereign bonds have offered a yield pick-up over others and for those investors prepared to either take or hedge the currency risk our market has offered periods of strong relative performance.
In the current environment this remains even more the case with monetary policy in major global advanced economy markets – and in particular in Europe – now delivering very low or even negative yields. This chart illustrates this point. While it lasts, this will underpin additional strong offshore demand in the AUD market.
CHART 7: SEARCHING FOR YIELD
Note: “-” denotes that the given curve does not extend to this tenor. Source: Bloomberg.
But even though outright offshore buying has been strong the proportion of offshore ownership has been steadily declining and it is currently around 60 per cent, compared with a peak of around 78 per cent a few years ago.
This chart shows combined Treasury Bonds and Treasury Indexed Bonds outstanding in market value terms, with the dark bars representing offshore holdings as a proportion of total holdings.
CHART 8: INTERNATIONAL INTEREST IN AUSTRALIAN GOVERNMENT BONDS
Source: Australian Bureau of Statistics, AOFM
What we know about this declining trend in offshore ownership is that:
- reserve manager (or official government sector) accumulation of Australian Government Bonds is a mature rather than a maturing story;
- net offshore buying continues steadily but overall the rate at which offshore buying has increased over the past few years has not met the rate of increase in issuance; and
- the market continues to attract new investors with a lengthening yield curve playing a notable role in this further investor base diversification.
With regard to the official government sector (for which we include central banks and sovereign wealth funds) – this forms a very stable core to the offshore investor base.
CHART 9: RESERVE MANAGER PARTICIPATION
Note: The one ‘Don’t know’ in the top 30 chart is the Eurozone region as a whole. This comprises the ECB plus all national central banks. For most of these central banks we know whether they hold or not but for a few we remain unsure – accordingly the Eurozone group as a whole has been described as ‘Don’t know’. Source: AOFM, Bloomberg.
This chart shows that of the largest 100 reserve managers in the world – half are investors in the Australian Government bond market; while in terms of the top 30 it is around three quarters of them. These investors hold our bonds on an unhedged currency basis and are therefore relatively insensitive to fluctuations in cross-currency rates. In fact we typically see a weakening in the currency as a signal for them to top up their allocations. They tend to be holders of short to medium-term maturities although we have seen central banks buying in the 20-year part of the curve and there we even several central banks that participated in the launch of the new 30-year bond last week. Sovereign wealth funds on the other hand tend on average to have a greater appetite for longer duration.
The Japanese investor influence
Let me finish with some observations on the significance of the Japanese investment community for our market.
Many of you have substantial holdings of AUD fixed income and are continually looking for further opportunities to invest in the credit, yield and liquidity this market provides. These attributes are in turn aided by an active and professional group of intermediaries providing pricing and research services. As of the last 12-18 months you can also add the availability of long duration as an emerging dimension to the market.
At the same time the cost of funding AUD fixed income, along with the cost of currency hedging those AUD investments, and the attractive returns that are occasionally available on JGBs swapped backed into AUD, can provide challenges to directly investing in some AUD fixed income securities.
What we can note from this chart (below) using Bank of Japan data, is that net flows in AUD debt securities from Japanese investors on a monthly basis, has been consistent over the past 3 years. While there were episodes of strong buying in prior periods, Japanese net monthly inflows have consistently outweighed net outflows for the past 31 out of 34 months. Since October 2013 there were only 3 months in which there were net outflows and these were only small volumes.
CHART 10: NET JAPANESE FLOWS INTO AUD FIXED INCOME
Source: Bank of Japan, Bloomberg
Obviously currency plays a role in this story. During periods of sharp appreciation in the AUD/YEN cross rate, there has tended to be very low net inflows or large outflows. Mid-2006 to early 2007 was a period of very low accumulation and in early 2013 there were large net outflows. During periods of currency stability, or where the AUD/YEN cross rate slowly depreciated, investors had opportunities to accumulate bonds. This was noticeable in three periods on the chart, mid-2007 thru to the end of 2008, mid-2009 to early 2011, and the last 3 years.
What has also occurred, although this is not shown on this chart is that gross turnover continues at heightened levels. Since the beginning of 2014 gross turnover has consistently averaged $7‑8 billion per month.
The next chart shows the steady accumulation of all AUD fixed income by Japanese investors – from $83 billion at the end of 2005, to just over $200 billion in June of this year.
This makes Japan one of the largest, if not the largest, offshore region for AUD fixed income ownership. Tokyo is by far the largest concentration of investors for the AOFM and a reason why I have spent a considerable amount of time here.
CHART 11: JAPANESE INVESTMENT IN AUD DEBT SECURITIES
Note: Forecast is based upon the net flow of funds witnessed in the first six months of 2016 being maintained at the same rate through to year end. Source: Bank of Japan, Bloomberg.
What is not evident from this chart but is also available from Bank of Japan data, is that AUD fixed income investments comprise the 4th largest currency group for Japanese investors after the USD, the Euro and Yen, but ahead of Pound Sterling and the CAD.
AUD fixed income therefore remains an important alternative fixed income for Japan with the strong potential for further opportunity as the AUD market grows in size and becomes more relevant globally.
Last updated: 18 November 2016