Source: http://www.aofm.gov.au/content/publications/reports/AnnualReports/2008-2009/html/04_Part_2.asp
Timestamp: 2013-12-06 02:13:53
Document Index: 483254697

Matched Legal Cases: ['art 2', 'art 3', 'art 4', 'art 4', 'art 7', 'art 7', 'art 8', 'art 8', 'art 9', 'art 9']

Part 2: Operations and Performance Introduction
One consequence of the global financial crisis was an increase in the demand for Treasury Bonds, as investors sought high quality fixed interest investments. As a result, conditions in the Treasury Bond market tightened. On 20 May 2008, following consultations with market participants about the adequacy of the supply of Treasury Bonds, the Treasurer announced that the Government would increase the issuance in order to ensure the continued efficient operation of the Treasury Bond and Treasury Bond futures markets. To this end, the Government legislated to allow an increase in Treasury Bonds on issue of up to $25 billion. Legislation providing for this received Royal Assent in July 2008.
Between 1 July 2008 and 3 February 2009, the AOFM issued a total of $8.8 billion of Treasury Bonds (in face value terms). Of this amount, $4.2 billion represented issuance under the core program announced in the 2008-09 Budget and $4.6 billion represented additional issuance. Issuance under the core program was in a new June 2014 bond line and the existing May 2021 bond line.
Following the change in fiscal forecasts in February 2009, Treasury Bond issuance was redirected towards raising monies to fund the Budget. The volume of issuance also increased; over $25 billion of bonds were issued between February 2009 and June 2009. Generally two bond tenders were held per week, each in the range $500 million to $700 million. The bulk of issuance was into existing bond lines in order to enhance their liquidity and improve their attractiveness to investors. A new bond line with a maturity date of April 2020 was also launched in order to establish a line that can act as the benchmark ten-year bond in 2010. The selection of bond lines for issue took account of current market conditions, relative value considerations, the aim of increasing the liquidity of all outstanding bond lines and the need to manage the maturity structure of the debt to limit refinancing risk.
The turnover of Treasury Bonds decreased by around 10.4 per cent in 2008-09 compared to 2007-08. The turnover of 3-year Treasury Bond futures contracts decreased by around 30 per cent in 2008-09 compared to 2007-08, and turnover of the 10-year contracts decreased by around 38 per cent.
Despite the large increase in issuance, tender performance measures in 2008-09 were broadly in line with those in recent years. Table 1 shows the results of the tenders conducted during the year. Table 1: Treasury Bond tender results — 2008-09
To facilitate performance monitoring, the assets and liabilities arising from the additional Treasury Bond issuance were allocated to a separate portfolio, called the Debt Hedge Portfolio. The portfolio was managed to minimise maturity gaps and to have an overall net interest rate exposure approaching zero. The investment mandate approved by the Secretary to the Treasury provided for the proceeds of the additional issuance to be invested in a range of highly-rated Australian dollar denominated debt securities. It also allowed funds to be invested in short-term money market investments such as negotiable certificates of deposit issued by Authorised Deposit-taking Institutions and term deposits at the RBA. The bulk of the proceeds were invested in semi-government bonds and Kangaroo bonds,1 as these Australian dollar denominated securities matched relatively closely the characteristics of Treasury Bonds. Purchases of securities were transacted by the following means:
At 3 February 2009, the Portfolio had a mark-to-market return of negative $12.1 million. The net accrual and mark-to-market performance of the Debt Hedge Portfolio through time is shown in Chart 3. The chart also displays the volume and make-up of investment holdings and the corresponding volume of additional Treasury Bond issuance through time.
The assets and liabilities in the Debt Hedge Portfolio were transferred to the Long-Term Debt Portfolio on 4 February 2009. The investments were no longer required and were completely divested by end-July 2009. Yields for both Kangaroo and semi-government bonds began to rise in the first quarter of 2009 and continued rising over the remainder of the financial year. This was a consequence of the general steepening in yield curves that occurred at this time. Over their entire holding period, Kangaroo and semi-government bonds generated a positive return of $175.4 million, comprising $165.5 million in interest revenue and $9.9 million in realised capital gains.
In August 2008, the AOFM began investing excess cash in a broader range of short-term investment assets, namely highly-rated bank accepted bills and certificates of deposit issued by Authorised Deposit-taking Institutions. Prior to this, excess cash was invested only in term deposits at the RBA. The broader range of investment options should help enhance investment returns on surplus cash balances. Interest rates for term deposits at the RBA are based on Overnight Indexed Swap rates.
Treasury Notes are short-term debt securities that can be issued to provide short-term funding. In recent years their issuance has not been needed because the AOFM's holdings of short-term assets have been sufficient to cover fluctuations in OPA balances. However, with the Budget balance moving into deficit and the transfer of monies to funds managed by the Future Fund, it was evident that the AOFM's short-term asset holdings would soon become insufficient to meet all within-year funding needs and that short-term borrowings would also be required. To this end, the issuance of Treasury Notes recommenced in March 2009. The notes on issue were built up over the remaining months of the financial year. The AOFM plans to keep at least $10 billion of notes on issue at all times so as to maintain a liquid market in them.
The size and volatility of the within-year funding requirement are indicated by changes in the short-term financial asset holdings managed by the AOFM, after deducting Treasury Notes on issue. Chart 4 shows the movement in the funding requirement in 2008-09. Chart 4: Within-year funding requirement 2008-09
The primary measure of cost used in this context is historic accrual debt servicing cost. This includes interest on physical debt and derivatives, realised market value gains and losses, capital indexation of inflation-linked debt and the amortisation of any issuance premiums and discounts. However, it does not include unrealised market value gains and losses. Accrual debt servicing cost is the most appropriate measure of cost in circumstances where financial assets and liabilities are intended to be held or to remain on issue until maturity and there is little likelihood that unrealised market value gains and losses will be realised. Information on unrealised market value gains and losses is useful in circumstances where it is possible that they may be realised in the future. In the AOFM's financial statements, debt servicing cost outcomes are presented on a 'fair value' basis that includes movements in the unrealised market value of physical debt, assets and interest rate derivatives. 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. Achieving the objective
Over recent years, market yield curves flattened and, at times, became inverted. This reduced the potential savings available from adjusting the portfolio's cost and risk characteristics through interest rate swaps. In its 2008 review of its portfolio management strategy, the AOFM concluded that this strategy no longer provided a firm basis for achieving future savings in debt servicing costs. While the strategy had produced substantial savings over many years, in the changed circumstances it was considered better to accept the maturity structure of the debt portfolio that resulted from debt issuance. As a result, the previous portfolio management framework was terminated from the end of 2007-08. Existing swaps were regarded as a legacy component of the portfolio to be managed in light of market conditions. Initially the legacy swaps were allowed to remain and mature, but when swap rates fell significantly in late 2008, the AOFM began terminating them, a process that was largely completed by May 2009.
The approach adopted to issuance after 3 February 2009 was designed to provide short-term flexibility within a framework directed to medium-term objectives. Decisions on the bond lines to be offered at tender were made weekly, taking account of market conditions, but a balance was maintained between issuing shorter and longer bonds. Issuance was spread over almost all the existing bond lines to increase their liquidity. Refinancing risk was managed by limiting the volume of debt maturing in the early years. The cumulative effect was that the average maturity and duration of the bonds issued between February 2009 and June 2009 was longer than if the selection of the bond lines to be issued had been guided simply by relative market demand. Performance
The debt servicing cost6 of the gross debt managed by the AOFM in 2008-09 was $3.0 billion (after swaps), on an average book value of $67.8 billion. This represented a cost of funds of 4.39 per cent. The return on gross assets was $1.6 billion, on an average book value of $29.4 billion, over the same period. This represented an average yield of 5.36 per cent.
Despite the volume of debt increasing in 2008-09 over 2007-08, the debt servicing cost of the total portfolio fell by $953 million. Chart 7 sets out the components of this change by instrument, broken down to show contributions from changes in the overall volume of debt and in the composition of the portfolio, and from movements in interest rates, exchange rates and the Consumer Price Index (CPI). Chart 7: Changes in debt servicing cost between 2007-08 and 2008-09
The reduction in total debt servicing costs was dominated by increased savings from interest rate swaps. Returns on swaps increased by $1.15 billion compared to 2007-08. A driving factor for this was the proceeds from the termination of swaps, which crystallised significant gains in market value. Also contributing to the increased returns from swaps were falls in market interest rates and a reversal in the shape of yield curves. In particular, lower short-term interest rates reduced the cost of the floating legs of swaps and brought a large increase in interest receipts from swaps in the second half of the financial year. Overall, swaps reduced the interest costs of the portfolio (before re-measurements) by $969 million during 2008-09. The debt servicing cost of physical debt increased by $406 million compared to 2007-08, as a result of the increased Treasury Bond issuance and the resumption of issuance of Treasury Notes. Also contributing were higher capital accretion costs on indexed bonds due to larger CPI increases. This was partially offset by relatively expensive debt maturing and being replaced with new debt issued at significantly lower interest rates. However, the lower short-term interest rates had a negative impact on the return obtained on term deposits. The interest revenue on term deposits in 2008-09 was $981 million, on an average book volume of $19.8 billion. This represented a return on funds of 4.97 per cent, compared with 6.89 per cent in 2007-08. Overall, term deposits in 2008-09 contributed $216 million less in interest compared to 2007-08, despite there being a slightly higher average volume. Unlike in 2007-08, term deposits in 2008-09 did not have a favourable effect on the net cost of funds in percentage terms, as the yield on term deposits was lower than the average cost of servicing gross debt.
Movements in market interest rates had an unfavourable impact on the market value of the portfolio in 2008-09, with unrealised losses from re-measurements amounting to $232 million. They comprised a gain of $1.01 billion on interest rate swaps, offset by losses of $1.07 billion on nominal debt, $35 million on term investments and $136 million on RMBS investments. The increase in unrealised losses from re-measurements in 2008-09 compared to 2007-08 was largely driven by falling interest rates inflating the market value of debt on issue. Conversely, lower market interest rates in 2008-09 had a positive impact on swap revaluations. Interest rate swap terminations
With the unwind of the swaps, the modified duration of the nominal Long-Term Debt Portfolio will in future be determined by ongoing issuance and maturing debt. Chart 8 illustrates this transition over the course of the unwind program. Chart 8: Modified Duration — nominal component of Australian dollar
Chart 9 shows the total savings provided by swaps over the period since 1992-93 and projected to 18 May 2010 when the final remaining swap matures. While final performance figures will not be available until then, the outcome is unlikely to differ greatly from the projections as only 21 swaps remained in the portfolio at 30 June 2009, of which 11 were subject to only one further repricing. The chart shows the cumulative direct cash flows from the swaps, cumulative realised (direct and indirect) savings and cumulative realised savings and (market value) revaluations. It also shows the yearly components of these aggregates. Total direct savings are projected to be $2.964 billion on 18 May 2010. Including indirect savings, the total benefit is projected to be $4.126 billion. Chart 9: Total Savings arising from interest rate swaps (inclusive of revaluations)
Credit management of interest rate swaps The use of interest rate swaps brings an exposure to counterparty credit risk. In 2008-09 the AOFM continued to use collateral agreements to manage this risk. These collateral agreements require counterparties to post collateral when the AOFM's credit exposure rises above a predefined threshold. Swap terminations were also undertaken to reduce the level of credit exposure during the year. The AOFM has Credit Support Annexes with 17 of its swap counterparties. On 30 June 2009, 84.7 per cent of the total nominal face value of the interest rate swap portfolio was covered by collateral agreements. Table 3 indicates the average credit quality across the counterparties to which the AOFM has an exposure.
Table 3: Derivative counterparties by credit rating
as at 30 June 2008 and 30 June 2009
credit rating as at
Number of AOFM
by credit rating as at
As a result of credit downgrades and movements in interest rates, the AOFM made five collateral calls from two counterparties totalling $106.3 million, and executed 13 credit-related swap terminations across five different counterparties, recouping $125.4 million in order to reduce its credit exposures to these counterparties. The AOFM's exposure to counterparty credit risk on swaps was $66.8 million at 30 June 2009. All remaining swaps will mature in 2009-10.
Since the late 1980s, the securitisation of mortgages into residential mortgage-backed securities (RMBS) has provided an important source of funding for new and small mortgage lenders to compete with the major banks in lending for housing. Commencing in 2007-08, developments in global financial markets reduced liquidity in the Australian RMBS market and constrained the ability of lenders to access funding from the source. In particular, margins on existing mortgage-backed bonds widened to a point that rendered securitisation uncompetitive as a source of finance for mortgage providers. This deterioration occurred despite the high quality of Australian RMBS and the fact that there has never been a credit-related loss on a rated prime residential mortgage-backed security in Australia. In view of these developments, the Government decided to invest in Australian RMBS to support competition in Australia's mortgage market during the current market dislocation. In October 2008, the Treasurer directed the AOFM to invest up to a total of $8 billion in eligible RMBS, including $4 billion to be invested in securities by issuers that were not Authorised Deposit-taking Institutions (non-ADIs). The allocation to the non-ADI sector was made in conjunction with the Government's decision to guarantee the deposits and wholesale funding of ADIs.
Securitisation is the process whereby income producing assets are pooled together to produce bond-like securities. Cash flows from the assets are directed to bondholders through a special purpose vehicle. The special purpose vehicle is legally separate to the originator of the assets, and is structured to remain unaffected in the event that the originator becomes bankrupt. The first RMBS transaction was undertaken in 1977 by Bank of America, and consisted of a simple 'pass-through' structure. The asset class has evolved, however, and now investors can benefit from credit enhancement techniques such as subordination and over-collateralisation. Subordination is the name given to the structure whereby the securities that are supported by the pool of mortgages are structured into 'tranches' that allow 'senior' notes to be repaid before the other 'mezzanine' and 'junior' or 'subordinated' notes. As the underlying pool of mortgages repays both principal and interest through time, the most senior tranches will be repaid before the mezzanine and subordinated notes, and the mezzanine notes will in turn be repaid before the subordinated notes. Based on historic mortgage prepayment experience, the cash flows associated with each tranche can be modelled with some degree of accuracy. In Figure 1 below, the senior notes are shown as classes A-S and A1, class AB is a mezzanine note and classes B1 and B2 are the subordinated notes. The senior tranches typically comprise the major part of an RMBS issue; in Figure 1, the senior notes make up 90 per cent of the total, whereas the mezzanine notes and subordinated notes together represent 10 per cent. With this deal structure, the senior notes and mezzanine note respectively have 10 and 5 per cent credit enhancement through subordination. While there is some variation from deal to deal, depending on pool characteristics, the senior and mezzanine notes typically obtain AAA credit ratings and subordinated notes are typically assigned lower ratings.
Investment Guidelines were developed that were consistent with the Treasurer's Directions and the first Request for Proposals (RFP) was issued on 13 October 2008. The RFP specified the selection criteria and minimum requirements that would be used in selecting proposals. The selection criteria were directed to the objective of supporting competition in the residential mortgage market, and comprised:
a maximum interest only period of 10 years; and a maximum time in arrears of 30 days of any loan. Twelve proposals that met these requirements were received, from which a panel comprising the Chief Executive Officer, the Director of Financial Risk and the Head of Treasury Services selected the four highest ranking transactions. These deals, totalling $1.996 billion, were transacted and settled by 15 December 2008.
Price was not a criterion used to rank proposals in the selection process. Instead, pricing was determined in consultation with issuers after mandates had been awarded. In this, the AOFM aimed to balance the objective of maintaining a competitive flow of funds for new lending for housing with the objective of attracting other investors. Where third party investors participated in transactions, the AOFM participated at the same price. Since mid-December 2008 when the wholesale bank guarantee was first used, the AOFM has typically been the sole investor in the longer-dated AAA-rated tranches of RMBS issues. At the same time, distressed selling in the secondary market increased, at price levels that were uneconomic for new mortgage lending. The AOFM sought to obtain margins that allowed the competitive origination of new mortgages, while maintaining consistency, on a risk-adjusted basis, in the pricing between transactions. The outcome was that the majority of investments in the longer tranches were undertaken at margins to the bank bill rate of between 1.2 per cent per annum and 1.4 per cent per annum, while smaller AAA-rated mezzanine tranches were priced at a wider margin to compensate for their subordination to the senior AAA tranches and longer WALs. Outcome and performance
Interest accrued in 2008-09 was $89 million, which represented an annualised return of 4.80 per cent. The securities purchased in 2008-09 were all floating-rate notes, paying a weighted average margin of around 1.3 per cent per annum over the one month bank bill rate. The average credit margin of around 1.3 per cent per annum on the RMBS portfolio is above the AOFM's cost of short-term funding, which has historically been below the bank bill rate. However this average margin is narrower than margins currently available in the secondary market, and the RMBS held by the AOFM showed an unrealised mark-to-market loss of $136 million in 2008-09. The market value of the AOFM's RMBS is determined by an independent service provider. The difference corresponds to a margin of about 80 basis points across the RMBS portfolio. This remeasurement effect can be considered to be the opportunity cost associated with purchasing these assets at prices that promote competition in housing lending, rather than at secondary market prices. If the RMBS investments had been priced at yields 80 basis points wider, they would not have provided a viable source of funding for housing. Table 4 provides details of RMBS investments at 30 June 2009. A total of $6.203 billion had been invested and had generated capital repayments of $179 million.
Table 4: RMBS Investments as at 30 June 2009 * Weighted average life
The Communications Fund was established in September 2005 to provide an income stream to fund the Government's response to any recommendations proposed by the Regional Telecommunications Independent Review Committee in reports reviewing the adequacy of telecommunication services in regional, rural and remote parts of Australia. The Fund was closed on 1 January 2009 and its assets transferred to the Building Australia Fund (which is managed by the Future Fund Board of Guardians). Prior to its closure the AOFM managed the investments of the Communications Fund on behalf of the Department of Broadband, Communications and the Digital Economy. The investments of the Communications Fund comprised short-term Australian denominated dollar money market instruments and deposits, including bank accepted bills, negotiable certificates of deposit and commercial paper. When the fund was closed the value of the Fund's investments totalled approximately $2,468 million. The before-fees investment portfolio performance benchmark for the Fund was the UBS Australian Bank Bill Index. The after-fees performance benchmark was the UBS Australian Bank Bill Index less 2 to 3 basis points. Performance against the benchmarks for the period the fund operated in 2008-09 is as follows:
Operational risk is the risk of loss due to operational failures resulting from internal processes, people, or systems, or from external events. It encompasses risks such as fraud risk, settlement risk, accounting risk, personnel risk and reputation risk. The AOFM aims to manage its exposure to operational risk to acceptable levels. Achieving the objective
The AOFM has an established technology platform that includes integrated services for the delivery of treasury management and market data. The services provided by AvantGard Quantum, Bloomberg and Reuters continue to meet the requirements of the AOFM by providing a reliable environment that supports the Agency's debt management and investment activities. Cooperation with other debt managers
Over the 2008-09 financial year, the AOFM continued to provide support for debt management activities in Papua New Guinea and the Solomon Islands. One position was staffed in each of these countries under the auspices of the Strongim Gavman Program and the Regional Assistance Mission to the Solomon Islands respectively. These deployments aim to develop cash and debt management capabilities through training and mentoring as well as the development of systems and procedures. This year a forum was conducted by the AOFM in Canberra attended by officials responsible for sovereign debt management of the two countries, together with seconded AOFM staff, to improve the assistance provided. During the year the AOFM also hosted two visits from debt management officials from Indonesia.
4 An interest rate swap is a financial contract where one party agrees to pay another a stream of fixed interest payments on an agreed notional principal amount, in return for a stream of floating interest rate payments on the same notional principal. 5 The modified duration of the nominal physical debt before swaps has generally been a little over 4.0 over recent years.