After the Storm - Does it Get Easier?
Presentation to the Australian Business Economists luncheon
Sydney 22 May 2012
Rob Nicholl - Chief Executive Officer, Australian Office of Financial Management
Thank you to Stephen Halmarick and the ABE for inviting me to speak again this year.
I am aware that tradition requires me to give you some 'colour and movement' on the issuance program for the coming year and in this regard I hope not to disappoint. We are at times asked for detail about issuance beyond the next year. However, an audience like this will no doubt appreciate that while we aim to be open and transparent, we do not want to unduly restrict ourselves in achieving the issuance task. Balancing flexibility with consistency and transparency will therefore, remain an important subtlety for the AOFM to manage!
I will use the time today to cover a bit of ground because I think it useful to address a few issues relating to expected changes in the CGS market. The issues I wanted to cover are namely:
- a possible misapprehension about the need for the CGS market to maintain the growth rate of the last few years;
- concerns about future liquidity in CGS, and
- the very strong offshore demand we have experienced.
We are now moving from a phase where the focus has been on growing CGS issuance in response to impacts arising from the GFC, to a phase where annual issuance will plateau. I will, therefore, also take the opportunity to cover some of our background thinking influencing this change. To say that there are things I could but won't say; things I can't and won't say, and things I can and will say - should go without saying -not to be inviting comparisons with a former US Secretary of Defence!
The title of this presentation would to many offshore issuers seem a bit overdone, with the references to both a storm and the prospect that things could be expected to be easier soon. The circumstances elsewhere obviously look much harsher, more difficult to manage, and with an air of 'crisis' set to remain for some time to come - this of course being particularly the case in Europe.
But if we were to ask - is what we experienced over the past few years akin to a "storm"? - the answer, relative to what AOFM had to do prior to the GFC, would most definitely be yes - but relative to what other issuers have faced over recent years -probably not. However, we continue to be exposed to the impact of events shaping the challenges for other sovereign issuers, at least indirectly, and therefore our challenges cannot be contemplated in isolation of broader financial market volatility.
So at one level our tasks would seem to have been somewhat easy compared with those of many other sovereign debt management offices. Australia has a stable triple-A credit status; the CGS market has enjoyed a steady run of increased investor interest; and our need to issue is comparatively modest. Together these circumstances have resulted most weeks in our bonds being absorbed smoothly and readily into the market.
At another level however, we do not - and should not - view the years ahead with complacency. The fact that demand for CGS is strong, with our yields continuing to touch historically low levels (of direct benefit to the Australian community through lower borrowing costs), should not prompt us to relax in the thought that the storm has passed completely.
Without doubt the CGS market has in recent years been thrust into growing recognition for a number of reasons. These include:
- the economic growth phase of the Asian region (and in particular China);
- the pattern of global financial turmoil and economic malaise following the peak of the GFC;
- an accumulation of sovereign reserves to unprecedented levels, heightening the need for managers to explore further diversifying reserve management;
- the need for a growing CGS market; and
- there are several currencies with growing liquidity and importance - the $AUD being one of these.
Furthermore, it wasn't all that long ago that all three major rating agencies recognised 14 triple-A sovereigns. The 'club' has now shrunk to 8, with CGS being the 4th largest of these remaining triple-A sovereign markets. Prior to the GFC there was little call for CGS to rate much attention amongst the broader international investment community, mainly due to the small size of the market and the seeming abundance of triple-A alternatives.
With the Government budgeting for a surplus in 2012-13 the forthcoming program, as anticipated, is to be set in the context of reduced issuance - particularly when compared with this year and last year. However, it is not clear that this should change anything about the discussion from last year regarding an appropriate future size for the CGS market. Stock outstanding (in face value terms) at 30 June this year will be just under 16 per cent of GDP. With the Budget Papers implying a forecast for steady issuance over the next few years, which will largely aim to refinance maturing bond lines, about four years will pass before the proposed 12-14 per cent of GDP as a long-term floor to the size of the market will become a binding consideration. So the message should be - determining an appropriate floor to the future size of the CGS market is not a pressing issue, and in any case it will remain around its current size for the foreseeable future. That said the Government as I understand is aware of the expectation that it should finalise a policy position on this sometime in the not too distant future.
Nonetheless, it has certainly attracted a steady flow of comment recently. One emerging theme is based on speculation that liquidity in our bond market will deteriorate as a direct result of lower CGS issuance and in the face of continually increasing demand (from predominantly 'buy and hold' investors) and the banking liquidity requirements to be implemented by 2015.
We certainly can't ignore the very strong prospect for underlying CGS demand to continue. This is the outcome of an increased focus on relative value assessments on a global scale. Therefore, other factors aside a continuation of the sovereign and banking sector tensions within the Eurozone (short of another full-blown crisis) should be sufficient to maintain the considerable support for current levels of demand for CGS. Putting this together with how many investors would view Australia's financial circumstances and economic prospects relative to other advanced nations, you would have to conclude that strong market interest in CGS will remain for a while. This in itself must reflect a view about the liquidity of our market given the importance of it to many investors.
Focusing only on the needs of investors, it would be easy to get caught up in the debate about the future supply of CGS not being adequate to meet future demand, in turn leading to illiquidity (or at least substantially reduced liquidity). But rather than exist for the needs of investors the role of the CGS market is to support financing of the operations of Government, and more broadly to facilitate a proper functioning and efficient domestic financial market.
The AOFM engages with many and varied participants in our market; from primary dealers to end investors. The feedback we receive on a regular basis is that liquidity in the CGS market is very good. There are many factors impacting liquidity and to the extent that the AOFM can promote it by maintaining steady supply, operating with transparency and consistency through our weekly issuance, and building-up sizeable bond lines, we will continue to do so. But we also know that liquidity is influenced by investor behaviour and from our discussions with investors we are aware that many do not match the typical 'buy and hold' descriptor.
According to our understanding many are already electing to repo their holdings, or are actively considering this - while some of these and other investors are actively trading in the secondary market as they adjust their portfolios to meet performance guidelines and benchmarks. At the same time, we are aware from discussions with domestic investors in particular that some tend to use CGS as a liquidity asset, leading them to be active traders for a different reason. In this respect a healthy diversity in our investor base, whether it be from onshore or offshore, is contributing to a well-functioning and liquid CGS market.
So the growing size of the CGS market, while having been an important factor in improving liquidity over the last 3-4 years, is likely to become less important as we enter a period of more static issuance patterns and investors adjust their expectations about future increases in the size of the CGS market. Financial markets adapt readily in response to changing expectations and conditions and there seems little reason otherwise than to believe that a new growth dynamic for the CGS market, to be linked to the size of the Australian economy rather than the impacts of the GFC, will be treated differently.
In any case, it is difficult to imagine anyone sensibly expecting CGS to fulfil a broader international sovereign bond market role, which would require a substantially increased market size. In fact if you compare Australia with the other three triple-A bond markets of over $200 billion in size, our bond market is substantially smaller as a proportion of GDP and it is substantially smaller in dollar terms. Our closest comparison Canada has a market over 25% of GDP (with its bond market more than double our market size); Germany's is just under 36 per cent of its GDP (at about six times our size in dollar terms); and the UK's is just over 61 per cent of GDP (at over seven times our market size). The US Treasury bond market is about 58 per cent of the size of its economy (and almost 40 times larger than ours). To put it another way, CGS represents about 1.8 per cent of the combined size of these four markets, confirming its niche status in a global setting.
So what does this mean to us for managing investor expectations? Unlike most issuers we have enjoyed the privilege of not having to heavily market our bonds, although we have been seeking to broaden awareness of CGS to encourage even further diversity in our investor base. More to the point, our investor relationships have been built on informing them as to how our market is developing, while seeking to understand their views on matters relevant for confidence in our market. However, while it is neither our role nor could we try to meet all market expectations, we do take our engagement seriously and recognise the benefit of understanding the range of views put to us. I think we have consistently demonstrated this.
Generally speaking investors raise a fairly wide range of issues with us, although this is not to say that every investor discussion is broad ranging. There are the obvious questions relating to economic themes such as the links between the Chinese and Australian economies, the health of the domestic housing sector and the dependence of our banking sector on short-term and offshore funding. We are also questioned on the extent to which AOFM sees itself as constrained in developing the issuance program (and the portfolio more generally); whether we are considering major changes to our pattern of issuance; and whether we have a view on the strong level of offshore demand for CGS.
While not an exhaustive list of issues that come up in discussions with investors it highlights some recurring themes. I will leave to one side the broader economic issues because they are dealt with in the Budget context. On the issue of how the portfolio and program are developed, I will say more about this shortly; but in summary investors appreciate the opportunity to hear that we are not constrained in how we can develop the market through the introduction of new lines, that we don't have formal limits on the size of bond lines we establish, and that we would consider longer maturities than our present 15-year bond if sufficient demand was thought to exist in support of another extension of the CGS yield curve. Furthermore, they also seem relieved to hear that we have a focus on building liquidity, and they acknowledge the benefits of regular supply. The way in which we take market demand into account when deciding each week which maturities to issue also seems to strike a positive chord.
In discussing the level of offshore holdings we are careful to point out that there are no restrictions or limits on offshore ownership of CGS and any observed level simply reflects a market outcome. To the extent that there is diversity in the investor base, we benefit from the fact that investors generally are likely to react differently to particular market shocks or developments. Furthermore, while not being able to determine exactly how much is held by certain types of investors, our offshore investor base is thought to be predominantly public sector, these entities typically representing a more conservative long-term investor type.
We also know from talking to investors that there is a substantial and growing number of them who now hold CGS on the basis of strategic portfolio allocations rather than tactical investment decisions. Some years ago the CGS market was more exposed to tactical investors whose decisions tended to be driven by movements in the exchange rate. However, given the evolved status of the CGS market many of those investors have now become long-term investors, some indicating to us that they will allocate part of their portfolio to CGS regardless of short-term volatility in the $AUD, or the market more generally. Many of our investors are regularly adjusting their CGS allocations while others have decided to increase their portfolio allocations into CGS over the past few years as sovereign markets elsewhere have become relatively less attractive. At the same time, a steadily growing number of new investors have been coming into the CGS market.
Together with the high degree of liquidity experienced in the CGS market, a growing number and diversity of strategic type investors should offer confidence that the CGS market is resilient and highly functional.
In summary, we have sought to manage and condition investor perceptions through conveying a picture of a stable and liquid sovereign bond market that provides access to regular supply, doesn't differentiate between domestic and offshore demand through regulatory or tax arrangements, and is one where the issuer has an appropriate degree of flexibility to, and an interest in, developing the market to achieve broad ranging benefits. This is helped in no small way by the efforts of the many price makers in CGS who are also actively engaged in promoting a healthy and stable market.
Our outlook is for a similar focus to continue, ensuring that our investor base remains well informed as to CGS market developments. Hopefully our efforts will also encourage investors who have been less familiar with the $AUD market, to steadily progress into other $AUD fixed income opportunities, as the supply of CGS moderates.
As I mentioned earlier, investors are also interested in detail regarding our issuance programs and of course they are not alone in that. Growing primary dealer expectations regarding our issuance plans have also become well established. In this context I will now turn to some observations on the task of managing the overall debt portfolio, which will lead me into some comment on issuance for the year ahead.
To go from an annual gross issuance program prior to the onset of the GFC of about $5‑6 billion per year to over $58 billion a year for the last two years has required considerable work in quickly formulating transparent and regular programs to meet a quickly emerging need for issuance.
But the challenge ahead is different as we contemplate circumstances in which annual issuance is set to decline, the CGS yield curve is now at 15 years, bond yields are at all time lows, and there are periodic requests for a greater allocation of issuance into TIBs.
We have now published our annual post-Budget Operational Notice indicating current estimates as to the volumes of Treasury and Treasury Indexed Bonds that will be issued for 2012-13. On the back of that I will spend some time giving thoughts as to how we see this program unfolding - including our intention to launch some new lines during the coming year.
In the lead up to a decision this year on how to allocate the program across nominal and indexed bonds we had a number of representations on increasing the size of the TIBs issuance program. You will note that the amount to be made available next year is about the same as we expect to issue in total this yea, but in the context of an appreciably smaller total gross issuance task.
A number of considerations influence our thinking on how we should shape the portfolio and in determining the substance of the issuance program. In the coming year, the AOFM's issuance strategy will be to continue building liquidity in our smaller bond lines while preparing to maintain a 15-year yield curve. The strategy of building up current lines, while maintaining the length of the curve and adding new bond lines to reduce the Government's refinancing risk, has proven to be an effective strategy and we will continue to adopt this approach.
We are also aware of the need to issue into those parts of the curve from where a large part of investor demand derives. This is not of course to say that we issue only to meet investor demand. In fact prior to the beginning of a financial year we develop an issuance strategy for the year ahead, but use decisions on when to issue different maturities throughout the year as flexibility when accounting for prevailing market conditions. Added to that, we must also be mindful of maintaining support for the 3 and 10-year Treasury Bond futures contracts.
Over the coming years we will gradually shift the weight of our issuance towards longer maturities, unless the curve steepens sharply during the period ahead, in which case this would give cause for reconsidering our broader strategy. But while outright levels remain favourable and investors continue to accept a relatively low yield differential to hold longer dated paper, our current strategy looks best in achieving an appropriate cost/risk trade-off on behalf of Government and the community.
During most of this year our weekly market sounding exercise has usually provided fairly obvious choices in maturities to issue. When we feel the need to issue maturities that don't look to be in favour our decisions of course are more difficult to make. With an increasing diversity in our investor base market signals, could prove to be more varied throughout the year leading to less obvious choices on the basis of demand. This is definitely where an overall issuance strategy for the year will be useful for reference.
One area where we have had mixed signals at times is in the TIBs market, where indications for demand can shift markedly during the year. We are currently trialling an approach whereby the next two lines to be tendered are always announced and to date there has been mixed feedback on this approach. Our motivation was to provide investors greater certainty for the near-term. Announcing a range for the volume and then determining the specific level a week prior to the tender aims to provide us with some flexibility.
We are also aware that TIBs investors would like to have more lines on issue, but we will remain constrained as to how we can achieve that given plans for reduced overall gross bond programs over coming years. By 30 June this year the proportion of TIBs outstanding relative to the term CGS market will be just over 9 per cent (in capital-accreted book value terms). The planned issuance for 2012-13 should bring that to about 10 per cent, completing the transition of getting TIBs outstanding into the target range announced last year in the Budget. This leaves us with substantial upward flexibility to develop the market if we were to be convinced that conditions for inflation-indexed issuance were favourable and that doing so was cost effective for Government. I must say, however, that at times the TIBs market appears fickle, which will require us to move forward with caution. Overall we don't doubt there is merit in maintaining a TIBs market and we are aware that there is growing offshore interest in TIBs, but at present this will be because we are one of the very few inflation-indexed markets offering positive real yields!
While the liquidity of this market is not comparable with that of Treasury bonds, feedback suggests that TIBs lines of $2-3 billion are sufficient in order to maintain a benchmark line. Our most recent launch of a new line was the 2022 maturity. The launch was well supported and attracted subscription coverage of just over twice the planned initial issuance.
Although we said last year we would not be introducing a new TIB line during 2011-12, we were persuaded to do so following several rounds of detailed consultations with investors. Having said the same thing again this year, I am more confident there won't be much opportunity to launch another new line during 2012-13. If for no other reason, this is because we now have five lines to issue into with the $2 billion of issuance planned. However, we will continue to consult investors on proposals for more intermediate lines between the five-year spaced maturities, understanding the impact that the current pattern will have on the changing duration of indices as lines mature. In this regard, we are also aware of the recent trend of many domestic investors away from the "All Maturities" index towards the 0-10 year index as the benchmark.
Planned Issuance for 2012-13:
This year we continued with the pattern of weekly Treasury Bond and Treasury Note tenders most weeks. The monthly tender arrangement for TIBs was maintained for most of the year, although there were times when we felt these wouldn't go smoothly with market signals suggesting a softening in demand. We responded to those signals by paring back the supply of TIBs for several months - even resorting for several months to multiple maturity tenders of relatively small volumes for each maturity.
There was also a few weeks around September last year when market volatility caused us to target nominal bond lines that represented 'safe bets' for the volumes we were looking to get away. Fortunately this experience was short-lived and coverage ratios and pricing outcomes since then continue to reflect healthy demand across the curve.
Like last financial year, total gross issuance this financial year will be around $58 billion. Total Treasury Bond issuance for 2012-13 is expected to be around $35 billion, of which $26 billion will cover maturities (compared with $14 billion this year) leaving $9 billion of net new issuance (compared with $44 billion this year).
We currently have 17 nominal bond lines with 11 of those having more than $10 billion on issue. Over the past few years we have issued second calendar year maturities while the yield curve had been maintained at 11-12 years. This was primarily to reduce refinancing risk. However, now that we have extended the curve to 15 years we have the capacity to create new issuance opportunities, while continuing to build existing lines to deep and liquid levels. Therefore, the practice of introducing second calendar year bond lines will cease for the foreseeable future. Furthermore, as we align the maturity dates of new bond lines with quarterly tax collections, this will assist overtime in managing refinancing risk. Nevertheless, we will continue to require the run up of cash using Treasury Notes in order to fund bond maturities for some years. This requires a lead time of months rather than weeks.
We have announced the introduction of a 2024 maturity for next year and we will also introduce a 2029 maturity to maintain the yield curve at 15 years. Even though successful in launching the 2027 line last year, we were aware of the possibility that it would take several years for CGS investors to become comfortable with longer dated paper. Although it has traded reasonably well over the last six months, it appears that it is a line we may need to build more slowly than others.
But we don't see this as a problem and in fact the issuance program set for the coming year will take into account the opportunity offered by current market conditions to consolidate the recent lengthening of the nominal yield curve. From now on we will be aiming to launch a new long bond line in every other year to meet this aim. We are confident that in a few years this will be viewed as standard procedure and that demand for the longer end of the curve will have become more established.
We maintain the belief that the strategy to lengthen the yield curve will continue to attract a new investor base of longer fixed income investors. To the extent that a longer CGS curve facilitates more efficient trading in other sectors of the Australian fixed income market, we also see this as a welcome outcome.
In keeping with our aim to be consistent and transparent, weekly bond tenders will again be held in 2012-13. Because of our preference for front-loading the issuance task, we may again see the opportunity to have comfortably achieved a good part of our planned annual issuance target prior to Christmas If this eventuates we may slow the rate of issuance from that point, rather than complete the program prior to the end of the financial year. This approach would avoid uncertainty as to whether there will be a regular supply of CGS.
Treasury Indexed Bonds:
The issuance plan for TIBs is for us to again tender around $2 billion (face value) in 2012‑13. Although we will look to build up the liquidity of our existing lines we will take into account indications for demand from the market. Tenders are planned to be later in the month with volume details announced, as is the case for the Treasury Bonds, at noon the Friday prior to the tender.
For TIBs as well as Treasury bonds the regular and consistent nature of our tenders, along with our regular market soundings should provide confidence to our primary bidders, market makers and investors that this market remains a relevant part of the AOFMs debt management strategy.
The volume of Treasury notes will by their nature and use, vary over the year, but we have once again committed to keeping a minimum of $10 billion on issue throughout the year. We had a total of 12 maturities throughout this year with the maximum number of outstanding maturities at any time being five. There is also no reason over the coming year to change our well established practice of using Treasury Notes to absorb the volatility in our cash position throughout the year.
In closing …
I will finish by offering several observations that reflect how we see our role over the coming years.
The experience of managing the fiscal impact of the GFC has provided useful reinforcement of the need to maintain ready access to financial markets. But the significantly increased focus on CGS has generated discussion about a range of emerging matters, some of which Government can respond to, some that clearly fall to the responsibility of the AOFM to manage (and where there are policy implications to Treasury as well), and yet other matters that should not and could not require any action or response.
The intensity of the last few years has not only been a reflection of the effort required to build issuance, but also to monitor and anticipate dramatic changes in financial market conditions. We can take confidence from the fact that our issuance arrangements have proven reliable and robust, and that the requirement of us to access markets has coincided with circumstances that have resulted in steadily building demand and historically low yields for CGS.
Where to from here is a challenge we should not take lightly given speculation in particular about further events unfolding in Europe. It is better to be over prepared and under tested, although we now live in a world in which sudden events can cause large adjustments that are both difficult to predict and even more difficult to absorb.
Having successfully navigated the challenges of the need to quickly and smoothly build issuance, the period ahead is one in which we will need to refine our outlook for the overall portfolio, while at the same time further developing the CGS market with a view to maintaining investor engagement. Our strategy and approach has not relied on complexity and inappropriate risk - conservative can be boring to some but of comfort to others. Let's hope the years ahead are not too testing, although our choice in this will no doubt be limited.