Euroweek Australia report: AOFM interview

Euroweek, August 2013

The Australian Office of Financial Management is the agency responsible for the management of Australian government debt. Aside from managing the curve of Commonwealth government securities, it intervened to save the mortgage-backed market during the financial crisis – a programme it concluded in April. CEO, Rob Nicholl, spoke to Chris Wright in Canberra.

It’s an interesting time to meet you after yesterday’s announcement ending the AOFM’s programme of support for residential mortgage-backed securities (RMBS). What did that programme achieve?

Without doubt, the AOFM’s involvement on behalf of the government was critical in preserving the securitization infrastructure in a period when it looked like the market was basically in seizure. We provided investor access to issuers at a time when they basically had nowhere else to turn. It seemed particularly important that the government focused on small issuers.

We’ve been careful to implement the policy in a manner that gave recognition to the fact that it was transitory. The government made it clear this was a temporary measure and it was our responsibility to be consistent with that. We achieved that, particularly in the last year or so, by whenever it looked like we were to be the sole investor in tranches, setting out pricing expectations at a level that would draw other investors. I think we’ve invested well on behalf of the government and community.

What’s the message that comes with the end of the programme?

The message is that the securitization part of the market has recovered. We have seen substantial price adjustments in the Australian market, and we are seeing increasing interest from offshore investors. That is a strong signal that the market is… not back to where it was, but I don’t think anybody had an expectation that the securitization market would return to pre-2008 levels. We don’t know whether this is what it looks like forever, but we’ve seen plenty of evidence that smaller issuers are capable of getting paper away without our involvement. It’s a much healthier market.

Speaking to bankers, there is widespread agreement that the programme had worked and that recent issues from non-banks had not required your involvement. But they ask: why close it? Why not leave it there in case it is needed again in the future? Is it about the message that it’s time to stand alone?

The programme’s served its purpose, so why wouldn’t you close it down? The Treasurer has said it will look at it again if things change in the future, but why not draw a line in the sand now? If it’s served its purpose, you would think it should end.

Total Commonwealth Government Securities (CGS) outstanding are far higher than they used to be, but still small on a world scale. If you look forward, where is the market going in terms of size?

In terms of scale relative to other markets, we’ll see what we see now. We know from budget forecasts that there’s no fiscal plan to continue to borrow at the rate that we had in the last few years. Because our issuance is directly linked to budget deficit funding, it stands to reason that we would see a market around the same size. You wouldn’t expect large marginal changes relative to the size of the market.

This brings us to a central question: the tension between the lack of need for a lot of funding; and the need to offer a liquid, developed benchmark. How do you handle that tension?

Well, two budgets ago, the government dealt with it by saying it would consider a policy proposal to maintain a CGS market at around 12 to 14% of GDP. This year it will be around 16%, and even if we have very modest issuance in the next few years it’s three to four years away from drifting back down to that 12 to 14% of GDP level. The government’s indication to investors was that it was conscious of the need to maintain liquidity in the market, but was prepared to consider a proposal to maintain the outstanding stock of debt relative to the size of GDP. That has been more than sufficient in signaling to investors that their participation in the market is warranted, that the market is and will be resilient, and that AOFM is focused on maintaining and building liquidity in the market.

We have various ways we are attempting to do that. The feedback we get is that liquidity is good so we are focused on trying to maintain bigger bond lines than the past, with regular supply and as much transparency as we can in our operations. Diversity in our investor base also helps so we don’t see the bulk of our paper on a buy and hold basis. All those things contribute to liquidity.

Do you still come up against a fear that the market might shrink again in the future?

Not specifically, not in the last two years, we haven’t had anyone raise this specifically as a fear.

Are there any interesting patterns in offshore participation?

Over the last four years we have seen a steady increase in public sector investors in our market, and that has resulted in quite a geographic spread of interest. There is strong interest from North and South America, throughout Asia, Europe, even in Africa now.

The majority of our investors by volume and number are public sector, but we are also seeing quite a lot of real money coming into the market. We will continue to see central banks coming into the market because the reserve management mandates will require them to diversify into other currencies, and Australian dollars are going to be an obvious one.

When you have such a high level of foreign participation in the market, there is always a concern about the potential for outflows. Are you confident that money will stick?

Yes. Look at the central bank market: they are very conservative. Most of those core investors holding A$ paper are holding it unhedged, because it’s a portfolio allocation. We’ve given a lot of thought to this, because a large proportion of offshore ownership comes with risk. But any solution comes with risk. And we don’t see the circumstances in which we would have a mass exit. We see plenty of turnover at the margin, but we expect that: as a healthy characteristic.

You’ve been moving to longer tenors. The latest was 2029.

Yes, 16 and a half when we issued it.

How’s that gone?

We just issued that again yesterday [IN APRIL] for the first time since syndication and it was a very pleasing result. The tender was over three times covered with pricing 0.25 basis points through mid-market. Our move to extend the yield curve to 15 years, 18 months ago, has been very successful, and we are in a period of consolidating that.

What role will CPF-linked [inflation-linked] paper take?

We have a broad mandate from the government to develop the inflation index part of our portfolio to 10 to 15% of outstanding. We’re just below 10% now. We’ve gradually increased the amount of issuance in that market and our outlook is to develop it in a steady way. We’ve got support to do that.

[Opposition Treasurer] Joe Hockey has said that if he was in power, he would ask you to launch 40 or 50 year bonds. We don’t currently have a 30 or even a 20. What’s your view about lengthening tenor?

Those are reasonable questions to ask and we should always be asking them. We are constantly asking ourselves this question, and we are asked a lot offshore. We say that we’re open to the idea but we are naturally fairly conservative in the way we will develop the portfolio. We would want to have a confident understanding that there was strong demand for us to be able to lengthen the curve. The means by which to do it would need to be by our normal process: syndication or tenders. Whether you go long and fill in, or incrementally move out, are open questions we think about all the time. I can’t give you a timeframe: we are taking the opportunity to consolidate this 15 year extension but we have an eye to do other things as well should the opportunity present.

Does longer tenor funding help infrastructure funding in Australia?

I think eventually it would. It is pretty hard to get past the proposition that a strong sovereign bond market is the foundation of the rest of your domestic market. In principle there is a good reason to argue that if you have a sovereign bond curve with longer-dated paper, that helps price discovery of other products in the market, including corporate bonds. We are certainly aware of the policy reasons you would want to do that, and the reasons that it would facilitate infrastructure development.

You’re from a state background with Tasmania. Can you spell out the relationship between Commonwealth and states in funding terms?

Australia is a federation, and that necessitates strong policy and fiscal cooperation between federal and state governments. We see that. Most investors understand that the states collectively draw half of their budget revenues from a nationally collected tax. They are intrinsically linked to the Australian story. That’s a strong indication of where the semis sit relative to the Commonwealth. There are lots of examples around where the Commonwealth steps in and assists the states when they need fiscal support. People like to highlight the differences between Commonwealth and states, which can be political, but if you step back you seem them working together for a common good.

You see no need for an explicit guarantee?

Not that I can see. The states borrow for different reasons, but their fiscal positions are monitored collectively including by the Commonwealth. There is very transparent reporting.

Does the AOFM lengthening tenor have an impact on the states?

We’re certainly told that our efforts to build relationships with offshore investors helps to pave the way for the semis to participate, and we talk to a lot of investors who are interested in the semis because of the yield pickup. A natural progression is for an investor to be interested in our currency, then buy our paper at the short end of the curve, then across the curve as they become more familiar. The next steps from there are to SSAs and semis, and we have talked to investors who go on to buy corporate paper.

There is a contradiction between the enormous scale of Australia’s superannuation funds, and the relatively small bond market, particularly corporate. Do you have a view on what might improve that?

No, they’re policy issues. We would make similar observations about where the money sits and goes, but how you bring about the redirection of those flows is a policy question.

Viewed from London, Australia appears in great shape relatively in the developed world. Do you see any threat at all to its safe haven status and rating?

No. If you look at the fundamentals, despite the volatility we see in economic performance, the underlying picture is one of strength and opportunity. That’s part of the national debate at the moment: how does Australia even better position itself in the Asian region when this is our centre of global growth? It’s a good problem to have: which choices we make in order to develop the country.