The Australian Government Bond Market
Speech delivered by AOFM's CEO, Rob Nicholl, to the Australian Government Fixed Income Forum
Tokyo 11 December 2013
Good morning. As many of you will be aware Australia has a long and close relationship with the Japanese investor community and this is a key reason why we have decided to hold this event. Should it prove useful we would certainly look to repeat it in the future, but we do not intend that it should replace the one-on-one meeting relationships we have enjoyed with you in the past.
What I will do is set some common context for the presentations by NSW Vic, Qld and WA by giving you an overview of the key fiscal ties between the Commonwealth and the States. I will also outline Australia’s current fiscal and debt positions; the AOFM’s issuance program for this year; our recent issuing strategy; and will finish with a brief look at our Commonwealth bond market.
Let me start with a snapshot of Australia through some key indicators:
After two decades of unbroken steady growth Australia is the 12th largest economy with GDP around US $1.5 trillion.
The cash rate is 2.50 per cent.
With a sell-off earlier in the year due to broader market changes we experienced a steepening in the yield curve. Even so, Australian Government bond yields remain at relatively attractive levels when compared to most other advanced sovereign markets.
The resilience of Australia’s economy and a focus on fiscal management are recognised through its triple triple ‘A’ status. Australia is one of only 11 S&P AAA (stable) rated sovereigns in the world and one of only 8 AAA (stable) rated sovereigns as rated by Fitch, Moody’s AND S&P;
The Australian dollar continues to grow in global importance as a trade currency, while having taken on some distinct reserve currency type features. It is the fifth most traded currency - with the AUD/USD being the fourth most traded currency pair.
Australia is made up of 6 states and two territories. The bulk of the population and around 85% of GDP centres on the four largest states - NSW, Queensland, Victoria and Western Australia.
The Commonwealth and the States are able to raise revenue through the collection of taxes but it is the Commonwealth which has by far the greatest taxing powers and as such is able to levy taxes which provide the largest sources of revenue - personal and corporate income taxes form the largest share of total public sector revenues. The Commonwealth raises just under three quarters of total public sector revenues.
The tax raising ability of the States is restricted by the Constitution to certain areas. They are able for instance, to levy a number of indirect taxes on labour, land and property transfers. It would require the Commonwealth to reduce its tax effort on personal and corporate income for the States to access this tax base. Instead, the Commonwealth has long chosen to provide a proportion of its annual revenue to the States by way of fiscal transfers.
The most significant of these transfers involves a formal fiscal agreement between the Commonwealth and the States to transfer in full the collection of a national Goods and Services Tax . This agreement provides for the States to use these monies for any purpose. Depending on the State it represents anything from 15% to 50% of total Budget revenue.
Also by Intergovernmental Agreement the Commonwealth makes a large number of dedicated specific purpose fiscal transfers to the States. Most of the money though goes into key service delivery areas such as health and education. As can be seen from the chart, these dedicated payments can provide up to 30% of a State’s revenue base, but in most cases it is closer to 20%.
A third source of Commonwealth direct support comes in the form of financial relief in the event of a large natural disaster. This covers amongst other things fires, floods and cyclones. The National Disaster relief & recovery arrangements allows for direct financial support of up to 75% of the cost for re-provisioning essential services and infrastructure. A recent example is the impact on Queensland of Cyclone Yasi in 2011. In this case the Commonwealth also provided substantial funding support through the imposition of a one off national income levy.
Relative to the size of its direct expenditure responsibilities the Commonwealth has a very large tax base and it uses the fiscal transfer arrangements to equalise - or re-balance- the Budget positions for itself and the States. This is referred to in Australia as Vertical Fiscal Equalisation.
As you can see from the chart - personal income and corporation’s tax provide up to two thirds of the total tax collection by the Commonwealth, with the GST being a dedicated source of revenue to the States from the Commonwealth. Total GST revenue is distributed on an adjusted per capita basis to take account of the inherent revenue raising and expenditure challenges of each State and Territory relative to their combined average experience. Therefore those States with relatively stronger economic performances will tend to receive a lower per capita adjusted share than other jurisdictions.
This diagram highlights the fact that it is the States that are the main providers of a number of key and important areas of expenditure through the direct provision of public services. While the Commonwealth is responsible for matters such as defence, security and immigration, the states carry most responsibility for expenditure on infrastructure, law and order, health and education.
Leaving Commonwealth-State financial relations let me turn to the Commonwealth in its own right.
As this chart shows, Australia’s national net debt position remains very sound by international standards. Compared to the other Triple-A nations, Australia does not have the powerful negative net debt positions of the Scandinavian countries, but it sits comfortably in the middle of the group and compares well to nations such as Switzerland and Canada.
At this stage Australia is forecasting an under lying cash deficit of $30.1 billion or 1.9% of GDP for this year - 2013-14. This compares to a deficit of $18.8billion or 1.3% in 2012-13. The budget is projected to return to surplus in 2016-17.
Recent indications suggest that there has been a further deterioration in the Commonwealth’s fiscal position since the recent election outcome. However, we will need to await the upcoming Mid-Year Budget Report to better gauge further fiscal impacts for the current year and a revised outlook for the 2-3 years ahead.
Recent deteriorations in the fiscal position are largely due to weaker than expected tax receipts - a result of slower than expected economic growth and lower nominal GDP outcomes than have previously been forecast.
However history indicates an ability of successive Australian Governments to successfully manage fiscal consolidation by returning the Budget to surplus. While there are no doubt challenges in achieving the current forecast position the incoming Government is expected to maintain a focus on returning the budget to surplus within the next 3-4 years.
This financial year we are expecting to issue a total of around $75 billion in bonds (both Treasury bonds and TIBs) compared with around $56 billion last year. Our plan for the current financial year is to issue around $70 billion in nominal Treasury Bonds. This figure has increased from $50 billion as announced at the May Budget. The reason for the increase has been a change in the fiscal position. The overall program will account for around $24 billion in maturities for this year, creating net new issuance for the year of around $47 billion. For inflation-linked bonds, or TIBs, both gross and net issuance is expected to be around $4-5 billion for the year.
The proportion of long term outstanding debt that we aim to keep in inflation-indexed bonds is around 10 to 15 percent. Our program of $4 billion in the current financial year was greatly advanced by the recent issue of $2.1 billion a new 2035 maturity, while the rest of our program is planned to be carried out by regular monthly tenders.
The last decade has seen the task of the AOFM go from one of managing surplus cash balances and issuing debt in order to maintain a minimum level of stock on issue, to one of funding a sharp increase in Budget deficits and facilitating a rapid growth in our issuance program. Given the narrow window in which this transition needed to be undertaken, this meant we needed to issue in a manner that arguably was more weighted towards meeting market demand than towards optimal portfolio construction, particularly in 2009.
As can be seen from this slide, during 2009 and 2010 that demand was very much in the shorter part of the curve and was our issuance. Between 2009 and 2011 about half of our annual issuance was in the 5-year or longer part of the curve. By late 2011 we had made a distinct push into extending the curve with the establishment of a 15 year bond, and this year we expect to issue well in excess of half our program into the 8-year or longer part of the curve. Lengthening of the curve and investor support for longer-dated maturities have both helped us in this regard.
We very recently established a 20-year nominal benchmark maturity and the April 2033 syndicated Treasury bond was very well directly supported by investors - both domestically and from offshore.What was interesting to the AOFM, apart from the large volume of bids we received, was that it had the largest amount of offshore bidding that we have received for any of our syndicated deals - this being at around 60%. The deal attracted a wide range of bids from a diverse geographic and market sector background.
Due to forecast budget deficits over the next few years, the volume of issuance will remain relatively high and the outstanding market level of Australia Government bonds will continue to growth. According to current expectations, outstanding bond volumes are expected to peak at the end of June 2017. What this means for investors is that the Australian Government bond market will remain a medium sized market in global terms, its size and liquidity over the past 4-5 years having grown substantially.
Australia currently has 20 Treasury Bond lines, 13 of which have over $12 billion on issue. Last week we launched a new Oct 2018 maturity and this will help us to manage the shape of our portfolio in the mid-part of the yield curve by opening up some additional issuance points. This is a practice you can expect to see us repeat over the coming years. The grey areas in the bar chart you see on the screen show how we have allocated out issuance so far this financial year. As you can see our issuance to date has been fairly evenly spread from a minimum of 2 years, but with a recent and slightly greater focus in the 8 years and longer, part of the curve.
The liquidity of Australian Treasury Bonds continues to increase. Total volume of turnover is shown in this chart on the left hand side and it includes repo transactions. The chart shows a 3 month moving average in order to help reflect the trend in activity but removing some of the short-term volatility. From a period of low monthly turnover in pre 2008-09 bond outright and repo transactions have been steadily increasing and recent rapid increases show that monthly market turnover is now well in excess of the outright size of the Treasury bond market.
The increase in liquidity is no doubt in part due to the increased volume we are issuing, but it is also reflective of the growing number of investors and participants in our market and the very competitive pricing that often occurs thanks to our intermediaries. We have included the turnover ratio which is the volume of turnover divided by the volume of bonds on issue. As you can see, the turnover ratio, which might be expected to decrease purely as volume of issue increases, has also gone through a recent rapid rise this year supporting the fact that turnover is not just about the larger issuance volume.
We now have 6 Treasury Indexed Bond lines. This market was reopened in September 2009 with a September 2025 $4 billion issue. Since then we have launched three new lines - a September 2030, a February 2022 and the August 2035. The recent TIB 8/2035 syndication was another step in developing the inflation linked market in Australia.
Liquidity in this market continues to rise according to the experience of our investors. The turnover ratio is also high though not to the extent of the TBs .
Many of you would have seen before or at least know the story behind, the proportion of Australian Government bonds held by non-residents. Non-resident holdings for bonds is now just under 70% and it has been widely discussed and mentioned how this percentage peaked around 18 months ago but has since been declining.
I would like to make a number of points here:
1st - It is well known that non-resident investors have been very active in this market for the last 4-5 years - particularly the offshore public sector in which we include Reserve managers, Sovereign Wealth Funds and National pension funds.
2nd - The peak of Non-resident holdings at just under 80% in the March quarter of 2012 started to decline as the entry rate of new foreign offshore public sector slowed. This impact was exacerbated further by active Japanese selling through late 2012 and 2013.
3rd - Our issuance program remained consistent over the last few years with large issuance programs in excess of $50 billion a year. This diagram shows market value of total Government bonds outstanding (shown here by the light blue bars). But the market value has grown throughout this history with the exception of the last quarter from Mar 13 to June 13. Obviously the face value of the bonds still rose in that quarter as they have done for the last 5 years.
4th - Despite the non- resident percentage falling, 5 of the last 6 quarters since Mar 2012 have had positive net transfers; that is there has been more offshore buying than selling. The reason for the non- resident holdings decline is not due to foreign investors selling out of our paper, it is due to the change in the market value of these holdings. The face value holding of non-residents has continued to rise although at a much slower pace.
And lastly - We do not see this decline as trend one way or the other, as some of my points earlier would suggest and we still expect to see strong offshore interest in the market against steady bond supply for this year and probably the next.
Australia’s AAA (stable) rating, strong net debt position, steady economic growth, and stabilising fiscal position, Australian Treasury Bonds provide an attractive return when compared to yields on other advanced economy securities. Our short-end yields provide a substantial pick up over the short-end yields of other curves, while the Australian-US 10 year spread this year has traded between 100 and 150 basis points, in the last few months reaching its widest point.
Interestingly, the Australian-Japanese 10yr spread has been widening steadily for almost 2 years. Currently it is around 350 bps, its widest point since 2011. Again, you can get a greater pickup into the long end of Australian curve from JGBs than you do in the short end. In comparing Australia to most other advanced economies yield curves, such as the US, the greater pick up is usually in the short end.
Australian Government bond yields still stand out strikingly against all other Triple-A economies, and against almost all other advanced economies (New Zealand being the exception) even in some cases against the fast growing emerging economies.
Finally I would like to mention the growing liquidity of the $AUD. Although not in the same category as one of the big four currencies like the YEN, when compared to comparable currencies like the CAD and Swiss Franc its growing position, at least as far as turnover is concerned, is evident. It is fifth in terms of turnover. This growing liquidity will only continue to benefit offshore investors by reducing transactional costs through narrower spreads, attracting a greater number participants including market makers and allowing a greater number of issuers and products to be originated in our currency.