TECHNICAL NOTE 1 INCOME ON DEBT


INTRODUCTION

1 The June quarter 2008 of this publication sees the introduction of a revised methodology for compiling accrued interest on long term debt securities. This note provides details of the new methodology and its impact on the measured net income deficit (NID) series.


BACKGROUND

2 The ABS conducts a survey of international investment to compile the financial account and income statement of the current account in the balance of payments. The survey is also the major source for the compilation of the international investment position. It collects data on financial transactions and positions and income flows, split by financial instrument.

3 Accrued interest flows on debt instruments are compiled according to the 'creditor approach', which applies market yields to the average reported position in the debt instrument (the alternative 'debtor approach' applies contracted yields). These flows are modelled for long term portfolio debt securities rather than being collected directly in the survey.

4 For long term debt securities issued by the Commonwealth and State governments, accrued income debits are compiled by applying composite yields on the long term debt currently on issue by the respective governments.

5 For all non-government issuers in Australia, and for all long term debt securities issued by non-residents, the previous methodology involved calculating accrued income by applying a composite corporate bond yield compiled by the Organisation for Economic Cooperation and Development (OECD). However, the OECD discontinued the series in 1998, and since then movements in the composite yield have been proxied by movements in the US 10 year Treasury bond yield.

6 One exception to this approach is the treatment of long term debt securities issued and held by entities in a direct investment relationship, which is classified as 'other capital' under direct investment. The ABS uses survey data for interest payable and receivable under direct investment 'income on debt' in the income statement.


LIMITATIONS OF THE PREVIOUS METHODOLOGY

7 Since bond yields tend to vary according to the currency of denomination and the credit rating of the issuer, the previous methodology had a number of limitations:

• a single composite yield was used as a proxy for yields on securities denominated in different currencies;
• a corporate bond yield was used as a proxy for yields on securities issued by foreign governments; and
• changes in the US 10 year Treasury bond yield were used as a proxy for changes in all other yields.

8 These limitations have recently become more pronounced as a result of the global financial crisis, which has seen a dramatic increase in spreads between government and corporate bond yields. This is demonstrated in graph 1.

9 The graph also demonstrates that yields in different currencies have moved differently, with yields on $US-denominated bonds in particular having fallen by more than yields on bonds denominated in other major currencies. As a result, changes in US Treasury bond yields have been a poor proxy for changes in other yields.


NEW METHODOLOGY

10 The new methodology employs government bond yields for calculating accrued income on government bonds and corporate bond yields for calculating accrued income on corporate bonds. The methodology also uses yields specific to the currency of denomination of the bonds.

11 For bonds held as assets by Australian resident investors, the survey of international investment provides the split across currencies of denomination (with the major currencies being Australian dollar, US dollar, pound sterling and Japanese yen). The survey does not provide the split between government and corporate bond holdings, but this is currently estimated from other ABS sources to be 33% government and 67% corporate bonds. The new methodology employs 10 year government bond yields and composite corporate bond yields in each of the major currencies to calculate accrued interest credits.

12 For bonds issued by resident non-government entities, the survey of international investment provides the split across the major currencies of denomination, and a composite corporate bond yield for each currency is used to calculate accrued interest debits. For bonds issued by the Commonwealth and State governments, the previous methodology has been retained, with accrued income debits calculated by applying composite yields on the long term debt currently on issue by the respective governments.


IMPACT ON THE NET INCOME DEFICIT

13 The new methodology has served to increase the level of estimates of both income credits and debits. This is due primarily to corporate yields being greater than government yields for each currency of denomination. Income debits have increased more than income credits, primarily because the level of long term debt liabilities is significantly higher than the level of long term debt assets. Graph 2 shows the impact of the new methodology on income credits, income debits and the net income deficit for the revisions period between the September quarter 2004 and the March quarter 2008.

14 The revised methodology has resulted in an increase in the net income deficit of $1.4 billion for the March quarter 2008, $0.7 billion for the December quarter 2007, $0.6 billion for the September quarter 2007 and $0.4 billion for the June quarter 2007, with smaller increases of between $0.1 and $0.2 billion for the prior quarters.