Chapter 12

Use of Swaps by the Central Government

Government Debt Management has been using swaps for almost 30 years. Over time, the trend has gone from relatively complex swaps to plain vanilla swaps.

Swaps are an integral part of government debt management. They are either transacted in connection with specific foreign loans or as portfolio swaps aimed at managing the overall interest-rate and currency exposure. Consequently, swaps cannot be assessed separately from the government debt portfolio.

The use of swaps provides for more flexible debt management, allowing a more distinct separation of issuance policy and the management of interest-rate risk. The focus of the issuance policy can thus be on creating high liquidity in the bond series, building up a broad investor base and keeping the refinancing risk low.

swap markets have expanded 12.1

A swap is a financial contract between two parties to exchange payments over a fixed period. The contract contains two opposite payments (legs). The recipient leg of one party is the payment leg of the other party. The number of payments in each leg depends on the maturity of the swap and the payment frequency. The most frequently used swaps are interest-rate and currency swaps, cf. Box 12.1.

INTEREST-RATE AND CURRENCY SWAPS

Box 12.1

Interest-rate swaps An interest-rate swap is an agreement between two parties to exchange interest payments on a specific principal over a fixed period. Normally, fixed interest payments are exchanged for variable interest payments, cf. the Illustration. The parties to an interest-rate swap do not exchange principals. The principal (notional value) of an interest-rate swap is only used to determine the size of the payments on the individual payment dates. Payments on the variable leg typically fall due every six months, and the interest rate is often fixed on the basis of a money-market interest rate. The interest rate on the fixed leg is called the swap rate. The swap rate is fixed so that the market value of the swap is zero at the time of transaction. In theory, the swap rate is independent of counterparty credit risk if full collateral is pledged in the event of fluctuations in market value. As a consequence of this, and a high level of liquidity in the swap market, swap rates are often applied as reference interest rates in the financial system.   Currency swaps A currency swap is an agreement between two parties to exchange principals and interest payments in two currencies (cross-country basis swaps), cf. the Illustration. The exchange of principals on transaction and expiry of the swap takes place at the spot rate. During the maturity of the swap, the counterparties pay interest on the principal they have received. The interest rate is often a 3-month money-market interest rate less a spread (basis swap spread "X") on one currency leg, whereby the market value of the swap is zero at the time of transaction.

Swaps are flexible financial tools, and the market for plain vanilla swaps is highly liquid. The global notional outstanding volume of interest-rate swaps is far larger than the outstanding volume of bonds. The outstanding volume of currency swaps¹has mirrored the growth in bonds, accounting for approximately 20 per cent of the outstanding volume of bonds, cf. Chart 12.1.1.

Global outstanding amounts in swap and bond markets	Chart 12.1.1
Note: BIS Quarterly Review.

Use of swaps by government debt management 12.2

The use of swaps by government debt management offices in both advanced economies and developing countries has increased in recent years.²

Government Debt Management in Denmark has been using swaps for almost 30 years. Over time, the trend has gone from relatively complex swaps to plain vanilla swaps. As opposed to structured swaps, plain vanilla swaps are easier to transfer to other counterparties and to price.

Government Debt Management clearly communicates the strategy for the use of swaps, and the transaction of swaps is fully transparent. The swap portfolio is published in the annual publication Danish Government Borrowing and Debt.

Swaps enable separation of issuance strategy and risk management
Swaps are an integral part of government debt management. They are transacted either in connection with specific foreign loans or as portfolio swaps aimed at managing the overall interest-rate and currency exposure, cf. Box 12.2. Consequently, swaps cannot be assessed separately from the government debt portfolio.

The central government's exchange-rate risk is limited by the foreign debt only having exposure in euro. Currency swaps make it possible to issue in a wider range of currencies, while limiting currency exposure to euro.

Interest-rate risk is managed by a strategic target band for the duration of the debt portfolio. The central government can manage the duration by using swaps rather than adapting its issuance strategy. A stable and predictable issuance strategy is important, since the central government is a key player in the domestic capital market.

Separation of the issuance policy and the management of interest-rate and exchange-rate risk allows for an issuance policy focused on:

• building up high liquidity in the bond series
• reducing the refinancing risk
• ensuring a broad, stable investor base
• exploiting comparative advantages.

Concentration of issuance causes higher liquidity in the bond series
Separation of the issuance strategy and the strategy for management of interest-rate risk via swaps enables the central government to issue in few benchmark segments. The concentration of issuance contributes to higher liquidity in the bond series, for which the investors are often willing to pay a premium. For small government issuers, concentration of issuance is particularly important.

In the period of falling debt, the use of interest-rate swaps enabled Government Debt Management to achieve the desired duration, while consolidating issuance in the 10-year maturity segment. Moreover, currency swaps contributed to the liquidity of domestic issuance in that maturing foreign loans were financed by borrowing in Danish kroner combined with currency swaps from kroner to euro.

Reduction of refinancing risk
The use of interest-rate swaps makes it possible to obtain a given duration by combining issuance in long-term bonds with interest-rate swaps. This reduces the central government's refinancing risk relative to increasing short-term borrowing since no refinancing is required of the principal of the interest-rate swap.

Against the backdrop of mounting debt and the financial turmoil, Government Debt Management focuses on keeping the refinancing risk low by e.g. covering the financing requirement well in advance and by means of a high liquidity reserve. The higher duration and the resulting increase in expected interest costs can be offset by using interest-rate swaps.

Issuance targeted to a broad investor base
The use of interest-rate and currency swaps provides for issuance in benchmark segments that are attractive to domestic and foreign investors. A broad, stable investor base reduces the risk of higher borrowing costs as a result of falling demand from one investor group.

In foreign borrowing, currency swaps contribute to expanding the investor base as e.g. issuance in euro and dollars caters for different investor types. When the central government needed to increase the contribution to the foreign-exchange reserve in connection with the financial crisis, it was particularly important to have flexibility for issuance in other currencies than the euro, cf. Chart 12.2.1. This was among other things attributable to increased issuance from issuers with the euro as their domestic currency.

Issuance of FOREIGN bonds BY TRANSACTION CURRENCY	Chart 12.2.1

In the period of falling debt and low borrowing requirements, the liquidity consideration was deemed to be more important than the consideration of a broad investor base. Against this backdrop, the central government's issuance was focused on the 10-year maturity segment. Given the prospects of government deficits in the coming years, the issuance strategy has been expanded to include T-bills and the 2-, 5- and 10-year maturity segments. Interest-rate swaps provide for flexible adjustment of the issuance strategy without changing the interest-rate risk.

Exploiting comparative advantages
Until the financial crisis in 2008, issuance of long-term government bonds and transaction of interest-rate swaps normally gave the central government a comparative advantage over direct issuance in short-term maturity segments. A wider long-term swap spread relative to the short-term spread entails an immediate comparative advantage for the central government. For a period, the comparative advantage shifted from long-term to short-term issuance due to the financial crisis, cf. Chart 12.2.2. The issuance policy was maintained in order to avoid a high refinancing risk. As a result of the changed conditions in the swap market, the central government did not transact interest-rate swaps for a while.

developments in short-term and long-term krone swap spreads	Chart 12.2.2
Note: The long-term swap spread is the spread between the 10-year swap rate and the 10-year government yield. The short-term swap spread is the spread between 6-month Cibor and the 6-month government yield. Source: Bloomberg.

In terms of foreign borrowing, issuance in e.g. dollars combined with currency swaps into euro sometimes gives the central government a comparative advantage over direct borrowing in euro. This is typically the case when the basis swap spread between euro and dollars is very negative.³

In connection with the financial crisis, a need arose among European banks for swaps into dollars as it was difficult for them to borrow directly in dollars. As a result, the basis swap spread became very negative, cf. Chart 12.2.3. During this period, the central government was able to issue in dollars and restructure currency exposure into euro on favourable terms.

3-year basis swap spread between euro and dollars	Chart 12.2.3
Source: Bloomberg.

Risks associated with the use of swaps 12.3

While enabling Government Debt Management to manage a number of risks, swaps also give rise to derived risks, primarily credit and instrument risks.

Credit risk on the central government's swaps is reduced via collateral
The market value of swaps may develop in favour of the central government, resulting in credit-risk exposure as the counterparty may default on its payment obligations. The credit risk is reduced by transacting swaps only with counterparties with a high credit standing. Moreover, the counterparties pledge collateral on an ongoing basis if the market value of the swap becomes positive for the central government.

Instrument risk became evident during the financial crisis
Instrument risk is the risk of diverging developments in interest rates on different instruments with the same maturity. The central government's management of interest-rate risk by using swaps entails the risk that the development in the short-term money-market interest rate that the central government pays in a swap will diverge from the short-term government yield. Considering this risk, it must be noted that the long-term swap-spread is received until the swap's maturity.

The spread between the Danish uncollateralised money-market interest rates and the Danish government yield curve widened considerably from the autumn of 2008, cf. Chart 12.3.1. Consequently, for a period of time the interest-rate fixing on the central government's interest-rate swaps in kroner was considerably higher than the government yield. However, these adverse market conditions in the swap market must be considered in the light of the fact, that the central government for several years has had a comparative advantage using interest-rate swaps.

development in 6-month cibor and the 6-month government yield	Chart 12.3.1
Source: Bloomberg.