Part 2: Performance and Outcomes
- 1 Introduction
- 2 Section 1: Annual Performance Statement
- 3 Section 2: Outcomes
- 3.1 Bond issuance
- 3.1.1 Aims
- 3.1.2 Approach to achieving the aims and market influences
- 3.1.3 Outcomes
- 3.2 Debt portfolio management
- 3.3 Cash management
- 3.4 Residential Mortgage-Backed Securities
- 3.5 Market Engagement
- 3.1 Bond issuance
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.
Section 1: Annual Performance Statement
The AOFM’s purpose is to ensure the government’s debt financing needs are fully met each year while managing the cash, debt and other portfolios over the medium-long term at low cost subject to acceptable risk. The AOFM will take into account the potential for its operations to impact domestic financial markets.
The purpose is achieved through three key objectives, which 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.
The AOFM is required to balance cost and risk considerations but its overriding aim is to ensure that the financing requirements of government are able to be met in full and on time. The AOFM has minimal appetite for failure in any critical function associated with issuance, settlement and cash management; the design and conduct of its core business processes reflect this risk appetite.
Like any agency of government, the AOFM is involved in many and varied tasks that go to support its overarching responsibilities. Management of the agency involves the maintenance of a variety of business processes and associated activities to support these overarching responsibilities. However, reducing all of these considerations to several key performance measures is considered relevant for the purposes of external performance accountability.
Table 1 presents the statement of results against six indicators summarising the AOFM’s performance in achieving its purpose. It also refers to Section 2, which provides detail on a range of outcomes important to the AOFM’s achievement of its annual and longer-term aims.
The Annual Performance Statement for 2017-18 is prepared in accordance with paragraph 39(1)(a) of the PGPA Act.
Table 1: Annual Performance Statement 2017–18
Key performance indicator
Objective: Meet the Budget financing task in a cost-effective manner subject to acceptable risk
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 2017–18 fully met through sufficient issuance ($81.05 billion)
Discussion from page 14
The cost of the long-term debt portfolio compared to the 10 year average of the 10-year bond rate
The effective yield of the long term debt portfolio for 2017–18 was 3.30 per cent (2016–17: 3.42 per cent). This is below the 10 year average of the 10 year bond rate of 3.80 per cent.
Debt issuance in 2017–18 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 average yield of Treasury Bond issuance (accounting for 93 per cent of all long term issuance) for 2017–18 was 2.70 per cent (2016–17: 2.38 per cent). This is below the 2017–18 average of the 10 year bond rate of 2.71 per cent (2016–17: 2.43 per cent). The average term to maturity of the Treasury Bond portfolio was 7.38 years as at 30 June 2018 (30 June 2017: 7.13 years). The average term of new issuance in 2017–18 was 11.08 years (2016-17: 10.29 years).
Discussion from page 26
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 ( 0.51 basis points), and Treasury Indexed Bonds ( 1.32 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. The overdraft facility was utilised once in 2017–18, however, the amount was below the threshold requiring Ministerial approval.
Discussion from page 31
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 $1.3 trillion and for Treasury Indexed Bonds $51 billion in 2017–18. 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 52 times (excluding intra-day uses), but only for small volumes and generally for short periods.
Discussion from page 20
Number of times the AOFM failed to undertake actions consistent with public announcements
All publicly announced specific operational publicly announced commitments were met.
Each year the AOFM’s financing task is determined by the forecast budget deficit, the need to refinance maturing debt, and funding to be undertaken by government that is additional to budget requirements. The financing task can be adjusted at the margin in response to changes in management of the cash portfolio the AOFM may judge as appropriate from year to year.
The financing task is achieved through issuance of AGS, the mix of which is determined through an annual strategy that balances debt portfolio risks (such as future interest rate volatility and funding risks) against differences in short and long-term borrowing costs.
The method of issuance is determined by balancing considerations of supporting market liquidity and managing execution risk against the anticipated transaction costs associated with different issuance approaches (all of which contribute to overall portfolio costs). The majority of issuance occurs via competitive tender, which achieves the ‘best cost’ outcome for the government in most circumstances. The syndication method is reserved for situations in which execution risk and/or the trading liquidity of the security being issued are of primary consideration.
The indicators in Table 1 above show that the financing task was fully met while meeting expected costs associated with how this was achieved. Of the $81.1 billion in gross issuance for the year, $62.5 billion was issued via competitive tender, with new issuance yields consistently lower than secondary market yields. The remainder was issued via syndication. Financing costs on the overall portfolio also compared favourably against market indicator rates. More detail on each of these aspects is provided in Section 2 below.
This objective is achieved through management of the cash portfolio in which the AOFM monitors both actual and forecasts for daily revenue collections and expenditure. It also monitors the cycles of each throughout the year, these cycles being independent of each other. This independence in cycles can at times create significant mismatches between revenue collected and expenditure needs, which the AOFM accommodates through managing cash reserves and the use of short-term borrowing. There was only one instance during the year where there was a need for the RBA overdraft facility to be used. The facility is used when the overnight cash balance in the official public account is not sufficient to cover expenditures. This event was a consequence of insufficient notification being provided to the AOFM on planned outlays. It did not involve an overdraw amount sufficient to warrant the need for ministerial approval.
That the AOFM is judged by financial markets to be a credible custodian of the AGS market can be assessed from a number of perspectives. Liquidity is, for example, a key consideration for most investors because it reflects an ability to transact in the market (either through buying or selling AGS) in a timely manner and in volumes to meet their needs, without market prices being materially moved as a result of those transactions. Liquidity is a product of having a wide range of active ‘price makers’ in AGS and a large, diverse and active investor base. The AOFM supports liquidity through regular and consistent issuance into maturities that are chosen to reflect investor demand, clear communication and transparency regarding the AOFM’s operations and issuance strategy, and a long standing focus on the development of a functional and resilient AGS market. High levels of secondary market turnover and regular feedback from investors attesting to their capacity to buy and sell large parcels of AGS at acceptable prices are strong indicators of liquidity for 2017–18. They also reflect favourably on the AOFM’s credibility as a sovereign issuer and custodian of the AGS market.
This section details 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 associated outcomes.
The AOFM currently has two different 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.
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.
Treasury Indexed Bonds may be repurchased ahead of maturity from time to time. This may be to assist in the issue of a new line, or to enhance the operation of the secondary market.
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. 84 Treasury Bond tenders and 17 Treasury Indexed Bond tenders were conducted during the year. One new Treasury Bond line was launched by syndication and two new lines were launched by tender. Two syndicated taps for bonds longer than the ten-year futures contract were held.
Buybacks of short-dated Treasury Bonds were conducted via tenders, in conjunction with syndicated issues, and via bilateral transactions with the RBA.
The government’s funding program was lower than the two most recent years. Funding markets (including the Australian repo market) were strained during the second half of the year, which restricted the ability of some investors and market-makers to hold large positions in AGS.
Over the past decade, some investors were attracted to the AGS market by the higher yields available on Treasury Bonds compared to those of other highly rated sovereign bonds. These relativities changed during 2017–18. The spread between yields on ten year Australian Treasury Bonds and US Treasuries turned negative for the first time since 2000. Currency-hedged yields on Treasury Bonds also became less attractive to investors.
The proportion of outstanding AGS held by offshore investors increased modestly in 2017–18, as illustrated in Chart 1. This followed a period of declining relative holdings of non-residents from 2012. Strong offshore interest in long dated AGS from a diverse investor base remains.
Chart 1: Non‑resident holdings of Australian Government Securities
The AOFM conducts regular competitive buyback tenders for the repurchase of short-dated Treasury Bonds. These operations are funded by separate tenders for issuance of longer-dated Treasury Bonds. Buyback tenders add to the AOFM’s operational flexibility and have become an accepted 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.
Holders of the 2018 Treasury Indexed Bond line were invited to submit offers of this line to the AOFM in conjunction with the syndicated issue of the new 2027 line. There are no plans to introduce a regular buyback program for Treasury Indexed Bonds.
At the time of the 2017–18 Budget, Treasury Bond and Treasury Indexed Bond issuance for the year was expected to total around $85 billion in face value terms. This volume was revised over the course of the year following an improvement in the government’s fiscal position compared to forecasts.
Treasury Bond issuance
Gross Treasury Bond issuance for the year totalled $75.5 billion. This was a significant reduction from the $103 billion of Treasury Bonds issued in 2016–17. 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 2017–18:
- a new bond line maturing in November 2022 was issued to support the operation of the three-year Treasury Bond futures contract, and
- new bond lines maturing in November 2029 and May 2030 were 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.
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, the liquidity of outstanding bond lines, and managing the maturity structure to limit funding risk. Two or three tenders were held during most weeks.
Large issuance volumes were achieved at issues of new Treasury Bonds. The November 2029 ($9.6 billion) was issued by syndication, while tenders were held for the initial issue of the November 2022 ($3.5 billion) and May 2030 ($2.5 billion) bond lines.
At the end of the year, there were 25 Treasury Bond lines, with 13 of these lines having over $20 billion on issue and 22 having over $10 billion on issue. Chart 2 shows Treasury Bonds outstanding as at 30 June 2018 and the allocation of issuance across bond lines during 2017–18.
A total of $22.9 billion of Treasury Bonds were repurchased ahead of maturity in 2017–18, of which $15.2 billion were bonds maturing after 30 June 2018:
- 22 Treasury Bond buyback tenders were conducted, at which $12.2 billion of bonds were repurchased,
- the AOFM repurchased $3.0 billion of bonds in conjunction with the syndicated issue of the new 21 November 2029 Treasury Bond,
- $7.7 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 3.
The AOFM’s alternative long-term funding instrument 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, providing a source of diversification in the funding base. 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 4).
Treasury Indexed Bond issuance for the year totalled $5.55 billion, of which $2.55 billion was conducted via tender. 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. A syndicated offer for $3 billion of a new November 2027 Treasury Indexed Bond line was conducted in August 2017. In conjunction with the syndication, around $2.7 billion of the November 2018 Treasury Indexed Bond line was repurchased.
Chart 5 shows the amount outstanding in each of the eight Treasury Indexed Bond lines as at 30 June 2018, and the allocation of issuance during the 2017–18 year.
Chart 5: Treasury Indexed Bonds outstanding as at 30 June 2018 and issuance in 2017–18
Table 2 summarises the results of Treasury Bond tenders conducted during the year. The results are shown as averages for each half-year and grouped by the maturity dates of the bonds offered.
Table 2: Summary of Treasury Bond tender results
|Period||Maturity||Face value amount allocated ($m)||Weighted average issue yield (%)||Average spread to secondary market yield (basis points)||Average times covered|
|July-December 2017||Up to 2025||13,300||2.1383||-0.89||5.77|
|January-June 2018||Up to 2025||6,200||2.3108||-0.53||5.43|
The average coverage ratio for all Treasury Bond tenders in 2017–18 was 4.44, an increase from 3.41 in 2016–17. The average tender size of $712 million was lower than in 2016–17, reflecting the smaller issuance program. Shorter-dated bond tenders generally received a greater volume of bids (higher than average coverage ratios), which reflected both core investor base interest and a lower supply of short-dated bonds.
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 3.53 for Treasury Indexed Bond tenders, an increase from 3.14 in 2016–17. 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.
The Treasury Bond market operated smoothly during 2017-18 with liquidity and efficient price discovery being maintained throughout the year. However, there were times during the year when repo rates were elevated, raising the costs to some investors and market-makers of holding AGS.
In previous years, data on secondary market turnover in Treasury Bonds has been obtained from the Australian Financial Markets Association (AFMA). However, in order to obtain more frequent and detailed data the AOFM began collecting secondary market turnover data directly from market-makers commencing in July 2016. Total secondary market turnover of Treasury Bonds in 2017-18 amounted to $1.3 trillion, an increase of 24 per cent from 2016-17. Growth was strongest in Europe, the UK and the Americas.
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 2017 18 was around $51 billion, an increase of 21 per cent from 2016-17. Turnover increased particularly sharply in Asia (ex-Japan) and Europe.
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 56 million three-year contracts (representing $5.6 trillion face value of bonds) and over 47 million 10-year contracts ($4.7 trillion face value of bonds) were traded in 2017–18. Turnover in the 20-year contract is considerably lower: 383,000 contracts ($19 billion face value of bonds) were traded. All contract close-outs in 2017–18 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 52 times for overnight borrowing in 2017–18 compared with 51 times during 2016–17. The volumes borrowed were higher than in 2016–17, with the total face value amount lent in 2017–18 being $1,667 million, an increase from $388 million in the previous year.
In managing the debt portfolio and meeting the government’s financing requirements, the AOFM aims for low and stable debt servicing costs over the medium-long term. It also seeks to maintain liquid bond lines to facilitate cost-effective issuance of debt through time and to effectively manage future funding and refinancing risks.
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 consistent and transparent stewardship of the AGS market in order to underpin confidence and promote market liquidity. 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 cost and risk measures that reflect the considerations faced by sovereign debt managers generally. The primary cost measure used is historic accrual debt service cost. This includes interest payments made on AGS, realised market value gains and losses on repurchases, 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 facilitates an assessment of financial risk exposures and changes in those exposures from year to year, the value of transactions managed and the economic consequences of alternative strategies. It is most useful in the context of trading for profit making purposes.
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.
While the AOFM is a price-taker in global capital markets, it does influence the cost and risk profile of the portfolio 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)1 although this is compensated by reduced variability in future interest cost outcomes and lower exposure to refinancing or rollover risk.2 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 portfolio decision making is informed by an ongoing research program, which is 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 conditions, as well as an assessment of broader market trends. Drawing on this research, the AOFM formulated a strategy for the structure and composition of issuance for the financial year which was 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 the debt issuance and portfolio strategy is reviewed if there are substantive changes to market conditions or the fiscal outlook.
During the year, the total volume of Treasury Bonds outstanding increased by around $29 billion, to $493 billion.
The AOFM’s strategy in 2017–18 followed a broadly similar theme to recent years, with a focus on longer term issuance and further lengthening of the average term to maturity of the debt portfolio. This will accommodate forecast growth in debt balances, while simultaneously reducing exposure to future interest rate and debt refinancing risks. The strategy also aimed to support diversity both in the AGS investor base, as well as the issuance options available to the AOFM across the curve.
The strategy was influenced by a range of factors including a continuation of low outright bond yields and low term premium (which increases the cost-effectiveness of longer term issuance). An external environment characterised by heightened regional security and trade tensions were also influential in shaping the AOFM’s risk based approach. At its core, the 2017–18 portfolio strategy was designed to preserve the AOFM’s flexibility to operate under a wide variety of circumstances (including the potential for disruption to ‘normal’ funding operations), while continuing to benefit from the relatively low interest rates on offer. A bias towards issuance of longer maturity bonds underpinned the strategy, which was complemented by a regular program of bond buyback tenders and maintaining a cash buffer that provided flexibility against potential threats to the government’s cash financing needs through the year.
Chart 8 demonstrates the lengthening bias implicit to the AOFM’s strategy with the average Treasury Bond issued in 2017–18 having a term to maturity of 11.08 years3. The issuance program continued to benefit from low interest rates and was delivered cost effectively, with an average yield on new issuance of 2.70 per cent4, which is lower than the average 10-year bond yield observed over the financial year of 2.71 per cent despite being more than one year longer.
Chart 8: Treasury Bond issuance — average yield, term to maturity and 10-year bond yield
Chart 9 shows that the average term to maturity of the Treasury Bond portfolio as a whole lengthened by 0.26 years to 7.38 years over 2017-2018. Duration was also higher by 0.27 years finishing 2017–18 at 6.17 years. The effective cost of funds (or yield) on the Treasury Bond portfolio fell from 3.22 to 3.12 over the same period.5
Chart 9: Treasury Bond portfolio — modified duration, average term to maturity and cost of funds
The reduced risk levels of the portfolio flowing from the AOFM’s strategy are demonstrated in Chart 10 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 time6. 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 27 per cent and 43 per cent. The AOFM estimates that the cumulative impact of its portfolio strategy is a gross borrowing task that is approximately $100 billion lower over the next five fiscal years than what it would otherwise have been7. This implies that the portfolio is now less exposed to funding, refinancing and interest rate risks.
Chart 10: Treasury Bond portfolio — maturity profile
In 2017–18, the AOFM continued to maintain an asset buffer (in the form of term deposits with the RBA) to act as a precaution against a possible deterioration in funding conditions.
The debt servicing cost8 of the net AGS portfolio managed by the AOFM in 2017–18 was $16.72 billion on an average book volume of $492.56 billion, representing a net cost of funds of 3.39 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 $17.45 billion on an average book volume of $528.50 billion, implying a cost of funds of 3.30 per cent. The difference between net AGS debt and the LTDP is attributable to the short term assets and liabilities the AOFM uses for liquidity management purposes (term deposits and Treasury Notes) and other residual assets (such as RMBS).
Chart 11: Net AGS debt and LTDP cost of funds analysis (per cent)
Chart 11 shows the funding cost profile of the net AGS debt portfolio and the LTDP back to 2007-08. These profiles are contrasted with the cash rate and the 10-year moving average of the 10-year bond yield. With interest rates trending down, funding costs on the net debt portfolio and the LTDP have declined by 180 and 196 basis points respectively since 2010-11. This compares to declines of 325 basis points in the cash rate and 176 basis points in the 10-year bond yield moving average over the same period. Given the largely fixed cost structure of the net debt portfolio and the LTDP, changes in funding cost will always lag changes in the overnight cash rate (changing only when existing debt securities or assets mature or new securities are issued/investments placed). In a comparison with the 10-year bond yield moving average, funding costs have fallen further because of the relative ‘over-representation’ of recently issued debt in the portfolio through a period where issuance yields have been declining.9
Table 3 provides further details of the cost outcomes for the portfolio of debt and assets administered by the AOFM broken down by instrument and portfolio for 2016–17 and 2017–18.
Table 3: Commonwealth debt and assets administered by the AOFM
|Debt servicing cost||Book volume||Effective yield|
|$ million||$ million||per cent per annum|
|Contribution by instrument|
|Treasury Indexed Bonds||(1,312)||(1,598)||(39,064)||(43,207)||3.36||3.70|
|Foreign loans (a)||(0)||–||(5)||–||8.42||0.00|
|Gross physical AGS debt||(16,443)||(17,519)||(482,728)||(532,448)||3.41||3.29|
|Term deposits with the RBA||570||650||33,123||37,095||1.72||1.75|
|State Housing Advances||115||110||1,958||1,880||5.86||5.86|
|Net AGS debt||(15,689)||(16,722)||(445,268)||(492,558)||3.52||3.39|
|Contribution by portfolio|
|Long Term Debt Portfolio||(16,372)||(17,452)||(478,389)||(528,498)||3.42||3.30|
|Cash Management Portfolio||498||583||28,784||33,145||1.73||1.76|
|State Housing Portfolio||115||110||1,958||1,880||5.86||5.86|
|Total debt and assets||(15,689)||(16,722)||(445,268)||(492,558)||3.52||3.39|
|Total after re-measurements||3,714||(16,141)||(445,268)||(492,558)|
|(a) Interest expense and effective yield on foreign loans incorporates foreign exchange revaluation effects.|
|(b) Re-measurements refer to unrealised changes in the market valuation of financial assets and liabilities.|
The cost of gross debt increased in dollar terms by $1.08 billion compared to the previous year. This was primarily due to an increase in the average volume of debt on issue from $482.73 billion in 2016–17 to $532.45 billion in 2017–18. However, in percentage terms the funding cost of gross debt declined by 12 basis points (from 3.41 per cent to 3.29 per cent). This improvement was driven by the issuance of new bonds at yields that were below the average of pre-existing (and maturing) debt.
The return on gross assets in dollar terms for the period was $797 million, an increase of $43 million compared to 2016–17. This was driven by an $80 million increase in income from term deposits (resulting from larger holdings) which more than offset a $33 million reduction in income from RMBS following the completion of the divestment process in February 2018.
The net servicing cost of the combined portfolio of debt and assets was $16.72 billion. This was higher in dollar terms compared to 2016–17, due to the volume of debt on issue being higher than the previous year. As a percentage of net debt, servicing costs fell from 3.52 per cent to 3.39 per cent, slightly larger than the fall in gross debt servicing costs.
Movements in market interest rates had a favourable impact on the market value of the portfolio in 2017–18. Unrealised gains from re-measurements amounted to $583 million. This compares to an unrealised gain of $19.40 billion in the previous year. Most of the re-measurement gains are attributable to changes in the 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 bond lines.
The AOFM manages the daily cash balances of the Australian Government in the OPA.10 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.11
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 $2.5 billion to $6.5 billion during 2017–18.
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 12 shows movement in the funding requirement over the year.
Chart 12: Within-year funding requirement 2017–18
The task of meeting the government’s financial obligations as and when they fall due was fully met. The overdraft facility was utilised once in 2017–18, however, the amount was below the threshold requiring Ministerial approval.
During 2017–18, the AOFM placed 386 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 $18.6 billion in January 2018 to a maximum of $61.4 billion in June 2018.
The average yield obtained on term deposits during 2017–18 was 1.75 per cent, compared with 1.72 per cent in 2016–17. The increase in average yield reflects the higher average level of short-dated interest rates that prevailed during 2017–18.
A total of $13.5 billion of Treasury Notes were issued in 2017–18 (in face value terms). The average coverage ratio at tenders was 4.07, an increase from 3.35 in 2016–17. Yields were on average around 25 basis points higher than Overnight Indexed Swap (OIS) rates for corresponding tenors (compared to around 10 basis points higher than OIS rates in 2016–17), reflecting higher spreads across Australian short-dated funding rates. 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 2017–18 are shown in Chart 13.
Chart 13: Short-term financial asset holdings and Treasury Notes on issue 2017–18
In undertaking its cash management activities, the AOFM was required to adhere to a set of cash management principles which required 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. The average OPA balance for the year was $1.218 billion.
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 invested12. On 5 May 2015, the Treasurer issued a direction under the PGPA Act to divest the government’s RMBS portfolio through a regular competitive process.
In accordance with the Treasurer’s direction, the AOFM commenced a competitive sales process for the government’s RMBS portfolio in June 2015. Under that Direction, five auctions were held in which around $458 million in amortised face value of RMBS 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.
In November 2017, the AOFM announced that it had determined that RMBS market conditions had improved sufficiently to warrant recommencing the RMBS divestment process through regular auctions. At the same time, the AOFM announced some changes to the auction process, most notably that the reserve price would be announced in the lead up to each auction, and the details of each auction would be announced at least two weeks in advance of the auction date (but the previous practice of announcing a pipeline of auctions would be discontinued).
Four auctions were held between November 2017 and February 2018, with a total amortised face value of $1.508 billion, resulting in the complete divestment of the AOFM’s remaining RMBS holdings. In all but one case each note was completely sold the first time it was offered.13 Table 4 puts the RMBS sales made in 2017–18 into a historic context.
Table 4: RMBS divestments over time
Amortised Face Value ($m)
Gain on sale ($m)
Over the life of the program from October 2008 to February 2018, around $31.3 million in gains were realised through RMBS divestments totalling just under $3.5 billion in amortised face value terms. No notes were sold at a loss and the remaining circa $12 billion in taxpayer funds were repaid in full through amortisation and/or the exercise of call options by the issuers.
Turning to the portfolio’s performance for 2017–18, accrual interest income was approximately $37 million. This represented an annualised accrual return of 4.04 per cent on the portfolio’s average book value of $915 million. This is higher than the corresponding rate of return in 2016–17, due largely to the inclusion of the realised gains on sale of around $11 million reported in Table 4. Unrealised gains of $5 million were recognised as at the end of the previous financial year, but fell to zero by definition as the divestment was completed. Consequently the rate of return on the portfolio, inclusive of re-measurements, was around 3.50 per cent in 2017–18.
The total gross return on the RMBS portfolio over the life of the program, inclusive of realised gains on divestment, was just over $2.9 billion. This corresponds with an internal rate of return of around 5 per cent per annum.14
The divestment of the remaining securities held by the AOFM brings the RMBS program to a close.
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, 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.
A major review of the investor relations strategy was conducted in December 2017 in which the objectives of the strategy were modified and the emphasis placed on these objectives, changed. The reasons for the major review came about through questions on whether the current strategy would remain relevant through the changing global rates environment, forecast lower budget deficits and the reduced issuance programs the AOFM has recently experienced and is looking to implement over the Budget forward estimates period.
Investor relations aims have been heavily focused on the diversification of the AGS investor base and maintaining information flows through direct engagement with key investors. With the investor base growing in number and by diversity and the government’s steadily improving fiscal position, the need to engage with investors on issues of AGS market development has been reduced.
However, with rapidly changing global macro conditions mentioned earlier in this report, such as a historically low interest rate environment, the tightening of monetary policy by the US Federal Reserve and other Central Banks, and the unwinding of expansionary monetary policy settings by the US Fed, the need for market perspectives and feedback from investors remains.
The three objectives of the revised strategy are:
- collecting and analysing market intelligence from investors,
- managing and maintaining updates to the AOFM’s program of activities and its intended operations with key investors, and
- a deepening of the investor base diversification through engagement with new or potentially new investors.
The first half of 2017–18 was very active for investor engagement. Along with annual engagements with regular investor groups in Japan and Australia, several commitments involving investor diversity opportunities were pursued.
For the year overall the total number of investors met was 128, (compared with 131 in 2016–17).
A number of different investor engagement opportunities arose throughout the year, the most notable of these included meetings with Japanese regional banks, universities, and agricultural credit institutions based outside of Tokyo. This trip also included an invitation to speak at a large Japanese domestic bank global investor conference, which the AOFM had not done before. This opened communication with a range of investors that would not otherwise have been readily accessible to the AOFM.
Early in 2018, several financial intermediaries hosted around 15 Korean life insurers on information gathering trips to Australia. For most of them this was their first visit to Australia. The AOFM was able to directly meet a number of them and present to all of them at a forum in Sydney. These new and different types of market engagement opportunities are infrequent and are made possible through the AOFM’s extensive network of relationships in the domestic and global banking sectors.
The bulk of investor relation activity, however, remained directed at ongoing investor engagement and information gathering. Face-to-face meetings with investors were held in North Asia, Central Europe, North America, and Tokyo. Central Europe and North America are places with key investors that had not been visited for three to four years. The Australian investor base is readily accessible and was covered through a series of meetings in Sydney, Melbourne and Brisbane.
The AOFM continued past practice of using appropriate opportunities at conferences and speaking events to engage with investors and reiterate key messages and themes regarding AGS issuance and market impacts. Each year Australian Business Economists hosts the luncheon post-Budget speech by the CEO. It remains the first and most important platform to provide information to the market for the upcoming year.
Other formats in which the AOFM presented were financial market conferences or investor missions (including the Mizuho Global Investor Conference, ANZ Hunter Valley conference, and the Deutsche Bank Investor Mission) hosted by the financial intermediaries, and several roundtables. While these events do not substitute for the benefits derived from face-to-face meetings, they remain useful in their own right and typically offer opportunity for short face-to-face meetings with selected attendees.
The major investor related event conducted by the AOFM this year was the Australian Government Fixed Income Forum in Tokyo in June 2018. The Forums have been conducted every 18-20 months. Speakers included the Treasury Secretary, the RBA Assistant Governor (Financial Markets), and the CEOs of the AOFM and the Australian Securitization Forum. Two panel discussions included the CEOs of the four largest state borrowing authorities, with a separate session that had four senior fund managers (two Australian and two Japanese). There were 90 attendees with 65 different Japanese investor institutions represented.
As well as face-to-face meetings and presentations, the AOFM conducted a number of phone meetings with international and domestic investors throughout the year. Regular fortnightly calls with ten domestic Treasury Indexed Bond investors assisted in the selection of individual lines to tender and were useful in gauging demand for Treasury Indexed Bonds in general.
Table 5: Summary of investor relations activities in 2017-18
Conferences, speaking engagements and investor roadshows
Presentations: large engagements/ roundtables
Approximate total audience size: large presentations
128 investor meetings
Individual cities visited
AOFM staff participating in investor relation activities
CEO, Head of Investor Relations, Head Portfolio Strategy & Research, Senior Strategist Investor Relations, Communications Officer Investor Relations, Analyst Funding and Liquidity
Hosting banks: Investor roadshows, conferences, roundtable discussions
ANZ, Bank of America Merrill Lynch, Citi Commonwealth Bank of Australia, Daiwa Securities Deutsche Bank, JP Morgan, Mizuho Asia Securities, Nomura Securities, TD, UBS, Westpac
1 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.
2 Refinancing risk, also referred to as rollover risk, is the inability to renew maturing debt by further borrowing.
3 Calculation is based on the term to maturity of each bond issued during the year, weighted by book value.
4 Calculation is based on issue yields during the year weighted by book value.
5 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.
6 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.
7 Compared to a counterfactual where the pre-2011 portfolio structure is retained.
8 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.
9 Bond issuance over the past five financial years for instance accounts for almost 80 per cent of the LTDP as at 30 June 2018. Bond yields over this period were on average significantly lower than the preceding five years, which largely explains why portfolio funding costs have fallen by more than the 10-year bond yield moving average.
10 The OPA is the collective term for the core bank accounts maintained at the RBA for Australian Government cash balance management.
11 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.
12 Copies of each direction are available on the AOFM website.
13 Further details of the auctions, including reserve prices and prices achieved, bids received and accepted, and volumes of each security sold, can be found on the AOFM website.
14 Note that this does not include the cost of financing the RMBS portfolio. Any estimate of the net return would be extremely sensitive to the assumptions regarding the choice of the subset of gross debt notionally allocated to the financing of the RMBS portfolio.
Last updated: 24 October 2018