Shifting sands change dynamics for Australia's government-sector issuers
KangaNews and Westpac Institutional Bank hosted their annual roundtable for Australia’s sovereign and semi-government issuers in June – via audioconference, as the discussion happened as many Australian states were re-entering lockdown following the latest outbreak of COVID-19. Despite the sting in the pandemic’s tail, issuers are confident about the resilience and functionality of their market as they enter new financial years.
* Some comments in this roundtable have been updated in light of the content of the Reserve Bank of Australia’s 6 July monetary-policy decision and update.
THE DURATION BALANCING ACT
Zaunmayr With larger funding tasks, most issuers last year looked to exploit long-dated demand when it was in evidence. What is the story now requirements are easing?
KELLY A few things have changed this year that mean we have priorities other than solely focusing on duration. Last year we took the modified duration of the debt portfolio to about 8.75 years from 6.25 years at the height of our involvement in the very long end of the curve. It has drifted back a bit as we have undertaken backfilling in some of our shorter lines.
We had a A$45 billion (US$34.2 billion) funding target last year and our primary objective was to surround ourselves with sufficient liquidity to meet our lending obligations. If there was a pocket of demand from domestic or offshore investors, we were more than happy to fill it – at the right level. The consequence is that the maturity profile of our lending to the public-sector debt portfolio has become a little uneven.
One of our objectives this year – likely a major one – will be to try to even out the maturity profile of our clients’ borrowing portfolios.
This does not necessarily correlate directly with the maturity profile of our bonds, given our ability to run mismatches on our own balance sheet. We will certainly keep an eye on opportunities to add duration when appropriate. The ultra-longs become a little less attractive as the curve steepens, noting that current pricing is still a bit away from where we issued our euro and Australian dollar 2050s last year.
GULICH We will not know our updated funding requirements until the Western Australia (WA) state budget is finalised in September 2021. Based on our current programme, we are keen to continue to support our longer-dated maturities – our 2034 and 2041 bonds.
Should the opportunity arise, we will look to issue a new benchmark line in the 10-year or longer space, given some of the gaps we have in our curve, and we will roll out a new floating-rate note at the 5-6 year mark.
KENNEDY As announced in our post-budget funding update, SAFA [South Australian Government Financing Authority] is going to continue to build liquidity in its even-year calendar benchmark lines, now targeting slightly higher outstanding volume in each – toward A$3.5 billion. This is to help manage refinancing risk as total debt on issue grows.
We will also consider a new 2036 line and nonbenchmark issuance beyond the existing 2040 line. The aim is also to spread SAFA’s refinancing risk, and this means the duration of debt is likely to be longer. Overall, there is probably a small emphasis on extending duration.
While not a new priority for SAFA, we are also going to consider putting a new 2025 AONIA [Australian overnight index average]-linked point on the curve to complement the existing June 2023 line.
KENNA Extending duration is a priority for TCorp [New South Wales Treasury Corporation]. There is a lot of talk about outright pricing levels and, while there has been an increase this year, they remain historically low.
For us, the extension of duration is about more than just locking in interest costs. We are contemplating a significant borrowing programme and need to plan for tomorrow as well today.
We have disclosed that we will continue to focus on the 10-year-plus part of the curve, and we will also look closely at any sensible opportunities in the ultra-long segment.
FAJARDO Smoothing and extending our maturity profile to reduce refinancing risk remains a priority – this makes sense right now given rates remain historically low.
We are always trying to add as much liquidity to our bonds as possible through issuing primarily in our benchmark bond curve. Complementary to this, QTC [Queensland Treasury Corporation] will issue other term debt, providing tenor and different types of debt to remain receptive to investor demand.
The recent increase of eligible assets in our green-bond pool also provides capacity for QTC to increase its issuance of green bonds. This includes issuing a new line and exploring reverse-inquiry opportunities to tap into demand in our existing green bonds.
Funding tasks dial back down
Perhaps the most notable feature of the early days of the pandemic for Australian government-sector issuers was spiralling funding requirements as revenue projections collapsed and governments stood up to support furloughed economies. The extreme spike has passed, but many issuers are still facing structurally higher borrowing tasks.
WHEADON After the budget in May we announced a 2021/22 funding programme comprising A$130 billion (US$98.9 billion) in Treasury bonds, A$2-2.5 billion in inflation-linked bonds by tender, the possibility of a new, syndicated, 10-year, inflation-linked bond and regular issuance of Treasury notes.
The risks look a bit more skewed toward a lower task. I don’t think this is particularly surprising given the strength of the economic rebound we have seen with employment growth, consumer spending and commodity prices all pointing toward a smaller deficit than forecast, at least for 2020/21.
Zaunmayr What is the demand story for long-dated issuance? Does interest primarily come from offshore?
MCCOLOUGH The difference between this year and last is that the basis swap or FX hedge options worked well for a number of offshore investors last year but this is perhaps no longer the case. We definitely need to focus on the domestic investor segment, but we do not have as much long-dated liability-management demand in Australia.
Of course there is always a clearing price and we have seen the long end of the curve flatten significantly of late on the back of the shift in outlook from the US Federal Reserve (Fed) and the Reserve Bank of Australia (RBA) when it comes to the outlook for and response to inflation.
I think there is a trade-off between yield-seeking behaviour, which is still a key determinant, versus the improved outlook for issuers’ funding requirements. But I am confident that their goals can be achieved in the upcoming fiscal year.
KELLY It is important for all investors to understand that we all have treasuries that are focused on interest expense. There is a balancing act between adding duration for portfolio protection and making sure we are backfilling and taking shorter-dated funding opportunities as well.
This is because the actual interest expense of the state becomes very important given the significant increase in debt positions. Duration is great, and a key strategy to protect against future rate rises. But every time we do duration trades there is a fair chance we will also issue back down the curve to smooth interest expense.
Zaunmayr What are the Australian Office of Financial Management (AOFM)’s priorities for its syndicated transactions and tender schedule?
WHEADON We are making the transition from the monster programme of this current fiscal year, where we have issued A$207.3 billion of Treasury bonds, to what we feel is more of a business-as-usual scenario. We undertook eight syndications in calendar-year 2020 and there will definitely be fewer this coming fiscal year.
We are not going to have any particular focus on duration. The ultra-long sector of the market, which is an important tool in managing funding risk and adds significantly to investor diversity, is not ever likely to be an enormous component of our overall funding – for a range of reasons.
We will at some stage look at a new infill bond between 2041 and 2047. We are in no particular rush to do this so it may be done in the coming fiscal year or the one after. It is not a high priority, but it is something we are committed to doing. We will continue to access the ultra-long segment through tenders when there is demand – in fact, we have done just that this week with a very well-subscribed tender for the 2051 line.
Beyond this, we will look at a new 10-year sector Treasury bond, possibly with a late 2033 maturity, at some point in the fiscal year. More generally, though, 2021/22 is not going to look anything like 2020/21 in the scale and frequency of new benchmark transactions.
Zaunmayr The reflation narrative is gaining ascendency. What is the state of play in inflation-linked demand?
WHEADON We are considering a new 10-year benchmark inflation-linked line and I am pretty confident a deal would go very well. Investors are indeed thinking about inflation again – and what better way to get some inflation protection than to buy one of our linkers? The 10-year maturity is the sweet spot on the curve, too. More generally, demand for linkers has been quite consistent and strong this year.
Zaunmayr Do relatively smaller issuance requirements provide SAFA and Western Australian Treasury Corporation (WATC)’s latitude around timing of issuance?
KENNEDY There are a couple of things we generally keep in mind, the first being that SAFA is a price-taker in markets. When we come to market, our goal is always that we have access to the widest range of investors and, hopefully, stable market conditions. But our primary responsibility is access to markets to meet the state’s funding requirements.
We make sure we can fund the state as best we can under all circumstances. But we also tend to take a pragmatic view around the timing of issuance to ensure we can price successful transactions, rather than looking to pick the eyes out of the market and get the lowest possible yield or tightest spread on offer at any point in time.
GULICH The size of our issuance task has not changed our strategy. We traditionally look for windows where we think conditions line up and also where there is not a lot of activity from our peers – which obviously gets harder given the size of the programmes from other semi-government borrowers and the AOFM. We are also now mindful of when the RBA will be active under its QE programme.
There is a lot of activity, so trying to pick our moments to come to market with a syndication will continue to be a challenge. But, given the size of our programme, I am confident we can continue to find windows that suit our requirements and our client needs.
Zaunmayr What are the main secondary-market trends in the Australian government sector?
MOORCROFT In July last year, the semi-government borrowers were trading in the mid-50s basis points over government bonds and they then outperformed through to the RBA’s QE announcement in November. This saw them trading at all-time tights, in the teens as a spread to government bonds. Things have been quite volatile since then.
There were ‘air pockets’ in the first few months of the 2021 financial year, just like in early July 2020 when there was a small gap wider. However, the market became more comfortable once primary issuance came and prices were set.
Since we hit the low in spreads around the RBA QE announcement, pricing has bounced around in a range from high-teens to low-30s spread to government bonds. Pricing is back out at the wide end of this range at the moment.
The periods of volatility mirror what has been happening in a lot of markets. When there is a sudden lack of liquidity, the whole market moves a long way and the clearing price is hard to find. In most cases, primary syndication is needed to reset the tone. We have not seen a syndicated deal in the last month or so and the market is washing around a bit trying to find clearing levels.
Zaunmayr Have there been any notable changes in the geographic make-up of demand in recent months?
MOORCROFT Most offshore segments of government-sector demand look for stability in the market before they re-enter. We have had periods of volatility and offshore investors have not participated as much. I think once things stabilise – and certainly once some primary issuance comes – it will give offshore investors a pricing level to get comfortable with. We should see them enter again.
The market move we saw in February and March was a global trend and offshore bond repricing fed into our market. To my mind, this was exacerbated a little by currency-related selling of SSA [supranational, sovereign and agency] bonds.
The Australian dollar is trading in the range of ¥80-84 (US$0.72-0.76) and I think Japanese investors are probably comfortable with this. It is more a matter of having some comfort around the clearing level for semi-government borrowers, while the outright market seems to be in a pretty defined range for 10-year yield.
KENNA One thing that could be different in the year ahead is the prospect of financial institutions returning to more regular issuance in the Australian dollar market. This will likely increase competition for issuance windows.
On the plus side, the market has demonstrated over the last 12 months and beyond that it has the capacity to support multiple issuers during conducive windows. This creates a little more space than there was in the past.
The last syndicated deal we issued pre-dates the volatility of February so our observations on the investor base are perhaps a little more dated than others. It is fair to say, though, that there had been a notable pick-up in offshore participation. Last year we had record offshore participation in our October green-bond transaction, at 41 per cent. This was then surpassed in our 2033 syndication in February, which hit 45 per cent.
Our sense is that there may have been a drop-off in demand from offshore since then. But we still think these investors will be a meaningful part of the programme and expect them to participate in transactions, just perhaps not at record levels.
KELLY I think demand has been fairly well spread throughout 2020 and 2021. We did four syndicated trades last year and the first three saw about 30 per cent allocation to offshore investors. In contrast, only about 17 per cent of our 2033 transaction, priced in April, went to offshore investors. This deal came pretty quickly on the back of a syndicated tap of our 2025 bond so the timing probably was not ideal. To put this in context, though, offshore-investor turnover almost doubled in dollar terms last year, and this is against a total turnover number that increased by around 40 per cent. This is a significant change.
In percentage terms, offshore turnover has been close to 30 per cent of total turnover, up from 20 per cent last year. The signs are that offshore demand has held up well across the maturity curve and we have continued to attract new offshore investors into our deals.
Looking to this coming year, I think we will be limited to one or two syndicated deals. At some stage, as mentioned in our budget update last month, we will come to the market with a labelled sustainability deal. We have just completed our sustainability framework.
The next long-end line we need to issue is a 2035. This is possibly a calendar-year 2022 transaction. It will take a while for us to build the internal demand to issue at this longer point on the curve. I think investors will need to look more to our monthly tenders for their price points this year.
Audience question Given the relative size of TCorp’s programme, what does it have in mind for approaching markets this fiscal year, especially with regard to use of tenders?
KENNA We issued around 65 per cent of the programme on a reverse-enquiry basis last year. We have confirmed that we are going to continue to use reverse enquiry and syndication to meet the funding task this year.
Reverse enquiry will continue to be an important and significant part of our programme. However, I would flag that we anticipate a little bit more balance in the year ahead – with a greater allocation to tenders and syndication.
Audience question QTC and WATC in particular were active in tendering bonds last year. What are their plans for tenders versus syndications?
FAJARDO With a A$21 billion borrowing programme last year, part of our strategy was to be more programmatic in nature. In our previous programmes of around A$10 billion we had more flexibility and could time our issuance to pockets of demand.
Considering we always like to do the majority of issuance via public transactions, the way to be programmatic was via more frequent tenders. Last year, 64 per cent of our issuance was through public transactions. We issued nine times through tender last year, compared with three in the previous year.
This worked well. We can identify when there is demand or when the market is short certain bonds and then issue into this. We have taken a flexible approach to the size of our tenders: we have done A$750 million tenders to meet market demand but also reduced them to A$500 million when we felt demand was more subdued. Our bid-to-cover ratio has been in excess of 3.5 on average.
I do not envisage our tender process changing with a A$17.4 billion programme. We will still do a reasonable amount of our issuance via tender and then look to syndication when we see larger pockets of demand or we have large client requirements at a point in time.
GULICH Our programme will be heavily influenced by what comes out of our budget in September. At this stage, based on what we are aware of, we are looking at 1-2 syndications. We will then look to use tenders where we have the volume requirements, but this will not be a large number given the size of the programme. We will continue to use reverse enquiry as needed.
Zaunmayr Last time semi-government funding tasks rose significantly there was a lot of focus on finding new investors around the world. Is this still a focus or is it more about maintaining contact and making the most of the investor relationships issuers already have?
FAJARDO For QTC it is always a focus to diversify our investor base, and we continue actively to market as much as possible using virtual platforms. We have also been involved in various roundtables and had good engagement from investors.
We have seen a number of new names come into our syndicated deals, although it has been a little while since we have done a large primary transaction. The two largest term transactions we recently undertook, for our 2032 line and our 2031 green bond, saw very strong offshore participation as well as good demand from domestic real-money accounts. The 2032 trade was our largest since 2011 and we had an orderbook of almost A$6 billion.
I think most books across the semi-government sector have seen increased hedge-fund interest. This is a result of the increased volume of issuance and greater liquidity in the sector. We are also seeing a lot more investors interested in what Queensland is doing in the ESG [environmental, social and governance] space and in QTC’s green-bond programme specifically.
MOORCROFT The elephant in the room when it comes to demand for government-sector bonds is the RBA. The RBA coming in every week for A$1 billion of semi-government bonds and A$4 billion of government bonds has been a big dynamic that has made spreads harder to manage and more volatile.
This is certainly changing curves a little, given the maturities the RBA looks to buy. We are seeing more curve-extension trades, which supports what issuers are looking to do in moving further out on the curve to the 10-15 year range and out of the pocket of demand for QE.
ESG's growing profile
More labelled green, social and sustainability (GSS) issuance is coming from Australia’s semi-government sector. Even those that have not issued labelled bonds say environmental, social and governance (ESG) themes are gathering momentum in the investor community.
ESG has been a slow burn in recent years but it is now centre stage. The conversation with investors has changed substantially. Instead of being an add-on it is now the primary aspect. Investors want to understand what the state’s ESG credentials are and exactly what is being done to manage and promote sustainability.
Zaunmayr The RBA is beginning to consider the next phase of its market intervention, which could involve flexible weekly bond purchases. What signs are there to indicate whether or not the market is ready for the programme to be changed?
MCCOLOUGH Almost all my recent conversations have been about this exact question. The Westpac view had previously been that there would be a QE3 of A$100 billion and then QE4 of A$50 billion. Now, however, we believe the RBA has earned the right to approach purchases with more flexibility.
We previously thought the weekly bond purchases would remain the same, at least initially, and that the ratio between ACGBs [Australian Commonwealth government bonds] and semi-governments would be maintained. The drop to A$4 billion of weekly purchases from September is a slight surprise but the maintenance of the 80-20 per cent split between ACGBs and semis is not.
Along with everybody in the market, we did not think yield-curve control would be extended to the November 2024 line, so this phase is over. It is now all about QE – and we see QE finishing around the end of 2022.
As to whether or not the market is ready for tapering, it is interesting to observe recent price action where the US and Australian markets reacted to the Fed starting to get the market ready for the tapering discussion. We saw a rapid unwinding of steepeners and fears around untethered inflation were more or less immediately soothed.
This is one sign that the market is getting ready for the discussion at least. Given the fact that outright yields are actually now lower and the curve has flattened, the market is not suggesting it needs extra support. I think this will be of significant interest to policymakers.
Another sign will be how the demand profile develops and price action looks as the new issuance of fiscal year 2022 begins. The RBA has not been buying as much as the semi-governments have been issuing, whereas we have had negative net issuance of ACGBs with the RBA buying more than the AOFM has been issuing each week.
I thought this scenario would see cross-market spreads perform a little better than they have and potentially this is a sign that they need support. I do not think, though, that we will get a big shift domestically in the near term that might suggest a negative impact from expected tapering.
Zaunmayr Will the roll-off of various monetary-policy support measures be smooth or does tapering and exit of QE potentially pose more risk to markets and the economy?
MCCOLOUGH It should not pose more risk if it is done effectively and under the correct economic conditions. If we look at the taper tantrum as an example of how the market can react, clearly communication is very important. There should be no surprises for the market.
So far this has been well managed. There was no surprise when the RBA announced the end of the term funding facility and a moderate decline in the amount of purchases per week, as the RBA emphasised that it believes it is the stock of bonds bought, rather than the flow, that matters. This message appears to have been embraced by the market.
Going forward, the RBA’s decisions need to be well understood in advance and tied to changes in economic outcomes rather than hard deadlines. But there should not be a major market dislocation if tapering is done at the right time.
Zaunmayr It is conceivable that the Fed ends up tapering and even raising interest rates ahead of the RBA. What risks might this pose for Australian government-sector borrowers?
MCCOLOUGH We think it is likely the Fed will taper and end bond purchases before the RBA. The currency would move in a direction the RBA would not like if it were to move away from asset purchases quickly. We expect the Fed to begin tightening interest rates by the end of 2022 and for the Fed funds rate to be 0.875 per cent by mid-2023. We think Fed funds will move higher than the RBA cash rate in this tightening cycle, which could be negative for the local market as higher interest rates attract investors to the US.
But I believe we will also continue to attract investor flows based on our good reward-risk characteristics. Having a triple-A sovereign rating will certainly continue to be a positive. We could see Australia outperforming the US, as happened when yields were on the way down.
Cash rates are the determining factor and we expect QE to run for a little longer in Australia than in the US. But this a positive environment for Australian bonds.
MOORCROFT I think all central banks are well versed in what happened with the taper tantrum in the US and will be very cognisant of it in the way they will come out of the current situation. Sequencing is critical, and I think the RBA will go after the Fed because the currency is a big factor the RBA will be worried about.
I think the signalling has been good so far. The RBA has given us a date for the monetary-policy meeting it will use to talk about the next phase of the QE programme and it has been talking about tapering for a while now. The staged process gives the market more comfort along the way.
As long as we go down the path of flexibility, where the RBA doesn’t have to reduce purchases on a set timetable and can respond to changing conditions, I think the market can cope.
There is some consensus in the market that the mix of QE purchases between semi-governments and ACGBs could change as the RBA starts to taper. Perhaps it will reduce purchases of government bonds first and leave the semi-governments at A$1 billion per week. This is based on outstanding volume in the market and future issuance to come from these issuers.
Zaunmayr Does the potential for rising interest rates affect how issuers could approach their funding programmes?
KENNEDY Our approach has always been about taking a blended cost of funds in a range of maturities over a long period of time, no matter whether rates are falling or rising.
Our objective is to complete our funding programme and we acknowledge that we are a price taker. The overall consensus is that we need to take a proactive and long-term approach to our debt management.
Paul Kelly mentioned earlier that interest cost is a very important consideration in the budget process and in what state treasurers consider when looking across the whole balance sheet. This is absolutely correct – but equally we can’t try to second-guess markets. We need to take a long-term view and a blended cost of funds across a range of maturities to have a good spread of refinancing risk and ensure we do not have any concentration of risk within the debt portfolio.
KENNA I would add that in a period of rising interest rates, or in fact in any circumstance that could cause uncertainty in the market, it is important to be close to the investor community and understand what demand looks like across the curve. We need to be responsive to demand and look for windows that work for us and for investors.
A rising rate environment would not necessarily change our duration approach, either – because our strategy includes objectives that go beyond the near-term interest-rate environment.
Rating moves manageable to positive
The importance of ratings – especially the triple-A gold standard – has eased in global rates markets in the past decade as many of the world’s reserve borrowers have experienced rating decline. Australian issuers have experienced positive and negative rating moves in recent months – but say neither has had a huge impact.
WHEADON No. There was very little impact on investor demand for Australian bonds when S&P placed us on negative outlook, either. But the revision is an expression of confidence in the Australian economy and the government’s fiscal path. It is nice to be one of only nine countries to hold a triple-A credit rating from all three major rating agencies.
Zaunmayr One theme that has come up consistently since the second half of 2020 is Australia’s privileged economic and health position relative to much of the rest of the world. Does this still hold in mid-2021?
GULICH The investor community is very well informed on what is happening at a macro level around Australia and across the different jurisdictions. When we are briefing investors, onshore and offshore, the relative strength of the Australian economy and the WA economy certainly shine through.
Investors are very aware of the health response from our governments that has supported our economic and fiscal position, and the key drivers that underpin economic growth. They are interested in the assumptions and to see if there is any further upside in our financial parameters. The sentiment is that all Australian jurisdictions are in a lucky place and have responded very well to what has been a very difficult time for many of the jurisdictions where the investors we meet with are based.
Zaunmayr WA in particular is benefiting from a very strong commodities cycle. What is the state’s forecast for iron ore?
GULICH Our forecasts for the iron-ore price are very conservative, at US$134 a tonne for this year compared with a year-to-date price that is tracking at around US$150. There is considerable upside for our budget. For next year, the current budget forecast is for US$65.60 per tonne – which is materially below where the price is currently tracking.
We don’t expect the current elevated level to continue into the medium term. Where the price comes down to, and over what timeframe, is a big question given the strength of the stimulus measures that are driving the commodity boom, as well as the relative quality of WA exporters’ product and their proximity to markets.
At the WA budget in September, we expect to see a material upside to our revenue projections as we update the current forecast price. Commodity prices also provide a considerable upside to the Australian federal government budget, which will benefit strongly from the commodities sector through income- and business-tax revenue.
“The RBA coming in every week for A$1 billion of semi-government bonds and A$4 billion of government bonds has been a big dynamic that has made spreads harder to manage and more volatile. This is certainly changing curves a little, given the maturities the RBA looks to buy.”
Zaunmayr Queensland has a large resources industry but is also more exposed to sectors like tourism that have been severely affected by the pandemic. What message is QTC communicating to investors on the state economy?
FAJARDO We have had a really good story to tell investors around economic growth and revenues being stronger than expected in Queensland.
For instance, revenue projections in the state budget released on 15 June show an improvement of approximately A$12 billion over the forward-estimates period compared with the 2020/21 budget. This is helping the state move toward a small net operating surplus in 2024/25. Further, our net debt is forecast to fall by around A$10 billion in 2021.
Engagement from investors, particularly offshore, has been encouraging. They have been interested to learn more about management and case statistics for COVID-19, as well as the economic recovery in Queensland and Australia.
WHEADON I think we are in a strong position. Our debt-to-GDP ratio is relatively low and investors certainly recognise this as an indicator of a well-managed economy with a credible fiscal trajectory. We have just had S&P [Global Ratings] revise Australia back up to AAA stable from negative outlook, which is another expression of confidence.
Investors see the health response in Australia and have been highly complimentary of it. Investors generally are quite positive on the Australian story and, from our perspective, it is not a hard one to convey.
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