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Trading and Capital-Markets Activities Manual

Instrument Profiles: Australian Commonwealth Government Bonds
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

The Australian Treasury issues Australian Commonwealth Government Bonds (CGBs) to finance the government's budget deficit and to refinance maEagle Tradersg debt. Since 1982, bonds have been issued in registered form only, although some outstanding issues may be in bearer form. The principal and interest on CGBs are guaranteed by the Commonwealth Government of Australia. 

CHARACTERISTICS AND FEATURES 

CGBs, with maturities ranging from one to 20 years, are issued every six to eight weeks in an average tender size totaling A$800 million. Most CGBs are non-callable, fixed-coupon securities with bullet maturities. The Australian Treasury has issued some indexed-linked bonds with either interest payments or capital linked to the Australian consumer price index. However, there are few of these issues and they tend to be very illiquid. CGBs can be issued with current market coupons, but in many cases the Australian Treasury will reopen existing issues. 

Interest for government bonds is paid semi-annually on the 15th day of the month, and it is calculated on an actual/365 day-count basis. Coupon payments that fall on weekends or public holidays are paid on the next business day. Semi-annual coupon payments are precisely half the coupon rate. Bonds that have more than six months left to maturity settle three business days after the trade date (T+3). Bonds with less than six months left to maturity may settle on the same day, provided they are dealt before noon; otherwise, they settle the next day. 

USES 

Australian banks are the largest single group of investors in outstanding CGB issues. They use these securities to meet regulatory capital requirements. The Australian pension industry holds CGBs mainly as investment vehicles. In addition, CGBs are viewed as attractive investment vehicles by many foreign investors because (1) they offer high yields relative to those available on other sovereign debt instruments and (2) the Australian bond market is regarded as stable. Although the bond market has a substantial foreign participation, due to its attractive yield and a much shorter period of time required for the bonds to mature, the majority of CGB investors are domestic. U.S. banks purchase CGBs to diversify their portfolios, speculate on currency and Australian interest rates, and to hedge Australian denominated currency positions and positions along the Australian yield curve. 

DESCRIPTION OF MARKETPLACE 

Issuing Practices 

CGBs are issued periodically on an as-needed basis, typically every six to eight weeks. Generally, issuance is through a competitive tender whereby subscribers are invited to submit bids as they would in an auction. Issue size is announced one day before the tender day. Bids, which are sent to the Reserve Bank of Australia through the Reserve Bank Information Transfer System (RBITS), are submitted to the Reserve Bank of Australia on a semiannual, yield-to-maturity basis. Specific information on the issue is announced later on the tender day, such as the amounts tendered and issued, the average and range of accepted bids, and the percentage of bids allotted at the highest yield. 

Secondary Market 

While CGBs are listed on the Australian Stock Exchange, nearly all trading takes place over the counter (OTC), by screen or direct trading. The primary participants in the secondary market are authorized dealers and share brokers. OTC transactions must be in amounts of A$250,000 or more. Stock-exchange transactions are essentially limited to retail transactions under A$1 million. Usually, authorized dealers trade bonds which are within five years of maEagle Tradersg. 

Market Participants 

Sell Side 

Authorized dealers are the primary participants in the sell side of the CGB market. 

Buy Side 

Australian banks and other financial institutions are the largest single group of investors in CGBs. These entities usually hold large quantities of shorter-term government bonds for regulatory purposes, as these securities may be included in the prime asset ratios of banks. In addition, a variety of other domestic investors participate in the CGB market. 

The Australian bond market has been known to attract substantial foreign participation over the years, primarily because it is regarded as a stable market which offers relatively high yields. In general, foreign market participants are institutional investors, such as securities firms, life insurance companies, banks, and fund managers. 

Market Transparency 

Prices tend to be active and liquid. Price transparency is enhanced by the dissemination of prices by several information vendors including Reuters and Telerate. 

PRICING 

CGBs are quoted in terms of yield and rounded to three decimal places to determine gross price for settlement purposes. While tick size is equivalent to one basis point, yields are often quoted to the half basis point. 

HEDGING 

Interest-rate risk may be hedged by taking an offsetting position in other government bonds or by using interest-rate forward, futures, options, or swap contracts. Foreign-exchange risk may be hedged by using foreign-currency derivatives and swaps. 

RISKS 

Liquidity Risk T

he CGB market is considered fairly active and liquid. Trading volume among the benchmark bonds is about equal, although the three-year and 10-year benchmark issues tend to have the most turnover. 

Interest-Rate Risk 

CGBs are subject to price fluctuation resulting from interest-rate volatility. Generally, longer-term bonds have more price volatility than shorter-term instruments. If an institution has a large concentration of long-term maturities, it may be subject to unwarranted interest-rate risk. 

Foreign-Exchange Risk 

Currency fluctuations may affect the bond's yield as well as the value of coupons and principal paid in U.S. dollars. A number of factors may influence a country's foreign-exchange rate, including its balance of payments and prospective changes in that balance; inflation and interest-rate differentials between that country and the United States; the social and political environment, particularly with regard to the impact on foreign investment; and central bank intervention in the currency markets. 

Political Risk 

A change in the political environment, withholding tax laws, or market regulation can have an adverse impact on the value and liquidity of an investment in foreign bonds. Investors should be familiar with the local laws and regulations governing foreign bond issuance, trading, transactions, and authorized counterparties. 

ACCOUNTING TREATMENT 

The accounting treatment for investments in foreign debt is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

Australian CGBs are assigned to the 0 percent risk-weight category. LEGAL 

LIMITATIONS FOR BANK INVESTMENT 

Australian CGBs are a type III security. As such, a bank's investment is limited to 10 percent of its equity capital and reserves. 

REFERENCES 

 de Caires, Bryan, ed. The Guide to International Capital Markets 1990. London: Euromoney Publications PLC, 1990. 
 Crossan, Ruth, and Mark Johnson, ed. The Guide to International Capital Markets 1991. London: Euromoney Publications PLC, 1991. 
 J.P. Morgan Securities. Government Bond Outlines. 9th ed. April 1996. 

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