Domestic debt program

The fundamental objective for the domestic debt program is to provide stable, low-cost funding to meet the federal government’s financial obligations and liquidity. Key strategic objectives are to maintain a prudent debt structure, maintain and enhance a well-functioning market for Government of Canada securities, and maintain a diversified investor base.

Maintaining a prudent debt structure

The primary focus of risk management in the context of domestic debt strategy has always been on the management of the structure of the domestic debt, which, due to its size and the potential impact of changing interest rates, is by far the most significant form of financial risk to which the government is exposed.

The structure of the debt is managed in a way to protect the fiscal position from unexpected increases in interest rates and to limit refinancing needs. A long-term strategic view is taken in choosing a target debt structure that balances prudence and cost savings under a range of potential interest rate developments. The decision is not based on a particular view on the future evolution of interest rates.

When determining the appropriate debt structure, the government generally faces a trade-off between keeping borrowing costs low and ensuring that the cost impact of unexpected increases in interest rates does not exceed its tolerance for risk. Specifically, long-term instruments such as bonds typically have higher debt-servicing costs than short-term instruments such as Treasury bills. On the other hand, interest costs for outstanding bonds are known with certainty over their entire life, while Treasury bills need to be refinanced several times throughout the year at new prevailing market interest rates.

The main operational measure of the debt structure is the fixed-rate share – the mix of fixed-rate and floating-rate debt instruments that make up the debt stock. The fixed-rate share is an attractive target because it is intuitive and easy to compute. It quickly presents the amount of debt exposed to interest rate risk over the following year. Debt-servicing costs increase (decrease) and interest rate risk decreases (increases) with a higher (lower) fixed-rate share. Canada also monitors other measures of the debt structure,

such as the average term to maturity and duration, to complement the information provided by the fixed-rate share.

Analytical framework

Canada has developed and enhanced in recent years a sophisticated simulation model to examine its debt structure. The model is intended to assist the government in the decision-making process for the selection of an appropriate debt structure that balances costs and risk. The main components of the model are illustrated in Figure 9.2.

Ten thousand random interest rate scenarios are first generated using a standard term structure model calibrated to be representative of the interest rate environment observed over the last ten-year period. Thus, it is assumed that the interest rate environment that prevailed over this period will continue going forward, and that the scenarios represent the full range of plausible evolutions of interest rates. The choice of the model and the historical period is critical, since the relevance of the analysis depends on the plausibility of the scenarios.

A financing strategy is then designed, taking into account existing debt and assumptions regarding future borrowing requirements. The financing strategy, which specifies the types and amounts of debt to issue, ultimately determines the debt structure.

Figure 9.2. Debt strategy framework

Economic Scenarios Interest rates State of the economy Financial balance

Analysis

Debt cost distribution Average costs, Cost at Risk Fixed/floating ratio ATM, Duration Maturity profile

Simulation engine Cash flows and debt costs

Current debt portfolio

Refinancing strategy

With this information, it is possible to run the simulation model to generate cash flows and compute debt costs under every interest rate scenario.

By combining the results for all the scenarios, a statistical distribution of future debt costs can be obtained from the model. Debt managers are then in position to examine the risk and cost profiles of a particular debt structure, and consider appropriate changes to the financing strategy, if necessary (see Box 9.1).

The average debt costs over the ten thousand scenarios provides a measure of expected debt costs for a given debt structure. While risk has several dimensions and can be expressed in a number of different ways, debt managers pay special attention to the risk that rising debt costs could disrupt the budget plan.

Cost-at-Risk, which allows for quantification of risk in terms of the maximum costs that could occur with a given probability in a particular year, is one the tools used to compare alternative debt structures. This measure is similar to the well-known Value-at-Risk measure used extensively by the financial community, but is based on the distribution of debt costs rather than marked-to-market values.

Relative Cost-at-Risk, defined as the difference between the 95th percentile of the debt cost distribution and their average level, expresses the maximum increase in debt costs that can be expected with a 95 per cent probability. This measure is particularly attractive for gauging risk in the debt portfolio because it can be directly compared to the level of prudence incorporated in the budget framework. In other words, in evaluating an appropriate debt structure, debt managers assess whether Relative Cost-at-Risk remains inside the risk tolerance limit.

Experience has shown that quantitative results of stochastic simulations are very sensitive to assumptions employed for the dynamics of interest rates, and thus need to be interpreted with caution. In addition, the technique may not capture adequately more extreme events.

Debt managers thus complement the stochastic analysis by examining scenarios to evaluate the impact of specific interest rate shocks on debt costs.

While it is not possible to fully specify the characteristics of such shocks or their probability, stress testing allows one to consider the impact of worst-case scenarios (events that are highly unlikely but still possible), which provide useful insight on the risk of the debt portfolio.

Canada is continuing to enhance its modeling techniques, and has recently started to consider debt strategy from a broader fiscal planning perspective, examining the co-movements of debt costs with the other components of the budget. Given the typical interaction between interest rates and the business cycle in an economy, debt costs tend to fall in periods of economic slowdown when government revenues are weak. Debt costs could

Box 9.1. Application of the model: finding a new balance

In the 1990s, the fixed-rate share of the federal debt was raised from one-half to two-thirds to provide more cost stability in an environment of large fiscal and current account deficits, volatile interest rates and high debt levels. By establishing a more prudent fixed-rate debt structure and reducing the debt, the sensitivity of annual debt-services charges to changes in interest rates was reduced in a period where the fiscal capacity to absorb shocks was limited.

For the last few years until 2002-03, the fixed-rate portion of the debt was managed around a two-thirds target. Over the same period, Canada’s economic and fiscal position strengthened substantially. Low and stable inflation and interest rates, declining foreign indebtedness and a current account surplus also contributed to increased stability. The reduction in the debt level over this period provided Canada with greater financial stability, reduced vulnerability to events happening beyond our borders, and contributed to the restoration of Canada’s triple-A credit rating.

As a result of these positive economic and fiscal developments, analysis conducted in 2002 indicated that the government was in a position to adjust its debt structure to reduce future financing costs without exposing itself to significantly higher levels of risk.

The simulation model was used to evaluate different debt structure targets.

The risk and cost profiles of the two-third fixed-rate debt structure were compared with alternative debt structures with five and ten percentage point lower fixed-rate shares. Results indicated cost savings could be expected over time by lowering the fixed-rate share while risk exposures would be kept within tolerable limits.

Compared to the two-thirds debt structure, a lower fixed-rate structure was more exposed to adverse movements in interest rates. However, the analysis also confirmed that it was unlikely that the additional debt costs stemming from a severe interest rate shock would be disruptive to the budget plan in a given fiscal year due to the cushion built in the budgetary framework and Canada’s lower debt level today. That is, relative Cost-at-Risk remains within the government’s risk tolerance. Over time, the additional costs resulting from an interest rate shock would be more than offset by the savings associated with a lower fixed-rate structure.

In light of these findings, the government announced a change in the debt structure target in the 2003 Budget. The fixed-rate portion of the debt will be lowered from the previous target of two-thirds to 60 per cent, over a five-year period.

thus be considered as a natural hedge that reduces the probability of a budget deficit. The implications of these relations in the design of debt strategy are just beginning to be explored.

Maintaining a well-functioning market

As the sovereign and largest borrower in the Canadian fixed-income market, the federal government has a major interest in sustaining a liquid and efficient market for its securities. A well-functioning market reduces borrowing costs and funding risk for the government as it increases investor confidence and reduces the likelihood of market disruptions. A liquid and efficient government securities market also provides key pricing and hedging tools for market participants and thereby contributes to the effective functioning of the broader fixed-income market. As a result, debt managers have worked closely with market participants in recent years to introduce initiatives, such as bond buybacks, to manage the decline in borrowing requirements in a way that contributes to a well functioning market for Government of Canada debt.

A diversified investor base is maintained by using a variety of instruments (nominal bonds, real return bonds, Treasury bills, foreign-currency instruments and retail products) and a range of maturities. The diversification of the funding sources reduces the reliance on any one group of investors and reduce the risk that unfavourable conditions in one market segment becomes costly to the government.

Operational risk

Most domestic debt operations (Treasury bill and bond auctions, buybacks, investment of cash balances) are conducted using auction mechanisms, which ensures an effective distribution of securities and fair treatment for all market participants. The auction processes are highly automated, which facilitates quick efficient operations and reduces the risk of human error. There are ongoing efforts to improve efficiency and to shorten processing times prior to the release of auction results, which reduces market risk for market participants.

Operational risk is also minimised through regular reviews and documentation of procedures, employee training, and planned redundancy for key systems and operations. Following 11 September 2001, the Bank of Canada, like many organisations, reviewed its business-continuity plan and strengthened its capacity to continue critical operations off-site. In August 2003, this plan received a live test, when a major power failure in North America forced the Bank to implement its business contingency plan and transfer key personnel to a backup facility in Ottawa. The plan proved effective, although the incident revealed areas for potential improvement that are being addressed.

Management of Canadian dollar cash balances

In addition to managing risks associated with domestic debt, the government must also manage risks related to the investment of domestic cash balances. In managing the cash position, the objective is to ensure that adequate liquidity is maintained at a reasonable cost.

Deposit auctions used to invest cash balances were conducted on an uncollateralised basis until 2002, and only a limited number of large Canadian financial institutions were allowed to participate. As a result, the unsecured credit exposure to individual institutions was occasionally quite significant.

A new collateralised framework for the investment of cash balances was implemented in 2002. The new framework strengthens the management of the credit risks involved in the investment of cash balances through the use of credit ratings, credit lines and collateral agreements, and increases competition in the auction of cash balances by opening auctions to a wider range of participants.