A matter of interest

Sovereign Debt Management

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The Australian Treasury faced a tough decision earlier in this decade. With the government proposing to sell its remaining stake in telecommunications company Telstra, some politicians were calling for the country's sizeable fiscal surplus to be used to pay off all outstanding debt. The Australian Treasury launched a consultation paper in late 2002 that appeared to favour this outcome - a move that caused alarm among bond traders, who claimed the shutting of the Commonwealth government bond and bond futures markets could have a knock-on effect on risk management and the pricing of corporate debt.

The government relented in 2003, declaring it would continue to issue sufficient debt to support the three- and 10-year Australian Treasury bond futures contracts traded on the Sydney Futures Exchange (which merged with the Australian Stock Exchange in 2006 to form the Australian Securities Exchange). "The current approach was decided by the government in May 2003, and we are issuing purely to maintain the markets in government bonds and futures, as Australia has a large surplus and no need to raise funds in the bond market," says Neil Hyden, chief executive of the Australian Office of Financial Management (AOFM) in Sydney.

The AOFM is charged with managing government bond issuance and ensuring sufficient securities are in issue to support the Australian Securities Exchange's bond futures contracts. The agency targets issuance of roughly A$5 billion ($4 billion) a year, and has a total outstanding bond portfolio of A$45 billion. Issuance is decided based on past and expected future volumes traded on the Australian Securities Exchange. Average daily volumes in 2006 for the three- and 10-year Australian Treasury bond future were 121,638 and 59,025 contracts, respectively.

"The bond lines we issue are chosen to meet the needs of the bond futures contracts," says Hyden. "We consult with the Australian Securities Exchange on the choice of bond lines and the timing of issuance. We aim to issue one new bond line each year, alternating between five-year bonds and 13-year bonds, and to issue around A$5 billion each year. We announce our planned issuance at the start of each financial year with the proposed dates and volumes. This is done on an indicative basis but, so far, over four years, we have not had to deviate from the initial announcements."

Key risks

The AOFM conducts its debt management operations using a risk-based framework for analysis and reporting. The key risks managed by the AOFM include funding risk, market risk, credit risk and operational risk. Those are managed through a dedicated financial risk division and geared towards managing variability in debt servicing costs. The research and modelling functions are overseen by the AOFM's advisory board.

Despite deciding to maintain issuance of nominal government bonds, the Australian Treasury opted to discontinue its inflation-linked issuance programme in 1999. That decision still stands, despite growing interest from pension funds across the globe to hedge inflation as part of a liability-driven investment strategy. Other countries have kick-started index-linked debt programmes in recent years in response to end-user demand, including Japan, South Korea and Germany. The UK and France, meanwhile, have issued 50-year inflation-linked bonds in response to pension demand for long-dated assets.

"The other stock, which is mainly in the form of indexed bonds, is being allowed to mature and we are not seeking to replace it," says Hyden. "The government remains committed to supporting the government bond and bond futures markets, but not the markets for other debt instruments."

The AOFM had A$6.02 billion in outstanding index-linked bonds as of the end of June 2006, with the capital value of the investment being adjusted by the rate of inflation. The notes pay a quarterly fixed-rate coupon on the inflation-adjusted capital value of the bonds, payable at maturity. However, the last index-linked bond matures in 2020.

To help manage the interest rate risk of the government's net debt portfolio, the AOFM enters into interest rate swaps of varying maturities, with the aim of reducing the cost of its debt portfolio by reducing the average term to maturity. In the first quarter of this year, the agency transacted A$600 million of interest rate swaps with a maximum tenor of four years. However, this could drop in future.

In July, the AOFM announced an increase in the target duration of its portfolio, from 2.5 years to three years. That decision reflected the flattening of yield curves in Australia and elsewhere last year and early this year.

As a result, the AOFM announced that in 2007/08 it plans to execute up to $1 billion of swaps to receive fixed-interest rates with maturities of at least four years and up to $1 billion of swaps to pay fixed rates with maturities not exceeding three years. That compares with its forecast in July 2006 of between $1 billion and $3 billion of swaps to receive fixed-interest rates with maturities of at least four years and up to $2 billion of swaps to pay fixed rates with maturities of up to three years.

In addition to its debt issuance and interest rate risk management duties, the AOFM also monitors a surplus investment fund, where the income is used for funding rural telecommunication projects in Australia. The Communications Fund obtained its initial funding from the budget surplus in September 2005 and is invested in liquid short-term low-risk Australian dollar-denominated securities, such as certificates of deposit and bank bills. The term of individual investments is typically three weeks and the typical return is in line with the yield on bank bills.

Managed separately from the AOFM, the Australian Future Fund (AFF) in May last year received its first transfer of A$18 billion of surplus from the cash management arm of the AOFM. Until that point, these assets - a result of surpluses and the government's sale of publicly owned assets - were held as term deposits with the Reserve Bank of Australia. That capital, transferred to the AFF, will be used to offset unfunded obligations on the government's balance sheet - namely, the pensions due to civil service and military personnel employed by the government.

"The AFF's objective is to help the government pay off superannuation liabilities for civil servants and the military, commencing from 2020," says Hyden. "Relieving the pressures on the budget to meet these liabilities will help the government meet increases in demand for expenditures from population ageing over the long term."

The fund has a long-term investment strategy based around global and Australian equities, fixed interest, pooled property, private market assets and commodities futures. It aims to achieve a return of at least 5% above the inflation rate over rolling 10-year periods. In addition, the Australian government announced in its 2007/08 budget that it will establish a higher education endowment fund to generate earnings for capital works and research facilities in higher educational institutions. That fund will have initial capital of A$5 billion.

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