Canberra takes a bond ‘step change’

The federal gov­ernment’s debt portfolio manager sees a ‘step change’ in bond issuance over the next two years

UBS has estimated total government debt could surge to about $500bn

The federal gov­ernment’s debt-portfolio manager sees a “step change” in bond issuance over the next two years, as it seeks to navigate severe swings in the market and help fund a spate of COVID-19 economic rescue measures.

The Australian Office of Financial Management chief Rob Nicholl said he expected that continual improvement in bond market conditions after a period of “extreme market stress” would create an environment for new issuance.

“There are many drivers to this,” he said, adding that net selling of government bonds and related portfolio changes were petering out and he expected net buying to resume.

Mr Nicholl would not give a time frame for the start of the bumper bond issuance program, but given the volatility expected in the near-term it would centre on shorter-dated notes.

“We will be led by where the demand is largest,” he said, noting the enormity of the funding task over the next 18 months to two years.

“It is a pretty big step change. We are still talking to treasury on the interaction of the stimulus and the budget position.”

The size of the bumper issuance program is a point of interest for analysts, because it is likely to exceed the more progressive rollout of bonds seen during the global financial crisis and its aftermath.

Nomura told clients debt issuance would have to “rise materially” to enable the government to pay for its COVID-19 stimulus measures, and it assumes half of the $130bn wage subsidy measure would fall within the current financial year.

“Allowing for all of these developments, the gross funding task for 2020-21, including refinancing of maturities, could be as high as $200bn on our estimates,” the firm said.

UBS has estimated total government debt could surge to about $500bn in coming years, suggesting a mammoth period ahead for bond issuance.

While Mr Nicholl wouldn’t comment directly on the new program’s size, in addition to normal liquidity requirements, he said: “They are going to be large compared to historic experience.

“This market is well positioned to absorb a lot of the increase in issuance.”

Support package

But Mr Nicholl conceded the size of the issuance rollout and investor nerves could at times lead to “uncovered tenders” of government bonds, which is unusual in Australia.

The AOFM and the Reserve Bank are key players in the government’s management of its funding blueprint, and now crisis plan, through the issuance and purchase of government bonds and other financial assets. The RBA has kicked off unconventional policy to help support the economy through a pandemic-related shock and also outlined a $90bn cheap funding facility for banks.

Alongside that, the AOFM has started operating the $15bn Structured Finance Support Fund to help smaller lenders access funding during a period of market dislocation. Further detail on the fund provided on Tuesday evening said it was available to non-bank lenders and authorised deposit-taking institutions that did not have the collateral required to tap the RBA’s $90bn funding facility for banks.

Mr Nicholl said the AOFM would seek to invest in packages of loans — that are securitised — to assist smaller lenders while also considering making investments in warehouse facilities.

The fund has triggered a wave of interest from smaller lenders, which confront a challenging funding and operating environment, and the AOFM this week has been receiving several inquiries every few hours.

On Friday, the AOFM started the operation of the structured fund, by investing $189m across six tranches of Firstmac’s $1bn mortgage bond. There was just one tranche where the AOFM was the only investor. “The risk is we turn up to the next one and we are the only investor,” Mr Nicholl said, but noted that the AOFM was seeking to keep the investment community involved and keep the securitisation infrastructure moving.

During the global financial crisis, securitisation markets froze, prompting the AOFM’s involvement of about $15.5bn in a program that had a $20bn limit.

Market participants are already saying the AOFM and the government may need to markedly upsize the structured finance fund. Mr Nicholl wouldn’t comment on those suggestions but said he was still working on the deployment plan ahead of taking “stock with government”. “It’s pretty hard … to work out the rate that we’ll deploy these funds.”

The tough operating climate has sparked concerns about the ability of borrowers and small businesses to repay loans, despite repayment deferrals on offer.

In a report on Tuesday, Moody’s said economic disruption caused by the coronavirus would increase delinquencies in Australian asset-backed securities and residential mortgage-backed securities in the short term, while defaults and losses would rise over the medium to long term.

“Coronavirus disruptions will cause loan delinquencies and defaults to rise across the entire structured finance portfolio, but risks will be greatest for deals exposed to SMEs, self-employed borrowers or sectors such as tourism, hospitality, entertainment and education,” said Christopher Chambers, a Moody’s assistant vice president

The report said while the government’s package of relief measures and low interest rates would “mitigate risks”, the payment deferrals on loans could cause cash flow or liquidity pressures and result in increased credit risk over the medium to long term.

“That said, Australian RMBS and ABS deals typically include liquidity reserves or facilities to mitigate risks of non-payment in such circumstances. Our analysis shows that broadly speaking, liquidity reserves are sufficient to cover approximately 12 months of interest and senior fee payment on average in the event of 100 per cent of borrowers being granted deferral,” Mr Chambers added.