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# Introduction

This part of the annual report is presented in three sections: Section 1 provides an Annual Performance Statement as required by the PGPA Act; Section 2 details the AOFM’s issuance operations, debt and cash portfolio management task and its engagement with the market (namely investors); and Section 3 presents the main considerations for how the AOFM approaches strategy development to underpin its operational objectives.

## Section 1: Annual Performance Statement

As the accountable authority of the Australian Office of Financial Management, I present the 2018-19 Annual Performance Statement of the Australian Office of Financial Management, as required under paragraph 39(1)(a) of the Public Governance, Performance and Accountability Act 2013 (PGPA Act).

In my opinion this annual performance statement accurately reflects the performance of the Australian Office of Financial Management, is based on properly maintained records and complies with subsection 39(2) of the PGPA Act.

Rob Nicholl

Chief Executive Officer

27 September 2019

## Purpose

The AOFM’s purpose is to ensure the government’s debt financing needs are met each year while managing the cash, debt and other portfolios over the medium-long term at low cost subject to acceptable risk. The AOFM takes into account the potential for its operations to impact domestic financial markets.

The AOFM has adopted three key objectives to achieve its purpose:

1. meet the budget financing task in a cost-effective manner subject to acceptable risk;
2. facilitate the government’s cash outlay requirements as and when they fall due; and
3. be a credible custodian of the AGS market, and meet other portfolio responsibilities as directed by government.

The AOFM balances cost and risk considerations but its overriding aim is to ensure that the financing requirements of government are able to be met in full and on time. The AOFM has minimal appetite for failure in any function associated with issuance, settlement and cash management. The design and conduct of its core business processes (including its business continuity arrangements) reflect this risk appetite.

The AOFM monitors its performance against the performance indicators presented in Table 1, sourced from the AOFM’s Corporate Plan 2018-19 and Portfolio Budget Statements 2018-19. Sections 2 and 3 of this part of the Annual Report provide detail on a range of outcomes important to achievement by the AOFM of its annual and longer-term aims. This detail is provided separately to the Performance Statement because it is aimed at financial market participants as the relevant audience.

### Measure (b)

Objective 1: Meet the budget financing task in a cost effective manner subject to acceptable risk

1. Term issuance

Shortfall in volume ($) between actual Treasury Bond issuance and planned issuance announced at the Budget and subsequent releases. 2.1 Financing cost (portfolio) 2.2 Financing cost (issuance) The cost of the long-term debt portfolio compared to the 10 year average of the 10-year bond rate. The cost of Treasury Bond issuance over the past 12 months compared to the average 10-year bond rate over the same period. 3. New issuance yields Weighted average issue yield at Treasury Bond and Treasury Indexed Bond tenders less prevailing mid-market secondary yields. Objective 2: Facilitate the government’s cash outlay requirements as and when they fall due 4. Use of the overdraft facility Number of instances the RBA overdraft facility was utilised to the extent that it required Ministerial approval during the assessment period. Objective 3: AOFM is a credible custodian of the AGS market and other portfolio responsibilities 5. A liquid and efficient secondary market Annual turnover in the secondary market for Treasury Bonds and Treasury Indexed Bonds. 6. Market commitments Number of times the AOFM failed to undertake actions consistent with public announcements. (a) Source: AOFM Corporate Plan 2018-19; Portfolio Budget Statements 2018-19 Budget Related Paper No. 1.16 — Treasury Portfolio, p. 108 (b) Source: AOFM measures performance against indicators using data captured from its market transactions; its financial systems recording portfolio composition; official notices to the market; and secondary financial market turnover data requested from intermediaries. ## Performance Results 2018–19 ### Objective 1: Meet the budget financing task in a cost effective manner subject to acceptable risk Indicator 1 Term Issuance: Shortfall in volume ($) between actual Treasury Bond issuance and planned issuance announced at the Budget and subsequent releases

Target

Zero

Result

Target met

At the time of the 2018–19 Budget, Treasury Bond and Treasury Indexed Bond issuance for the year was expected to total around $77 billion in face value terms. This volume was revised at the time of MYEFO in accordance with a revised improvement in the government’s fiscal position compared to Budget forecasts. #### Treasury Bond issuance Gross Treasury Bond issuance for the year totalled$55.0 billion. This was a significant reduction from the $75.5 billion of Treasury Bonds issued in 2017–18. The bulk of this issuance was into existing bond lines in order to enhance market liquidity. In addition, two new Treasury Bond lines were launched in 2018–19: • a new bond line maturing in June 2031 was issued to support the operation of the 10-year Treasury Bond futures contract and to reduce growth in the amount outstanding in surrounding bond lines, which will make it easier to manage maturity of those bonds lines; and • a new bond line maturing in May 2041 was issued to support the operation of the 20-year Treasury Bond futures contract. In selecting the bond lines to issue each week, the AOFM continued to follow its standard practice of taking into account the debt issuance strategy, prevailing market conditions, information from financial market contacts about investor demand, relative value considerations, the liquidity of outstanding bond lines, and managing the maturity structure to limit funding risk. One or two tenders were held during most weeks. Large transaction volumes were achieved at issues of new Treasury Bonds. The May 2041 ($3.6 billion) was issued by syndication, while a tender was held for the initial issue of the June 2031 ($3.0 billion) bond line. At the end of the year, there were 25 Treasury Bond lines, with 13 of these lines having over$20 billion on issue and 21 having over $10 billion on issue. Chart 2 shows Treasury Bonds outstanding as at 30 June 2019 and the allocation of issuance across bond lines during 2018–19. ### Chart 2: Treasury Bonds outstanding as at 30 June 2019 and issuance in 2018–19 #### Treasury Bond buybacks A total of$23.1 billion of Treasury Bonds were repurchased ahead of maturity in 2018-19, of which $16.7 billion were bonds maturing after 30 June 2019: • 25 Treasury Bond buyback tenders were conducted, at which$14.7 billion of bonds were repurchased;
• the AOFM repurchased $2.05 billion of bonds in conjunction with the syndicated issue of the new 21 May 2041 Treasury Bond; •$6.3 billion of bonds were repurchased from the RBA; and
• a small amount of bonds were repurchased from retail investors who sold their holdings via the Australian Government Securities Buyback Facility.

Buyback tenders are effectively a reverse of normal competitive issuance tenders. The AOFM sets the total volume of bonds it is prepared to buy back and offers from intermediaries are accepted from the highest yield (lowest price) in descending order until the total volume is reached. All Treasury Bond buybacks other than those from retail investors were of lines shorter than the three-year futures basket.

The volume outstanding in short-dated Treasury Bonds was reduced as illustrated in Chart 3.

### Chart 3: Volume outstanding in short-dated Treasury Bonds as at 30 June 2018 and 30 June 2019

#### Treasury Indexed Bond issuance

The AOFM maintains less than 10 per cent of the long-term debt portfolio in the form of Treasury Indexed Bonds, the capital values of which are adjusted with changes in the CPI. The issuance of these bonds typically attracts a different (and predominantly domestic) class of investor compared to Treasury Bonds, providing a source of diversification in the funding base. While the indexed bond portfolio has declined marginally as a share of the long term funding, the total stock of indexed bonds has continued to grow steadily (as shown in Chart 4).

### Chart 4: Treasury Indexed Bonds — average term to maturity and share of the long-term funding base

Treasury Indexed Bond issuance for the year totalled $5.9 billion, of which$2.2 billion was conducted via tender. Two tenders for the issue of Treasury Indexed Bonds were conducted in most months. The volume of each line outstanding, relative yields and other prevailing market conditions were considered in the selection of which line to offer. A syndicated offer for $3.8 billion of a new February 2050 Treasury Indexed Bond line was conducted in September 2018. In conjunction with the syndication, around$2.1 billion of the August 2020 Treasury Indexed Bond line was repurchased.

Chart 5 shows the amount outstanding in each of the eight Treasury Indexed Bond lines as at 30 June 2019, and the allocation of issuance during the 2018–19 year.

### Chart 5: Treasury Indexed Bonds outstanding as at 30 June 2019 and issuance in 2018–19

#### Efficiency of issuance

Table 2 summarises the results of Treasury Bond tenders conducted during the year. The results are shown as averages for each half-year and grouped by the maturity dates of the bonds offered.

### Table 2: Summary of Treasury Bond tender results

Period

Maturity

Face value amount allocated ($m) Weighted average issue yield (%) Average spread to secondary market yield (basis points) Average times covered July - December 2018 Up to 2026 4,900 2.1670 -0.51 5.44 2027 - 2031 20,900 2.6644 -0.30 3.39 2032 - 2047 900 3.0703 -0.15 2.38 January - June 2019 Up to 2026 3,200 1.5485 -0.39 4.45 2027 - 2031 19,600 1.8815 -0.10 3.25 2032 - 2047 1,900 2.3736 0.08 2.64 The average coverage ratio for all Treasury Bond tenders in 2018–19 was 3.57, a decrease from 4.44 in 2017–18. The average tender size of$829 million was higher than in 2017-18, reflecting a move to less frequent tenders. Shorter-dated bond tenders generally received a greater volume of bids (higher than average coverage ratios), which reflected both core investor base interest and a lower supply of short-dated bonds.

The strength of bidding at tenders was also reflected in competitive issue yield spreads to secondary market yields. At most Treasury Bond tenders the weighted average issue yields were below prevailing secondary market yields.

The average coverage ratio was 4.40 for Treasury Indexed Bond tenders, an increase from 3.53 in 2017–18. At most tenders, the weighted average issue yields were below prevailing secondary market yields.

Full tender details are available in Part 5 of this annual report.

#### Market liquidity and efficiency

The Treasury Bond market operated smoothly during 2018-19 with liquidity and efficient price discovery being maintained throughout the year. Repo rates during the first half of the year remained high compared to long term averages with continued pressure around quarter ends, raising the costs to some investors and market makers of holding AGS. The elevated rates experienced during 2018 eased somewhat during the second half of the year.

AOFM monitoring of the market indicates that liquidity in Treasury Indexed Bonds has continued to prove noticeably more challenging than for Treasury Bonds. This is consistent with the relative liquidity of nominal and inflation-linked securities in other sovereign debt markets. Treasury Indexed Bond turnover in 2018-19 was around $52 billion, an increase of 3 per cent from 2017-18. This was driven by a decrease of Interbank turnover Australian investors and in Asia (ex Japan). Intermediaries are responsible for the bulk of trades. ### Chart 7: Annual Treasury Indexed Bond Turnover There was tightness in several indexed bond lines at times during the year, requiring some market participants to borrow these from the securities lending facility. Turnover in the Treasury Bond futures market is significantly higher than in the underlying Treasury Bonds. The three and 10-year Treasury Bond futures contracts are highly liquid: over 60 million three-year contracts (representing$6.0 trillion face value of bonds) and over 52 million 10-year contracts ($5.2 trillion face value of bonds) were traded in 2018–19. Turnover in the 20-year contract is considerably lower: 259,000 contracts ($15.8 billion face value of bonds) were traded. All contract close-outs in 2018–19 occurred smoothly.

The AOFM’s securities lending facility allows market participants to borrow Treasury Bonds and Treasury Indexed Bonds for short periods when they are not otherwise available in the secondary market. This enhances the efficiency of the market by improving the capacity of intermediaries to continuously make two-way prices, reduces the risk of settlement failures, and supports market liquidity. The facility was used 21 times for overnight borrowing in 2018–19 compared with 52 times during 2017-18. The volumes borrowed were lower than in 2017–18, with the total face value amount lent in 2018–19 being $393 million, a decrease from$1,667 million in the previous year.

## Debt portfolio management

### Aims

This section details the outcomes of the AOFM’s portfolio management activities. In managing the debt portfolio and meeting the government’s financing requirements, the AOFM aims for low and stable debt servicing costs over the medium-long term. It also seeks to maintain liquid bond lines to facilitate cost-effective issuance of debt through time and to effectively manage future funding and refinancing risks.

### Approach to achieving the aims

To meet these aims the AOFM endeavours to execute a debt issuance strategy that appropriately accounts for the trade-offs between cost and risk while providing consistent and transparent stewardship of the AGS market in order to underpin confidence and promote market liquidity. Through its operations the AOFM contributes to an efficient and resilient market while seeking to maintain continuity of access to financial markets for the Australian Government.

The AOFM uses cost and risk measures that reflect the considerations faced by sovereign debt managers generally. The primary cost measure used is historic accrual debt service cost. This includes interest payments made on AGS, realised market value gains and losses on repurchases, capital indexation of indexed debt, and the amortisation of any issuance premiums and discounts. Total accrual debt service cost can be expressed as a percentage of the stock of debt outstanding to provide the effective yield of the portfolio. The use of an historic accrual debt service cost measure excludes unrealised market value gains and losses.

An alternative measure of cost is ‘fair value’, which takes account of unrealised gains and losses resulting from movements in the market value of physical debt and assets. Debt service cost outcomes are presented in the AOFM’s financial statements on this basis. 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. Fair value facilitates an assessment of financial risk exposures and changes in those exposures from year to year, the value of transactions managed and the economic consequences of alternative strategies. It is most useful in the context of trading for profit making purposes.

The AOFM calculates and compares several metrics to assess risk. In general, an acceptable level of risk can be characterised as an acceptable level of variation in interest cost outcomes over time. Debt issuance decisions made today impact the variability of future interest cost outcomes because of their influence on the maturity profile of the portfolio and hence the amount of debt that needs to be refinanced (and ‘re-priced’) through time.

### Outcomes

#### Portfolio cost

The debt servicing cost[1] of the net AGS portfolio managed by the AOFM in 2018–19 was $17.42 billion on an average book volume of$527.01 billion, representing a net cost of funds of 3.31 per cent for the financial year. The largest component of net AGS debt is the Long Term Debt Portfolio (LTDP), comprised primarily of Treasury Bonds and Treasury Indexed Bonds, which incurred debt servicing costs of $17.92 billion on an average book volume of$550.16 billion, implying a cost of funds of 3.26 per cent. The difference between net AGS debt and the LTDP is attributable to the short term assets and liabilities the AOFM uses for liquidity management purposes (term deposits and Treasury Notes) and other residual assets (such as state housing advances).

Table 3 provides further details of the cost outcomes for the portfolio of debt and assets administered by the AOFM broken down by instrument and portfolio for 2018-19 as well as 2017–18.

### Table 3: Commonwealth debt and assets administered by the AOFM

Debt servicing cost

$million Book volume$ million

Effective yield

per cent per annum

2017-18

2018-19

2017-18

2018-19

2017-18

2018-19

Contribution by instrument

Treasury Bonds

(15,854)

(16,136)

(485,291)

(505,825)

3.27

3.19

Treasury Indexed Bonds

(1,598)

(1,785)

(43,207)

(44,337)

3.70

4.03

Treasury Notes

(67)

(63)

(3,950)

(3,398)

1.70

1.85

Gross physical AGS debt

(17,519)

(17,984)

(532,448)

(553,560)

3.29

3.25

Term deposits with the RBA

650

459

37,095

24,748

1.75

1.85

RMBS investments

37

915

4.04

0.00

State Housing Advances

110

106

1,880

1,801

5.86

5.89

Gross assets

797

565

39,890

26,548

2.00

2.13

Net AGS debt

(16,722)

(17,419)

(492,558)

(527,011)

3.39

3.31

Contribution by portfolio

Long Term Debt Portfolio

(17,452)

(17,921)

(528,498)

(550,162)

3.30

3.26

Cash Management Portfolio

583

396

33,145

21,350

1.76

1.85

RMBS Portfolio

37

915

4.04

0.00

State Housing Portfolio

110

106

1,880

1,801

5.86

5.89

Total debt and assets

(16,722)

(17,419)

(492,558)

(527,011)

3.39

3.31

Re-measurements (a)

581

(43,550)

Total after re-measurements

(16,141)

(60,969)

(492,558)

(527,011)

Note: Sub totals and totals are actual sum results, rounded to the nearest million dollars. Effective yields are based on actual results before rounding, rounded to two decimal places. Book volume is a through the year average.

(a)  Interest expense and effective yield on foreign loans incorporates foreign exchange revaluation effects.

(b)  Re-measurements refer to unrealised gains and losses from changes in the market valuation of financial assets and liabilities.

The cost of gross debt increased in dollar terms by $0.47 billion compared to the previous year. This was primarily due to an increase in the average volume of debt on issue by$21.11 billion to $553.65 billion. However, in percentage terms the funding cost of gross debt declined by 4 basis points to 3.25 per cent. This improvement was driven by the issuance of new bonds at yields that were below the average of pre-existing (and maturing) debt. The return on gross assets in dollar terms for the period was$565 million, a decrease of $232 million compared to 2017–18. This was driven by a$191 million decrease in income from term deposits (resulting from smaller holdings) as well as a $37 million reduction in income following the completion of the RMBS divestment process in February 2018. However, in percentage terms the return of gross assets increased by 13 basis points to 2.13 per cent. The net servicing cost of the combined portfolio of debt and assets was$17.42 billion. This was higher in dollar terms compared to 2017–18, primarily due to the higher volume of debt on issue. In percentage terms, net debt servicing costs fell from 3.39 per cent to 3.31 per cent, slightly larger than the fall in gross debt servicing costs.

Movements in market interest rates had an unfavourable impact on the market value of the portfolio in 2018–19. Unrealised losses from re-measurements amounted to $43.55 billion. This compares to an unrealised gain of$0.58 billion in the previous year. Most of the re-measurement losses are attributable to changes in the market value of Treasury Bonds. Re-measurement items are highly volatile from one year to the next and have no bearing on the AOFM’s debt issuance strategy. Indeed, were the AOFM to adopt a strategy designed to minimise the ‘noise’ from re-measurements, issuance would be limited to only very short-term debt securities, for example Treasury Notes and near maturity bonds. However, this would create a portfolio structure that would maximise expected variability in debt servicing costs when measured in cash, accrual and public debt interest terms, while also maximising exposure to refinancing and funding risk. In practice the AOFM has been seeking to reduce these risks through allocating a greater proportion of issuance to long dated bond lines.

#### Portfolio risk management

Chart 8 shows the funding cost profile of the net AGS debt portfolio and the LTDP back to 2007-08. These profiles are contrasted with the cash rate and the 10-year moving average of the 10-year bond yield. With interest rates trending down, funding costs on net debt and the LTDP have declined by 188 and 200 basis points respectively since 2010-11. This compares to declines of 350 basis points in the cash rate and 205 basis points in the 10 year average of the 10-year bond rate over the same period. Given the largely fixed cost structure of net debt and the LTDP, changes in funding cost will always lag changes in the overnight cash rate (changing only when existing debt securities or assets mature or new securities are issued/investments placed).

### Chart 8: Net AGS debt and LTDP cost of funds analysis (per cent)

The reduced risk levels of the portfolio in terms of funding, refinancing and interest rate risk are demonstrated in Chart 9 below. The chart shows a steady decline in the short to medium term Treasury Bond refinancing task, measured as the proportion of the stock of Treasury Bonds on issue through time[2]. At 30 June 2010 the structure of the portfolio was such that 43 per cent and 65 per cent of bonds required refinancing over the next three and five year periods respectively; these have continued to decline and have now fallen to 21 per cent and 39 per cent.

## Cash management

### Aims

The AOFM manages the daily cash balances of the Australian Government in the OPA.[3] This is undertaken in a manner that ensures the government is able to meet its financial obligations as and when they fall due. Other objectives are to minimise the cost of funding and the carrying cost of holding cash balances (which centres on holding only balances assessed as prudent to cover forecast needs and contingencies, while investing excess balances at low or minimal risk). In minimising cost, the AOFM seeks to avoid use of the overdraft facility provided by the RBA.[4]

### Approach to achieving the aims

Achieving the cash management objective involves formulating forecasts of government cash flows, and developing and implementing appropriate strategies for short-term investments and debt issuance.

A precautionary asset balance is maintained to manage the forecasting risk associated with potentially large unexpected cash requirements (or shortfalls in revenue collections) and the funding risk associated with market constraints.

Cash balances not required immediately were invested in term deposits at the RBA, with the magnitudes and tenors of the term deposits determined by the AOFM. Maturity dates of term deposits were selected to most efficiently finance net outflows. Interest rates for term deposits at the RBA reflect the rates earned by the RBA in its open market operations.

Treasury Notes are issued to assist with management of the within-year funding requirement. The volume of Treasury Notes on issue ranged from $2.5 billion to$5.0 billion during 2018–19.

The size and volatility of the within-year funding requirement are reflected in changes in the short-term financial asset holdings managed by the AOFM, after deducting Treasury Notes on issue. Chart 10 shows movement in the funding requirement over the year.

### Outcomes

The task of meeting the government’s financial obligations as and when they fall due was fully met. The overdraft facility was not utilised in 2018–19.

During 2018–19, the AOFM placed 390 term deposits with the RBA. The stock of term deposits fluctuated according to a range of factors influencing the AOFM’s cash portfolio management needs. The balance of term deposits ranged from a maximum of $46.0 billion in July 2018 to a minimum of$11.3 billion in January 2019.

The average yield obtained on term deposits during 2018–19 was 1.85 per cent, compared with 1.75 per cent in 2017–18. The increase in average yield reflects the higher average level of short-dated interest rates that prevailed during 2018–19.

## Market engagement

### Aims

Consistent and regular market engagement assists the AOFM to maintain a comprehensive understanding of market related issues including major announcements and events, impacts on the global flow of capital, changing investor preferences, and the performance of banks that play the role of intermediaries — particularly in the AGS market. While this latter aim can in part be served by assessing announced regulatory changes, there remains the need for ongoing direct engagement with market participants. The AOFM also understands the importance of regular engagement with investors to ensure that they understand the key considerations underpinning the AOFM’s issuance and market maintenance/development strategies and appreciable changes in operation should these arise from time to time.

Market engagement by the AOFM continues to place a heavy emphasis on maintaining lines of communication with investors and bank intermediaries. This is done directly with both, and indirectly, with investors through feedback from the banks. Ongoing engagement assists greatly in understanding how investors view financial markets generally and in turn their view on the outlook for AGS and how intermediaries interact with and service the end investor.

### Approach to achieving the Aims

Market engagement is based on an investor relations program underpinned by an investor relations strategy that is reviewed annually. This review takes account of changes in market conditions, investor activity, known changes in the key investor base, and the AOFM’s planned issuance strategy.

The Investor Relations strategy has three themes:

• collecting and analysing market intelligence from investors;
• managing and maintaining updates to key investors about the AOFM’s program of activities and its intended operations; and
• a deepening of the investor base through engagement with new or potentially new investors.

Diversification of the AGS investor base is expected to change with appreciable shifts in financial market conditions. Given the complexity of influences on the attractiveness of AGS relative to alternative investment options it is difficult to predict with a high degree of confidence full detail of the AGS investor composition at any point in time. However, the AOFM is highly active in looking to understand changes as they occur. It does this through high frequency and comprehensive communication with market participants. In this regard the major focus of investor engagement continues to be, engaging with our key investors and collecting and analysing the information on their portfolio activities as we receive it from them.

### Outcomes

For the last two years the AOFM’s market engagement has been heavily guided by the shift in its operations away from active market development through yield curve extensions and the introduction of a high number of new Treasury Bond and Treasury Indexed Bond maturities, to more of a market maintenance role. There were effectively two key drivers for this change; one was achieving the market and portfolio objectives of establishing 30-year benchmark yield curves for both the nominal and indexed yield curves (with no strong incentive to extend beyond 30-years), and the ongoing reduction in the budget deficit with consequent smaller funding tasks. Together these factors have made the AOFM’s discussion with market participants appreciably more straightforward and this has allowed for an easier task of updating investors via teleconference and videoconferencing as substitutes for the regular face-to-face engagement that had previously been more appropriate. Due to the April Budget followed by the federal election, direct engagement over the months of March through to June was not conducted.

For the year overall, discussions were held with 95 investors directly (compared with 128 in 2017–18). This comprised of 65 face to face meetings and 30 video/teleconferencing calls. Although direct investor meetings were down from the year before, the AOFM was still able to cover a larger number of geographically diverse key AGS investors from differing sectors of the market. Key investors engaged via teleconference and videoconference were from 19 cities outside of Australia.

The AOFM intends to continue these methods where appropriate as a supplement to direct face-to-face meetings. However for some areas or regions the AOFM did not feel that conference calls were an appropriate method to use due to the lack of familiarity with certain investors and other practical considerations.

Face-to-face meetings with investors were held with the domestic investor base; around 30 meetings with large fund managers, bank balance sheets and superannuation funds. Domestic investors continue to hold around 40 per cent of total AGS outstanding. There was one overseas series of meetings conducted in London, Paris and Madrid.

To also supplement communication with investors, the AOFM launched a quarterly investor note (Investor Insights) on the 1st of June this year via the AOFM website. ‘Investor Insights’ will provide AOFM views and background thinking on a range of AGS related matters.

The AOFM continued its past practice of using appropriate opportunities offered through conferences and speaking events. These events offer AOFM the opportunity to engage briefly but directly with investors and to reiterate key messages and themes, regarding AGS issuance and its market impacts. Each year the Australian Business Economists hosts a post-Budget speech by the CEO. It remains an important platform to provide information to the market for the upcoming year by giving the market some detail around the AOFM’s intentions for forthcoming issuance and operations; (June) 2019 was the ninth consecutive year for this event.

The conference and investor missions hosted by the financial intermediaries in which the AOFM participated included a CBA Fixed Income Conference, ANZ Hunter Valley Debt Conference, the Deutsche Bank Investor Mission and an ANZ Investor Tour. The AOFM also spoke at the annual KangaNews roundtable and again participated in its annual year book publication. While these events do not substitute for the benefits derived from face-to-face meetings, they remain useful in their own right and typically offer opportunity for short face-to-face meetings with selected attendees.

The current approach to maintaining investor engagement is considered appropriate during lower and stable issuance programs and with the current operational approach to achieving these programs having been comprehensively explained to and understood by AGS investors. In the event that the AOFM foreshadowed a significant change in issuance or the nature of its approach to the market, a return to more intensive and widespread face-to-face investor engagement would be considered as appropriate.

### Table 4: Summary of investor relations activities in 2018-19

 Activity Details Conferences, speaking engagements and investor roadshows 9 events Presentations: large engagements/ roundtables 5 presentations Approximate total audience size: large presentations 220 attendees Individual investor meetings 65 investor meetings Individual investor Tele/ Video Calls 30 Individual cities visited 7 cities AOFM staff participating in investor relation activities CEO, Head of Investor Relations, Head Portfolio Strategy & Research, Head Funding & Liquidity. Head of Market Intelligence, Senior Analyst, Investor Relations, Analyst Funding and Liquidity Hosting banks: Investor roadshows, conferences, roundtable discussions ANZ, Citi Commonwealth Bank of Australia, Deutsche Bank UBS, Westpac

## Section 3: Portfolio and Operational Strategy

### Debt Portfolio Management

#### Aims

The AOFM is a price-taker in global capital markets but influences the cost and risk profile of the AGS portfolio through the maturity structure of the securities it issues (and to a lesser extent, the mix between nominal and inflation-linked securities). Issuing longer-term securities will typically involve paying higher debt service costs (in the presence of a positive term premium)[5] although this is compensated by reduced variability in future interest cost outcomes and lower exposure to refinancing risk.[6] Issuing shorter term debt securities by contrast will typically incur less interest cost (avoiding a term premium), but result in higher variability in cost outcomes through time and a greater debt refinancing task. Striking the right balance between these cost and risk considerations is the debt manager’s ongoing challenge.

Developing a medium to long-term view on appropriate portfolio management and then translating that into annual decision making on a strategy to implement that portfolio management objective is informed by an ongoing research program. This program is focussed on exploring the cost and risk characteristics of alternative portfolio structures and issuance strategies under a wide range of scenarios. This is done in light of prevailing fiscal and economic conditions, as well as an assessment of broader market trends. Drawing on this research, the AOFM formulated a strategy for the structure and composition of issuance for 2018-19 that was approved by the Treasurer at the time of the Budget. Separately, a range of complementary limits, thresholds, guidelines and targets governing the AOFM’s operations were submitted to the Secretary to the Treasury for approval through an Annual Remit. These governance arrangements provide appropriate oversight for the impact of AOFM’s gross issuance decisions each year on overall debt policy.

Implementing the annual issuance strategy involves weekly decisions such as determining how much and which lines to issue, or when a new maturity should be established. These operational decisions are influenced by several factors including prevailing market conditions, relative value considerations and feedback from intermediaries and investors. The ongoing suitability of the annual debt issuance and portfolio strategies is under constant review, but the strategies would only be changed during the year in the face of substantive changes to market conditions or the fiscal outlook.

#### Debt Issuance Strategy

The AOFM’s strategy for 2018-19 was formulated amid a strengthening global economic environment, and was in large part influenced by a continuation of low outright bond yields (from a historical perspective), and a low term premium (which increases the cost-effectiveness of longer term issuance).

In the first half of 2018-19 the synchronised strengthening of global economic data continued and expectations of higher policy rates tended to result in higher government bond yields. However, there was an abrupt change in the outlook in mid-2018-19 as expectations for global growth and monetary policy were revised to reflect a weakening outlook, leading to a significant rally in government bond yields (Chart 12).

### Chart 12: Evolution of Treasury Bond benchmark yields

The yield curve flattened through the first half of 2018-19 before re-steepening in the second half of the year. Most of this change in longer bond yields reflected changes in other markets more than appreciable changes in the demand for AGS. Short-term AGS yields decreased in 2018-19 reflecting market expectations for a lower RBA monetary policy rate. The cash rate was subsequently lowered in June 2019 to 1.25 per cent to a new historic low. The 10-year and 30-year benchmark yield ended the financial year at 1.32 and 1.94 per cent respectively (also near historic lows).

In light of prevailing market conditions and funding requirements, the AOFM’s strategy in 2018–19 followed a broadly similar theme to recent years, with a bias toward longer term issuance and further lengthening of the average term to maturity of the debt portfolio. Low outright rates and a very low (or zero) term premium reinforced this strategy from a cost effectiveness perspective. At its core, the 2018–19 portfolio strategy was designed to preserve the AOFM’s operational flexibility under a wide variety of circumstances, while continuing to benefit from the relatively low interest rates on offer. The strategy was complemented by a regular program of bond buyback tenders. The strategy also aimed to support diversity in the AGS investor base.

#### Debt Portfolio and Issuance Metrics

Chart 13 demonstrates the lengthening bias implicit in the AOFM’s issuance strategy with the average Treasury Bond issued in 2018–19 having a term to maturity of 11.27 years[7]. The issuance program continued to benefit from low interest rates, with an average yield on new issuance of 2.29 per cent. [8]

### Chart 13: Treasury Bond issuance — average yield, term to maturity and 10-year bond yield

Chart 14 shows that the average term to maturity of the Treasury Bond portfolio as a whole lengthened by 0.06 years to 7.44 years over 2018-2019. Duration was also higher by 0.43 years finishing the year at 6.60 years. The effective cost of funds (or yield) on the Treasury Bond portfolio fell from 3.12 to 2.99 over the same period.[9]

### Chart 14: Treasury Bond portfolio — modified duration, average term to maturity and cost of funds

The structure and effective yield on the Treasury Bond portfolio as at 30 June 2019 is a product of issuance undertaken since the 2007-08 fiscal year. Around two thirds of the current portfolio for instance was issued in the last four financial years at average yields below the portfolio average of 2.99 percent as depicted in Chart 15.

### Chart 15: Treasury Bond portfolio — composition and average yield by issuance year, as at 30 June 2019

Chart 16 shows that more than half of current Treasury Bonds were issued with an original term to maturity of between 9 and 12 years. When issuance beyond 12 years is included, around three quarters of the portfolio has been issued with an original term to maturity of 9 years or longer. The predominance of longer term bonds in the portfolio is reflective of the AOFM lengthening bias since the start of the decade. This has contributed considerably to aim of reducing funding risk and the potential for high volatility in future interest rate outcomes.

### Chart 16: Treasury Bond portfolio — composition and average yield by original term to maturity, as at 30 June 2019

The AOFM’s strategy for the indexed bond proportion of the portfolio has been to provide sufficient supply to meet investor requirements while supporting liquidity and the continuing development of the market over time. Over 2018-19, Treasury Indexed Bonds comprised on average around 8 per cent of total term debt (nominal and indexed bonds) on issue. This share has been stable for several years now although the overall size of the market has continued to grow in dollar terms. Issuance of Treasury Indexed Bonds in 2018-19 was $5.9 billion gross and$0.5 billion in net terms after buybacks and maturities. The real yield curve was extended to 30 years through the successful launch of the 2050 line in September 2018.

In 2018–19, the AOFM continued to favour a relatively defensive liquidity strategy by maintaining an asset buffer (in the form of term deposits with the RBA) to act as a precaution against a possible deterioration in funding conditions. The AOFM anticipated that it would have sufficient cash and liquid assets available, each business day of the fiscal year, to fund the next four or more weeks of projected net government outlays and AGS maturities.

[1]     Debt servicing cost includes net interest expense (measured on an accruals basis and includes realised gains and losses on the disposal of assets or liabilities) plus foreign exchange revaluation gains and losses (now minimal). Unrealised changes in the market valuation of domestic debt and assets are not part of this measure.

[2]     In absolute dollar terms, the quantum of three and five year maturities in the portfolio has still grown although this has occurred at a considerably slower pace compared to growth in the overall stock of Treasury Bonds.

[3]    The OPA is the collective term for the core bank accounts maintained at the RBA for Australian Government cash balance management.

[4]    The overdraft facility is more costly than equivalent short-term borrowing (for example, issuance of Treasury Notes). The terms of the facility provide that it is to cover only temporary shortfalls of cash and is to be used infrequently and, in general, only to cover unexpected events.

[5]     The term premium is the additional yield demanded by investors in order to hold a long-term bond instead of a series of shorter-term bonds.

[6]     Refinancing risk, also referred to as rollover risk or re-pricing risk, is the risk that renewed borrowings to replace maturing debt occurs on unfavourable terms (or perhaps not at all).

[7]     Calculation is based on the term to maturity of each bond issued during the year, weighted by book value.

[8]     Calculation is based on issue yields during the year weighted by book value.

[9]     These are point in time measures as at 30 June each year, in contrast to the debt servicing cost incurred throughout the year captured in Table 3. Figures are calculated by weighting Treasury Bond issuance yields by book volume.