Euroweek Australia report: public sector borrowers

Euroweek, August 2013

Standfirst: Australian government bonds are widely held overseas, and increasingly, state paper is too. But will foreign central banks continue to commit their capital as the Australian dollar falls and yields come down too? By Chris Wright

Australian government paper, whether federal or state, is in great demand. Of the A$266 billion of Commonwealth Government Securities on issue, 70.4% were held by non-Australian residents as of March 2013, a figure that has at times touched 80%.

And why not? There is a lot to like in Australian government bonds. The country is one of a shrinking elite worldwide to be rated AAA. Its budget deficits, when they occur, are modest, certainly in comparison to any other developed world country. The legal system is tried, tested and trusted. The securities are liquid – the more so since Australia committed to maintain a CGS (Commonwealth government securities, or Australian government bonds at a federal level) market equivalent to 12 to 14% of national GDP. They pay a far greater yield than treasuries of similarly developed nations. And, until recently, the currency itself had been on an endless upward trajectory.

And yet, there is always a risk when levels of foreign ownership are so high: that it could all take flight once again. And while there is never any realistic danger of that in a country that is thriving, just lately there has been a sense that Australia’s economic time in the sun may be coming to an end. As the economic overview explains, a slowing China and an ending resources boom have removed the dynamo from the Australian economy, and the currency – partly by design from the Reserve Bank of Australia, it should be said – has fallen heavily from its highs, dropping more than 10% in a month and back below parity with the US dollar. At the same time, rate cuts by the Reserve Bank have reduced the yield differential with other currencies.

Could it be enough to cause capital flight? Those in the market, from Australia’s debt management office to bankers and fund managers, tend to argue against it. “We’ve given a lot of thought to this, because a large proportion of offshore ownership comes with risk,” says Rob Nicholl, CEO of the Australian Office of Financial Management in Canberra, in an interview that can be found in full on page xx. “But any solution comes with risk. And we don’t see the circumstances in which we would have a mass exit.” Nicholl says that the foreign central banks who make up the bulk of foreign ownership in the market – and in particular new ownership – tend to hold Australian dollar paper unhedged, as a portfolio allocation rather than an opportunistic play on the currency. “We see plenty of turnover at the margin, but we expect that as a healthy characteristic.”

Bankers agree. “The question we are constantly asked is: with the Aussie dollar falling, do reserve managers exit the A$ trade?” says Michael Correa, managing director, global capital markets at Westpac. “At the moment, we don’t see that occurring. Among the reserve managers we talk to, the Australian allocation is now stable in their portfolios, with the only possible exception to that being Japanese investors because of what is happening post the Abenomics changes on monetary supply there.”

“It has now become a fixed allocation of reserve portfolios, whereas before it was in the discretionary bucket. It’s now seen as more of a reserve currency.” Westpac is calling the Australian dollar to remain at current levels or higher. “We don’t see that as a trigger to exit government bonds, and we still think the carry on an Australian government bond versus other reserve currency assets is attractive.”

If investors do stay the course, then their questions about CGS issuance are likely to be threefold: about supply, about tenor, and about inflation-linked product.

Supply is the easiest to answer, because of the commitment to keep the outstanding debt in CGS at a consistent level to GDP; in fact, today it stands at 16%, so should be expected to drift back a couple of percentage points in the year ahead. But in aggregate, a market around today’s level is what investors should expect.

Then there’s tenor. Earlier this year, the AOFM put out its longest bond, due 2029, for a tenor of 16 and a half years at the time of issue. It went well. But, viewed from developed markets, it is strikingly short for the longest bond in a national armoury. In the UK, for example, Gilts have an established curve for 30 or even 50 years.

Many bankers would like to see the AOFM stretch itself out along the curve. “There is no 30-year government bond in this country because of the size and preferred financing structure of the government’s debt,” says Steve Black at Credit Suisse. “This lack of a benchmark makes it more difficult for issuers to raise very long-dated financing.”

The issue has become political. Earlier this year Joe Hockey, the shadow Treasurer and almost certainly the federal treasurer if the Liberal party win September’s general election, called for longer-dated funding. “If there is a change of government, one of the first things I’ll be doing is meeting with the AOFM and asking them to start extending the maturity date of Commonwealth government securities so that we can create a benchmark yield curve,” he said in April. “I’m prepared to go 40, 50 years.”

Many in the market would like to see exactly that, for two reasons: one, it would help the corporate bond market develop greater tenor, as there would be government bonds to price off; and two, it would help the availability of long-dated infrastructure funding, which would clearly help the country. But not everyone is keen. “I don’t see any real change in demand from domestic investors in terms of tenor in the government curve,” says Correa. “The water has been tested – we’ve seen TCV [the Victorian state treasury] issue in the ‘32s, with a 20-year nominal bond – but demand for tenor in Australia is driven more by offshore than onshore investors.

“I know there has been a lot of discussion about whether Australia could issue a 30 or a 50, but for me, it’s more of a folly than a reality,” he says. “I don’t think there is enough demand out there to push a full line of stock beyond 20 years, although we could certainly do more between 10 and 20.”

For his part, Nicholl says in our interview that Hockey’s are “reasonable questions to ask and we should always be asking them”, but declined to put a timeframe to lengthening tenor.

The third question is around inflation-linked securities. Australia has $18.52 billion of treasury indexed bonds on issue, and has a mandate from the government to develop the inflation-indexed part of the portfolio to 10 to 15% of outstanding, from around 6% today.

Bankers say there is a market for more. “At the moment inflation-linked is probably on the nose a bit from the global investor point of view, but it has a longer-term role to play in Australia,” Correa says. “Our advice to AOFM is to issue more inflation-linked. New Zealand is issuing double the amount compared to Australia.” Specifically he suggests buying back some shorter-tenor bonds in this area and re-issue down the curve, “at a mid-2030s sort of tenor”.

Beyond the federal government, Australia’s states are sophisticated issuers in their own right, and are gathering increasing attention from investors who might take their first look at Australia through commonwealth bonds and then move into semi-governments in order to diversify and pick up yield.

Tim Galt, executive director, fixed income syndicate at UBS, says “we are seeing an increasing number” of new buyers of government paper “rotate into the States as they look to diversify in Australian dollars and not only hold sovereign debt.” UBS was, with ANZ, a joint lead on the longest benchmark transaction to date for the Northern Territory earlier this year, dated 2024, following a nine-year deal for the Australian Capital Territory. “Both these transactions evidence the desire among investors to hold deeper and more diverse exposure to Australian dollar borrowers,” Galt says. An A$750 million trade for the Queensland Treasury Corp as another standout, a syndicated offering of 11-year funding which went 7% to Asia and 8% to Europe.

One challenge for investors, though, is that the states don’t seem to need as much money as they used to. “In the last six weeks, we have seen the states and treasuries come out and announce their budgets,” says Apoorva Tandon, director, syndicate at ANZ, speaking at the end of July. “There appears to be a reduced funding need in the next 12 months because of the states’ fiscal positions, and some asset sales taking place at a state level.” A look at Victoria’s funding requirements, announced in May by the Treasury Corporation of Victoria, demonstrates: having set its funding task at A$7.2 billion for 2012/2013, its need for the year ending June 2014 is $6.69 billion; to June 2015, A$5.66 billion; to June 2016, $1.91 billion; and to June 2017, just $1.88 billion.

“The biggest takeaway is that supply has diminished compared to previous years, so investors are looking for exposure in the secondary market, which has outperformed,” says Tandon.

Correa says that besides Queensland, most of the semis are looking at either balanced or surplus budgets within the next two years. He says investors – particularly bank balance sheets, a potent source of demand as regulatory requirements become more onerous for them – want more and more of this paper just as its availability is diminishing.  “We are very constructive on the semis, particularly the premium states of NSW, Victoria and WA,” he says. “We like that they are looking at FRN-type products; it helps bank balance sheets in Australia to meet their reserve requirements. We much prefer that to fixed in terms of how they manage risk.

“Inquiry around semis is growing at a time when supply is looking to fall.”

Also, whereas Australian corporate issuers have benefited from strong interest from Asia, the states are garnering more and more attention in the west. “International participation in state issues has improved,” says Tandon at ANZ. “Recent transactions from QTC [the Queensland treasury] in particular have had increased participation and flows from Europe and the US.

“We have seen transactions go 30-40% to central banks, and the bulk of that growth has been from Europe.”

One trend for the future will be retail participation in government securities through the stock market, since government listed bonds started appearing on the ASX in May. Initial take- up has been subdued, but “it’s relevant because of what it may become rather than what the impact is now,” notes Allan O’Sullivan at Westpac. “The listed sector has gone from $38 billion to $280 billion just because investors can now access Australian government bonds.”