Review by the Chief Executive Officer
The year also marked a successful conclusion of the AOFM’s six‑year strategy to extend the Australian Government Securities (AGS) yield curve. This will: accommodate growth in the debt portfolio over time if required; increase AOFM’s issuance options; contribute to further diversification of the investor base; reduce funding risk; and reduce the impact of interest rate volatility on debt servicing costs should this occur in future. Establishing a 30‑year benchmark bond also brought the AGS market into line with other major sovereign bond markets. This will increase its attractiveness to non‑resident investors in particular, but has also benefited the domestic investor base. The new benchmark bond was launched by syndication and attracted wide and deep support from the market. Two other new maturities established by syndication during the year, also attracted (successive) record total bids.
With the AOFM needing to maintain a consistently high rate of issuance through the year, managing the liquidity risks associated with a potential reduction or loss of access to the market was an important consideration. As the Government’s cash manager, the AOFM took measures to ensure that a reasonable contingency was in place at all times to cover payment obligations even if the ability to issue bonds was temporarily impeded. While the 2016‑17 program was completed as planned, there were times during the year when signs of market congestion raised legitimate concerns regarding the capacity of intermediaries to absorb the elevated rate of issuance.
The large ongoing quantitative easing programs of major central monetary authorities (namely the European Central Bank, the US Federal Reserve and the Bank of Japan), formed an ongoing backdrop to financial markets and this was largely supportive of sovereign bonds. Given the amount of issuance undertaken since 2008, the AGS market now has international significance and supports a diverse range of global sovereign bond investors. These investors are attracted by the strong underlying liquidity of the AGS market, the credit quality and yield advantage over other comparable markets and the transparency and regularity of issuance.
A continued decline in the proportion of AGS held by non‑resident investors would seem to contradict the above observation but global financial markets are complex and the changing patterns of participation underlying high‑level trends are not straightforward to determine. While non‑resident investors collectively continued adding to their AGS holdings, the rate of this has not matched increases in issuance. The difference is reflected by stronger domestic investor buying, most notably by bank balance sheets. This is in large part because of requirements for bank balance sheets to hold increased high quality liquid assets under Basel III. It is difficult to make a judgement about the re‑balancing between non‑resident and domestic AGS ownership other than to say that the AOFM continues to observe diversity across the investor base overall. Should this diversity endure and liquidity remain strong, we are confident that the AGS market will continue to exhibit efficiency and resilience.
The likely pace of increases to the US federal funds rate remained a high profile consideration in global financial markets given its impact on US Treasury yields and relative comparisons with other sovereign bond markets. Added to this was speculation about how quickly the US Federal Reserve will reduce the size of its balance sheet — this will reinforce (or even amplify) the influence of a rising federal funds rate. During the year the European Central Bank also signalled that conditions across the EU might warrant a slowing of its quantitative easing program. All other things equal, these factors combined to create conditions for an easing in offshore demand for AGS and higher bond yields. Continued low yields on Japanese sovereign bonds acted as an offsetting factor. Furthermore, the sharp sell‑off in US Treasuries (and sovereign bonds generally) in response to the change in the US Administration in November 2016 was a clear reminder of how quickly market conditions can change.
Over 2016‑17 AGS yields broadly tracked the global sell‑off in rates, which began in August (when AGS yields were at a multi‑decade low) before rising sharply after the US elections. While the sell‑off was partially reversed over the second half of the year (due to a combination of economic and geopolitical factors), three and 10‑year, AGS yields still rose by around 35 and 60 basis points respectively in the year to 30 June 2017.
Treasury Bond issuance of $103 billion in 2016‑17 focused on executing the AOFM’s portfolio strategy, while also being responsive to a diverse investor base and supporting the three‑year, 10‑year and 20‑year futures contracts. Market facing operations were also augmented by introducing a regular bond buyback program. The aims of the program are to: manage funding risk by reducing the volume outstanding of short‑dated bonds (thus reducing future gross issuance programs); improve efficiency of the AGS market through effectively switching bonds with less demand for longer maturities in greater demand (which reduces inventories of bank trading accounts used for AGS and improves market efficiency); and assist the RBA in managing system liquidity through reducing the size of cash flows on maturity dates. Competitive buyback tenders operate in the reverse manner of issuance tenders; they are funded by the issuance of equivalent amounts of longer‑dated bonds.
Gross issuance of Treasury Indexed Bonds for the year totalled $3.25 billion, almost all of which was issued via twice‑monthly competitive tenders. This segment of the AGS market continues to be predominantly domestic investor focused.
The AOFM exercises informed judgement in devising a portfolio management strategy to guide debt issuance choices each year. The structure of the portfolio can only be changed gradually and the core aims of minimising cost and reducing risk typically present as competing objectives. For example, issuing longer‑dated bonds reduces funding risk and dampens the potential for future interest rate volatility to impact debt interest costs; but normally comes at a higher overall interest cost. Similarly, the cash management portfolio incurs increased carrying costs when cash balances are high; however, cash balances need to be able to accommodate short‑term or unforseen Budget financing requirements and are required ahead of bond maturities.
The average term to maturity of Treasury Bond issuance in 2016‑17 at just over 10 years was higher than it was the previous year but as the portfolio has grown over time and the yield curve extended such increases are getting harder to achieve. However, the outcome for 2016‑17 underpinned a further lengthening of the average term to maturity of the portfolio to 7.13 years, from 6.97 the year before. In operation since 2011, the lengthening strategy is estimated to have deferred the need to re‑finance about $15 billion on average per year in maturities over the next five years. This is a considerable reduction in near‑term funding risk, which is now being complimented by the buyback program.
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 commenced in June 2015. The Direction requires the AOFM to exercise discretion on timing and sales volume to minimise potential market disruptions; and to suspend RMBS sales that cannot occur at a price that is acceptable to the AOFM.
Due to a marked widening of RMBS yields the AOFM (consistent with the intent of the Direction) suspended the auction process in November 2015. The auction process remained suspended throughout 2016‑17 because the AOFM assessed prices to remain at unacceptable levels. In addition to ongoing assessments of investor demand for RMBS, credit market conditions will influence the AOFM in its deliberations regarding a resumption of the divestment process.
The outlook continues to be dominated by speculation about global economic growth and inflation, changes to the conduct of monetary policy overseas, and the performance of sovereign bond markets generally. In particular, the prospect of steadily improving economic growth in the US and now the EU attract close scrutiny by the investor community. However, uncertainty associated with these outlooks is likely to persist in the coming year, not least because of heightened geo‑political risk and a weakening consensus about the ability for broad stimulatory budget measures to be implemented in the US. These, amongst other factors, remain relevant to the AOFM’s deliberations.
The AOFM remains focused on portfolio management objectives that will support a diversified investor base and an outlook for declining issuance, but little expected change in the overall size of the debt portfolio. If achieved, these objectives will maintain an efficient AGS market that will support domestic financial market operations generally.
With completion of its long‑term market development program (including a substantial yield curve extension), the AOFM will appear more to the market like a business as usual operation over the coming years. In particular this will allow more straightforward and less intensive engagement with the investor community.
Chief Executive Officer
Last updated: 20 February 2018