Australia's government-sector issuers contemplate rising rates, growing ESG interest and the pandemic exit
It has been a challenging two years for Australian government-sector issuers, from the spiralling funding needs and dislocated markets of the early days of the COVID-19 pandemic through choppy economic outcomes in 2020-21 and the growing spectre of inflation in global markets. Nonetheless, entering the new year these issuers say markets are conducive and their funding tasks manageable, while ever-increasing sophistication of sustainability-aligned issuance is helping maintain investor engagement.
MARKET CONDITIONS AND EXECUTION
Davison The year has started with a healthy level of liquidity but spreads are wider than they closed out last year. What is issuers’ read on the market at the start of 2022, relative to how 2021 ended?
NICHOLL Australian Commonwealth government bond (ACGB) market conditions are a lot more settled this year than they have been at the start of the year for some time. Tenders have been well covered and prices look good, despite the fact we have been going through another sell-off in the market.
One thing I would like to draw attention to specifically is that the three-year futures contract has started to recover its depth and liquidity after the RBA [Reserve Bank of Australia] stepped back from yield curve control (YCC). This is good for the short end and the middle part of the yield curve.
We are confident the ACGB market will remain relatively smooth in the months ahead. We are expecting a bit more volatility as the Fed [US Federal Reserve] steps back from QE and we expect the RBA will follow not too far behind. But overall the market looks good.
Davison Is improvement in the three-year futures market based on a view about the RBA’s trajectory, in the sense that we may see tapering of bond purchases? Or is it just the product of the end of YCC?
NICHOLL Having the bonds that were targeted by YCC in the futures basket created some real technical issues. A lot of the recovery in this part of the market is more due to YCC having ceased than an expectation of what the overall RBA bond buying programme will do, although expectations about RBA cash rate projections have also been very influential.
Davison There was limited volume of syndicated issuance by the states from late 2021 to January this year though South Australian Government Financing Authority (SAFA) completed a transaction in the last days of 2021. How was the market at the time and how has it changed into the new year?
KENNEDY The last quarter of 2021 may have been the most difficult issuing conditions we have seen for more than a decade. I have been surprised by how quickly markets have stabilised since the start of 2022. The year started on a note of positivity and some other trades have come to market, including TCV [Treasury Corporation of Victoria] bonds.
On the specifics of the deal, it was simply that we saw an opportunity from an investor to open up some of our floating-rate lines. We were happy to oblige during what is normally a very quiet time of year.
KELLY It was certainly a difficult end to 2021, with a lot of external factors contributing. TCV has not executed a syndicated trade since November but we have been active, issuing just more than A$1.6 billion (US$1.1 billion) in December and a further A$1.25 billion in the first weeks of January. There has been solid support for tenders and via investor reverse enquiry.
I see this as evidence that the market is receptive to semi-government supply, even with the amount of SSA [supranational, sovereign and agency] and bank trades that have priced in the past few weeks. I think it unlikely we will see a syndicated semi-government trade ahead of the RBA’s February meeting, though.
KENNA It is not unusual to start the year with a flurry of SSA issuance, but some things have been a little different this year. We ended last year with a bout of issuance via reverse enquiry and were active right into Christmas, which was a little unusual. Through January, we have probably been more active taking issuance out of the market than we have been putting it back – thanks to the proceeds of the state debt retirement fund being put to work.
I agree that it may be a better time to approach the market for syndication after the RBA decision in February but, even so, the underlying state of the market is reflected by continued enquiry. The market is in pretty good health.
CINQUINA We were also considering coming to market late last year but decided against a syndicated transaction given the backdrop. Our funding task is the lowest it has been for quite a few years, so we can be selective in our timing.
FRN and linker opportunities in a rising rate environment
Other than to fund a relatively small borrowing client need for floating-rate debt – centred on South Australian Government Funding Agency (SAFA) – semi-government floating-rate note (FRN) issuance has been minimal in recent years. This seems likely to remain the case – as does limited issuance of sovereign inflation-linked bonds.
KENNEDY Late last year, we extended our FRN curve out to three-and-a-half years in AONIA format. The reception was not quite as strong as we have seen with some of the other issues we have done in the format but there were some challenging market dynamics around that time, including concerns that short-dated asset swaps were pricing very, very tight or negative out to 3-5 years.
Trying to do FRN issuance was a little problematic because – even though markets should view the asset swap level on a fixed-rate bond in the same way they do on an FRN – there is a very different psyche about the way the market interprets the two products.
FRNs, including issuing in AONIA format, remain a key component of our strategy. However, we need to continue to be aware of changing dynamics that will affect the ability to access markets.
Davison Given all these comments, does the lack of syndicated issuance say more about the practice of syndication itself – ie that the states are less keen to use it – than the state of the market, liquidity or demand?
KELLY Syndication is a reasonably inefficient issuance method at the moment. The new-issuance premium for the mechanism seems to increase every time we do a trade so it has become an expensive way to issue bonds.
It is important for us to be clear about how and when we want to use it. We may do so less frequently than in the past and instead work a little harder on reverse enquiries and tenders as more cost-efficient options.
NICHOLL We haven’t changed our view or approach. We typically rely on syndication for new maturities of 10 years or longer in duration. Although we do not need to use syndications for all new 10-year issuance, it is a method that works well for us.
We haven’t done a nominal syndication since mid-2021. We have announced a new nominal line for the last quarter of this fiscal year and how we execute it will be widely anticipated by the market.
KENNA We are doing a much greater percentage of our progamme via tender and syndication than we have done historically. There is a cost that comes with syndication but there are benefits, too.
We might end up continuing to lean toward tender or reverse enquiry issuance in the second half of our fiscal year – but I want to emphasise that this decision would not be down to cost alone. We have flagged a potential new line of ESG [environmental, social and governance]-linked bonds and this is definitely something we would expect to issue via syndication. Everything plays a role – the mix comes down to the market.
KENNEDY Toward the end of 2021, SAFA launched a syndicated transaction that we ended up not following through on and closing. We know that, at certain times, some techniques are more effective and efficient for accessing markets – and this outcome tells us that in the last quarter of last year syndication was not an efficient way to generate the volume we wanted without paying significant concessions to market. Syndication is not necessarily a good process for distributing risk in volatile markets.
We have changed our communication techniques for what we release to market to provide more flexibility. A lot of this has to do with the fact that – given what we are seeing in markets, liquidity and funding conditions – we need to have a bit more flexibility in the way we are going about our programme.
CINQUINA From a WATC [Western Australian Treasury Corporation] perspective, we would be very unlikely to use syndication to tap existing lines. Reverse enquiry and tenders would be the preferred approach. If we are talking about a new maturity of A$1 billion or more, we will continue to use the syndication process.
Davison Market expectation is that the RBA is not going to be far behind the Fed in raising rates, much as the RBA itself insists rate hikes are not in its plans for 2022. What feedback are issuers getting about global investor sentiment on relative rate dynamics?
NICHOLL I tend to think the RBA’s cash rate decisions do not have a strong influence very far out on our curve. We have good offshore investor representation and I believe the bulk of our curve is priced off competing overseas markets, most heavily the US. This idea that RBA cash rate decisions will affect the whole yield curve is not a story I buy, to be honest.
We published an Investor insights piece at the start of the year that aimed to look at what investor engagement might look like post-RBA QE. We did this with the aim of trying to keep the market informed.
Our understanding is that there has not been and will not be much change in the underlying investor base, especially in breadth of engagement. We expect some investors will re-engage once the RBA steps back, but I don’t think we have seen structural change. The ACGB investor base remains very diverse. There may be some volatility when the bond buying programme ceases but it should not last long.
Davison Is foreign currency issuance for the states on the agenda or are the economics still some way from working? Do issuers think it will be part of the mix in the year ahead?
KELLY I think it has to be part of the discussion and part of our planning. As our programmes grow, diversification becomes more important – and the threshold we used to set for that diversification is perhaps not as high as it used to be. If we can find an attractive source of funds that doesn’t come from the domestic market, it can only be a good thing.
However, I don’t think we are in a position where we need to be chasing or paying a massive premium for it at the moment. What I’m saying is that it makes sense to ask: if we were looking to take the pressure off the domestic market, where would the next market be?
KENNA We will always monitor markets and look at opportunities. With larger funding programmes, New South Wales (NSW) and Victoria in particular are going to look more closely at some of the alternatives that could take some of the pressure off the domestic market.
Not having executed in foreign currencies recently is also not necessarily a failure or a disappointment – it just means it didn’t happen to line up at the time or that we didn’t need the funding when it did. We will keep looking for an opportunity to access those markets if it makes sense. If it does, we will look really closely at the opportunity.
KELLY We showed in late 2020 that we can access the euro market via our EMTN programme: we completed four euro trades for around A$330 million equivalent. We can turn these trades around pretty quickly, too. It is just a matter of being prepared to respond to demand and, as I said earlier, assessing the price relativities.
KENNA We continually monitor offshore markets. At the moment it does not really come close to lining up but there have been points over the past 6-9 months where, across the benchmark tenors, it has not been that far from the levels we think about.
Living with COVID-19 and living with volatility
Several Australian states have ongoing elevated funding tasks, and more issuance to do could mean less ability to step back from challenged markets. Meanwhile, the Australian Office of Financial Management (AOFM) and others are dealing with the end of Reserve Bank of Australia (RBA) market intervention.
KENNA For the semis with large funding requirements it is true that it is harder to avoid weaker patches in the market. Sometimes we have been able to execute in almost perfect conditions but there are other times when it is more challenging. We tend to oscillate between different methods of execution based on the market at the time.
The issuance run rate is something we definitely track. But it doesn’t always dictate what our execution requirements will be. With a larger funding task and more volatile conditions, we have run a pretty significant liquidity position that allows us some flexibility to navigate markets.
The main impact of the larger funding task is probably on the split across reverse enquiry, tender and syndication. With a higher funding task and volatile market conditions it is harder to stay ahead of the task than it would be with a smaller programme.
Although we are always looking ahead, we are also competing for air time among our peer group. The reality is the number of clear days in the calendar is becoming smaller. Generally, we try not to add stress to stressed markets – but sometimes we just have to pull the trigger.
Davison Does economic divergence between states and territories register with investors, domestically or offshore?
CINQUINA There is at least some degree of differentiation between states, particularly for the domestic investor base – relative pricing shows this to be the case. It is probably also the case for offshore investors but I suspect QE, specifically support being provided to all the issuers based purely on the ratio of their issuance, has suppressed the differentiation.
We will probably see a little more divergence over time once the RBA ends QE. This is when state-by-state outcomes will probably become a little more evident in market pricing.
KELLY Investors understand the semi-government market pretty well and they also understand individual state dynamics. These days it seems to be a decision that is less focused on ratings and more on supply metrics.
The most recent round of state budget updates in December showed some divergence between state funding requirements but it was absorbed with minimal discussion.
Davison The level of interest in environmental, social and governance (ESG) factors in the bond market is readily apparent. In South Australia (SA), SAFA has made some moves toward integrating ESG into its debt programme without going down the road of issuing labelled bonds. What has the response been and what are SAFA’s plans from here?
KENNEDY It is a continually developing, expanding and maturing area in the market. It is not just from the investor’s perspective but also from the issuer’s that the focus continues to grow and change.
We have not done a labelled issue and it is still not our intention to do one, but we are continuing to adopt a wider approach to how we manage sustainability as a state.
The first step was the release of a sustainability statement to outline the state’s key credentials in this area. The response has been extremely positive. Even though it has not been out there long it has certainly helped advance the conversations we have been having with investors and other issuers about our approach and why we are going down this path.
With the Council of Financial Regulators supporting, although not mandating, sustainability reporting requirements for corporates and financials in connection with the implementation of the TCFD [Task Force on Climate-related Financial Disclosures] framework, our first step is using the reporting requirement within SAFA as a benchmark case for how the TCFD should be reported across government.
This is an important step in being able to provide alignment between the state budget, agency statements and sustainability credentials. Once we have this established, and buy-in at government level on what it looks like, we can build out a sustainability framework that will sit over our whole debt programme.
We think this is more productive than just trying to do labelled issuance. The reporting we will have to do for TCFD alignment fundamentally replicates what issuers already do if they are trying to validate a green, social or sustainability (GSS) bond.
“There is at least some degree of differentiation between states, particularly for the domestic investor base. It is probably also the case for offshore investors but I suspect QE, specifically support being provided to all the issuers based purely on the ratio of their issuance, has suppressed the differentiation.”
Davison Is it easier to start from the holistic approach than to build from the ground up by starting with specific transactions?
KENNEDY Absolutely not! I think it is a far more difficult approach. Some of the challenges we face I think we might have been able to address if we had done a labelled transaction. We could have got buy-in on a bottom-up basis then taken it out across the rest of the programme or the whole state over time.
The issue I have is that we do not want to be in a position where we have orphaned issues in which we cannot continue to build liquidity. Some of the other states now have very open pools of assets for labelled issuance, so these lines will be built up to a bigger benchmark size over time. But it is possible to end up with bifurcated curves, where an issuer’s GSS bonds trade away from where its non-sustainable debt trades.
We do not want to go down this path because it would mean we end up marketing two curves. This is likely to become a bigger risk over time.
Fundamentally, we would rather do what we think is right than what is easy. But it has been a hard sell. Getting buy-in first across SAFA, then state treasury, then across government and from investors required patience and an ability to look through today and toward tomorrow. This has been the biggest challenge. But I would rather take the long road to doing something once and doing it right than have to do it multiple times.
KELLY I applaud what SA is trying to do. Issuing a labelled bond is an inefficient process and it takes a very long time to complete. It makes a lot of sense to move to a standard that focuses on the state’s ESG credentials, which can then be applied to a borrowing programme.
TCV is committed to the ESG market either way, but we will follow the evolution of what is going on globally and in SA closely. I guess we will find out in time what investors want to see. We will respond accordingly.
KENNA More generally, I don’t think there is really a right answer to what approach an issuer should take. We think it is important to recognise that there has been a progression of maturity and increased depth in this market over time and, as things move on, what is considered to be the right approach changes as well. Branded issuance has been valued by investors and has played an important role in promoting awareness and focus on important issues.
Davison Western Australia (WA) has said it will issue in labelled format somewhere down the line but it also published an investor information pack on the state’s ESG activities late in 2021. The state has something of a challenge in the sense that its small new-issuance programme means GSS bond issuance might not make sense from a funding strategy perspective but at the same time global investors have some scepticism about WA given its reliance on the mining industry. How does an issuer like WATC demonstrate sustainability commitment and can you give some colour on the information pack?
CINQUINA Developing an ESG information pack was not an easy process to go through: it has often been said that just about everything governments do has some ESG link to it.
The key purpose of the ESG information pack is to better inform investors, or prospective investors, in WA debt securities of the state’s ESG profile now and into the future to assist with their ongoing investment decisions as ESG considerations become a primary focus.
From a WATC perspective, we view the response to the document as quite positive. It has engendered a lot of interest and the two webinars we ran were well received with strong representation from domestic investors and from the European and Asian investor base.
We have not noted any scepticism directly on the investor side. The state is committed to net zero by 2050 and work is ongoing to support this target.
The document will be updated after the 2022/23 budget. We do not have a definite timeframe on issuing under an ESG programme but we have made the point that WATC is working toward development of a sustainability-bond framework. This already has government approval and support, and some detailed work has started on the framework governance and asset identification.
Important context is that our borrowing programme is quite small including forward estimates with negligible new-money requirements. However, we have some reasonably sizeable refinancing tasks over the next four years, and where it is possible to link those refinancing requirements to GSS funding we may consider doing so.
The step toward actual issuance, whether it is green or sustainability based, needs to be considered holistically with forward funding needs as part of the 2022/23 budget process.
Davison It is obviously early in the process but, based on the conversation we have had about integrating ESG into the issuance programme, would WATC aim to issue GSS bonds that are part of its main curve – so the 2033 benchmark, say, just happens to be a GSS labelled bond? Or would a GSS bond always be considered apart from the mainstream curve?
CINQUINA It would be a positive to put out a labelled bond, whether it be sustainability or green based, and – to the extent possible – manage the issuance of that bond in a similar fashion to our standard fungible benchmark issues.
I don’t think Western Australia and WATC will have the funding requirement to manage multiple maturity points across the curve in labelled format. If we were putting a labelled issue to market, my preference would be for it to have the same support and functionality mechanisms for investors and intermediaries – such as a stock lending facility.
These are questions we are probably going to have to consider a little more closely when we have made decisions about whether we are in a position to undertake a transaction and what the framework looks like.
Zero CLF a boon but not a game-changer for Australian issuers
A major market announcement in 2021 was the Australian Prudential Regulation Authority’s plan to wind down the committed liquidity facility (CLF) local banks have been able to use to top up their high-quality liquid asset holdings. This is likely to mean a larger bank bid for sovereign and semi-government bonds, though issuers say it will not completely reshape the market.
NICHOLL We all reasonably expect the result will be a bit of a tailwind in the sense of bank balance sheets buying our bonds. But the change will be gradual.
As to whether there will be a shift in the mix of semi-government versus ACGB [Australian Commonwealth government bond] holdings as this unfolds, it is hard to predict. I cannot point to anything at present that I think reflects the outlook for a structural change in the appetite from the bank balance sheets once this process has finished, but it is hard to know what might happen during it.
KELLY I agree. Banks are keeping their plans fairly close to their chest, as we would expect. We know the asset swap level is the trigger to banks adding to their semi-government positions or lengthening existing positions, but it is still unclear how much they will need to add and over what timeframe.
ADIs are well-managed and they are not going to be in the position where they have to accumulate liquids at times that do not work for them. At the times when it does work, however, I think we will see them become a lot more meaningful investors than they have been in the past.
Davison TCV came back to the labelled GSS market last year, roughly five years after being the first such issuer among the Australian states with its debut green bond. How had the market changed during that time and in particular how far has it moved toward considering GSS bonds to be part of issuers’ mainstream curves?
KELLY The GSS market continues to evolve and investor engagement has never been greater. Much of our early discussion with ANZ, our sustainability bond coordinator, ahead of our market return was about the most appropriate issuance format and specifically what investors say they want to see from issuers. The feedback was that there is growing interest in sustainability issuance, which actually suited us given the assets we had identified for potential inclusion were biased toward social and sustainable projects. There was still a large volume of green assets in the pool as well, though.
This also supported our decision to do a large initial trade and announce that the 2035 sustainability bond would be the 2035 TCV benchmark bond. The size of the asset pool will allow this bond to grow to a comparable level with our other benchmark bonds over time. It also supports our view that GSS issuance can and should be traded in line with an issuer’s curve. In this case, we have made it clear that the sustainability line is the curve bond in 2035.
Davison TCV is aiming to build the sustainability bond’s volume and is therefore open to tapping it. One thing that gets mentioned a lot in the supranational, sovereign and agency market – and in fact across issuer sectors including in credit – is that there is lots of incremental demand for ESG product especially among domestic investors. Does this match TCV’s experience?
KELLY I think genuine, specific demand for ESG assets is still growing and specific mandates still made up a smaller proportion of our syndicated launch. By issuing the 2035 sustainability bond and making it a benchmark bond we will have ample supply for any investor that wants to participate in our name in the ESG space, and ample supply for any other bond buyer that just wants to buy 2035 TCV bonds.
KENNA Demand is a question for the market as a whole. We were pleased to see TCV take the approach it did, specifically offering an extension of the curve in GSS format.
We have found, regardless of the approach we might take, that GSS bonds have been a little less liquid and marked a bit tighter than our benchmark curve has been at times. Whether these marks reflect reality is another discussion, but this has been our observation.
Davison In a phase where the market is integrating ESG more and labelled issuance may no longer be the be-all and end-all, are investors demanding more information on ESG? What is the sovereign being asked to provide by investors?
NICHOLL We have been using an appendix to our investor chart pack for about three years that includes high-level information about climate-change-related programmes happening in Australia.
I have fielded quite a few questions in meetings with investors for some years about what is happening in Australia, and we have tried to delineate helpfully between programmes the states have put in place and the Commonwealth’s role. We have been building up this ESG or climate change pack in response and it is now quite comprehensive on Commonwealth policies.
Over time, issuer credentials could possibly overtake the need for a specific asset class, as in labelled bonds – along the lines of the view we have heard from SA. Having said this, we continue to monitor the market closely and it is fair to say there is not just one voice within the Commonwealth on the merit of or need for labelled bonds.
I will be interested to see how the market develops over the coming years. Looking at global sovereign markets, green bonds still constitute less than 1 per cent of sovereign assets. It is still a very small sector. There is a lot of work involved in doing labelled issuance and lots of different standards to choose from – which is not a reason not to do it but it is a reason to understand why it is a big commitment once an issuer decides on this course.
I should add that I understand why lots of investors and banks are excited about the idea of labelled bonds: they have created a new part of the market that satisfies specific investor mandates.
Davison Is the AOFM watching the New Zealand sovereign’s process of establishing a GSS programme fairly closely?
NICHOLL Yes, along with the UK and Germany. We were interested in the German approach to introducing green bonds and how these bonds are interchangeable with the rest of the nominal curve. We have spoken with the UK about its experience of getting a programme up and running, so we understand what is involved.
The AOFM is not recommending we should do it at this stage but at the same time we are not ruling it out or saying we will not do it. My view has been that if the proportion of sovereign assets out there gets to a tipping point, we will not be able to avoid doing it – otherwise we could see marginal narrowing of the investor base.
As for timing, if the AOFM were to plan to issue labelled bonds we would be hard pressed to do something meaningful in less than a year.