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SAFA leads the way for Australian ARR issuance with AONIA debut

South Australian Government Financing Authority (SAFA) came to the fore in Australian alternative reference rate (ARR) innovation on 6 June, when it priced the first-ever deal linked to the Australian overnight index average (AONIA) reference rate. Deal sources say the rate is not meant to be a replacement for bank bill swap rate (BBSW), but a part of a broader suite of products Australian issuers and investors can access better to suit their needs.

SAFA’s A$500 million (US$349 million) one-year floating-rate note (FRN) deal, led by UBS, was first proposed to the market late in 2018 when the issuer and lead met with investors to consult on the structure of the notes. SAFA began taking registrations of interest for the deal at the beginning of March, before launching on 4 June with indicative volume of A$100 million and price guidance of 38-43 basis points area over AONIA.

The deal received more than A$230 million of bids by the end of 5 June and climbed to its capped amount of A$500 million on the morning of 6 June. The final price was set in the middle of the guidance range, at 41 basis points over AONIA. IHS Markit was the calculation agent.

Benchmark alternative

Benchmark reform has been at the top of the agenda in the US and UK capital markets in the last 6-12 months, as they grapple with the impending end of LIBOR.

Unlike offshore jurisdictions, the end of Australia’s interbank offered rate (IBOR), BBSW, is not imminent. However, there are pressing reasons for institutions still to look at alternatives such as AONIA, which is derived from the Reserve Bank of Australia (RBA)’s cash rate and is therefore essentially risk free.

Deal participants are eager to convey that the AONIA-linked FRN is not a replacement for the established benchmark. Rather, it forms part of what should be seen as a broader suite of products issuers and investors can access better to suit their individual needs.

For SAFA as a government-guaranteed risk-free entity, issuing off BBSW, a benchmark rate which has inherent credit risk, has long been a bugbear. Andrew Kennedy, director, treasury services at SAFA in Adelaide, says: “SAFA decided that the risk of a credit benchmark was not appropriate, so we have articulated this to the market and have identified AONIA as a viable risk-free rate from which we can issue. Regardless of regulatory compulsion, there is impetus for issuers and investors to be looking at this space for the diversification it provides.”

Tim Galt, executive director and head of debt capital markets, APAC at UBS in Hong Kong, echoes the sentiment that this structure is not intended to replace BBSW. He says the work the domestic market has done in making BBSW robust and workable into the future is positive. The use of AONIA as a benchmark is appropriate for select issuers and investors in hedging and managing risk, and therefore he expects to see further use of the structure.

“SAFA decided that the risk of a credit benchmark was not appropriate, so we have articulated this to the market and have identified AONIA as a viable risk-free rate from which we can issue. Regardless of regulatory compulsion, there is impetus for issuers and investors to be looking at this space for the diversification it provides.”

Operational challenges

The principal challenge in moving to AONIA as a reference rate is that AONIA is not a term rate. The coupon structure resets daily based on AONIA and therefore coupon payments are uncertain due to their backward-looking nature.

Nick Kalisperis, Sydney-based director, fixed-income syndicate at UBS, tells KangaNews that investors will not know what the rate is until the end of the period. It will be compounded monthly and typically comes very close to the cash rate plus a margin.

Investors needed to become comfortable with the structure before they could participate. Kennedy says issuer and lead have spent considerable time with interested parties to ensure appropriate systems were implemented.

This investor-relations work was also integral to establishing fair pricing for the transaction, given its inaugural nature means there is no steadfast way to compare the price with benchmark transactions on SAFA’s vanilla curve.

Kennedy says SAFA is happy with the pricing result and believes it represents fair value for all involved. He adds though that SAFA is a price taker and the focus was on delivering a transaction which forms a part of, and is in line with, its short-term funding goals – rather than meeting a pricing objective.

There were three main routes for investors to become comfortable with the participating in the deal. Kalisperis reveals: “Investors could observe the historical relationship between the AONIA to the cash-rate target. They could focus on the liquid Australian dollar derivatives market which references AONIA. Or they could look at similar developments offshore, which demonstrates that this methodology is applicable. Each of these avenues proved sufficient to convince investors the rate was applicable.”

In offshore jurisdictions where the need for institutions to look at ARRs is more pressing, regulators such as the UK Financial Conduct Authority have been pleased at the take up from market participants of its chosen ARR – the sterling overnight index average – which is also derived from retrospective calculation. KangaNews has previously reported that the preference among market participants in the UK is to develop a term structure which more directly reflects that of LIBOR.

In Australia, for ease of transition, the preference among investors and other market participants is likely the same. Even so, Galt says the speed with which some investors were able to develop their internal systems for participation was one of the most encouraging outcomes of the transaction.

Domestic investors accounted for most of the book but this participation was augmented by investors in Asia and Europe (see chart 1). Kalisperis points out that given ARR transactions are becoming more commonplace in US dollar and sterling markets, some of these investors were able to gain approvals quicker than their domestic counterparts.

There are hopes that there will be follow-on demand. According to SAFA’s deal summary, 6 per cent of the deal was allocated to trading accounts (see chart 2). Kalisperis says there were some accounts which could not get approval to participate in primary but may be able to add to the deal’s momentum in secondary.

Source: South Australian Government Financing Authority 7 June 2019

Source: South Australian Government Financing Authority 7 June 2019

Next steps

While the need for ARR transition in Australia is not the same as it is in other jurisdictions that reference IBORs, there are considerations for many market participants in considering fallbacks for contracts that reference offshore IBORs as well as BBSW. AONIA appears to be the best rate to do this with.

Furthermore, as RBA deputy governor, Guy Debelle, stated at an IBOR transition event in Sydney in May, “most issuance reflects BBSW whether it is fit for purpose or not. While BBSW is likely to continue for the foreseeable future, this does not mean it isn’t sensible to ask whether it is the right reference rate”.

SAFA has made clear its preference to base its funding off AONIA, rather than BBSW. Kennedy says SAFA’s intention is to instil this structure in its short- and long-term funding, so that its overall funding profile better reflects the risk-free nature of a semi-government institution, compared with basing its funding off a credit rate.

There are certainly other sectors where the appropriateness of the rate ought to be questioned. For example, while BBSW is widely considered to have been made sufficiently robust by new calculation methodology for the three- and six-month rates, question marks still hang over the thin trading volume of the one-month rate off which securitisation transactions are typically based.

“From a physical issuance perspective, this is a first step in interest-rate benchmark development for the Australian market,” says Galt. “It is difficult to say when the next issuer will come or which issuer it will be, but most will be at least thinking about what the development means for them and whether or not it is applicable to their needs.”

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