Portfolio Management
Overview
The magnitude of the Commonwealth debt portfolio largely reflects the accumulation of past Commonwealth fiscal results. In recent years, substantial Commonwealth budget headline surpluses have led to a decline in the face value of the Commonwealth net CGS portfolio from a peak of around $107.3 billion as at 30 June 1997 to around $83.5 billion as at 30 June 1999. The outstanding Commonwealth debt portfolio, however, continues to represent a large exposure for the Commonwealth to market risk.
Market risk refers to the exposure of the on-going cost and value of the Commonwealth portfolio to movements in financial prices such as interest and exchange rates. While market risk is intrinsic to all debt portfolios, there remains a management role to ensure that this risk is taken on as efficiently as possible across the portfolio as a whole.
For a variety of reasons, many sovereign debt managers allow the market risk of their debt portfolios to evolve passively as a consequence of their accumulated debt issuance and redemption decisions. For a number of years, the Commonwealth has adopted an approach that aims to manage the nature of market exposures at the portfolio level. This approach recognises that it may be more efficient to make explicit decisions at the portfolio level affecting market risk, rather than risk sub-optimal outcomes by implicit decisions at the level of individual transactions.
The Commonwealth's portfolio management objective is to minimise the cost of debt over the long-term, subject to acceptable market risk. This objective forms the basis for a defined portfolio benchmark that serves as a target for the composition and nature of market risks within the Commonwealth debt portfolio. The analytical framework behind the benchmark assesses the trade-off between the long-term expected cost and risk of different portfolio structures thus allowing informed decisions about the nature of Commonwealth market exposures.
The benchmark framework has a long-term focus and is based upon assumptions about structural factors in financial markets that influence the expected cost and risk of different market exposures. The framework does not incorporate any views or forecasts as to the future levels of interest and exchange rates in an attempt to 'beat the market'. The benchmark reflects a hypothetical portfolio structure that, based upon judgement about structural market factors, can be expected to minimise the expected long-term cost of the Commonwealth portfolio for an acceptable degree of risk. In other words, the benchmark represents a portfolio structure that is efficient from a long-term perspective.
The benchmark is defined in terms of exposures to exchange rate and interest rate risks, measured by target ranges for currency shares and the modified duration of each currency exposure in the portfolio. The currency share targets are for 85 to 90 per cent Australian dollar exposure and 10 to 15 per cent United States dollar exposure in the Commonwealth portfolio. The target range for Australian interest rate risk is a modified duration between 3 and 3½. The range for United States interest rate risk is a modified duration between 1 and 1½.
These benchmark ranges represent a target for Commonwealth portfolio management operations. The extent to which the Commonwealth portfolio is maintained within these ranges is a broad indicator of the performance of these portfolio management operations. That said, the Commonwealth pursues these market risk objectives recognising that there may be, at times, a balance required between meeting these objectives and the sound management of other financial risks including funding, credit, liquidity and operational risks. Aside from striking this balance, as any debt manager must do, the Commonwealth is also cognisant of public policy considerations that are binding on a sovereign debt manager. These include ensuring debt management transactions do not destabilise financial markets, or opportunistically exploit the dominant position of the Commonwealth in these markets.
The benchmark framework and supporting sofware and systems were developed with the assistance of external portfolio management consultants, Quantitative Finance Group, of the investment bank Warburg Dillon Read. These consultants have advised the Commonwealth on portfolio management since the original Commonwealth Liability Portfolio Management Consultancy contract with them in late 1995.
The Commonwealth's long-term portfolio management strategy - i.e. seeking to maintain the Commonwealth debt portfolio broadly within the benchmark ranges - set the broad framework within which the Commonwealth's domestic interest rate swap and cross-currency swap programs were planned and executed. While the Commonwealth's debt issuance and redemption programs affect the market risk of the Commonwealth portfolio, the Commonwealth's swap program was the primary instrument used to manage market risk.
Portfolio Management in 1998-99
Throughout 1998-99, a variety of factors influenced the structure, duration and currency exposure of the Commonwealth debt portfolio. Important factors included movements in market interest rates and exchange rates, time decay, and the form, maturity and timing of new debt issuance and swap transactions.
Chart 12: Australian Interest Rate Exposure, 1998-99
The major market risk exposure of the Commonwealth debt portfolio is related to Australian interest rate risk. Chart 12 illustrates the domestic interest rate exposure of the Commonwealth debt portfolio and the impact of the Commonwealth's domestic interest rate swap program through the course of 1998-99. Australian interest rate exposure is measured here by the modified duration of all Australian dollar denominated debt (including Treasury Fixed Coupon Bonds, net of those held by the LCIR, Treasury Adjustable Rate Bonds, Treasury Indexed Bonds and Treasury Notes), all Australian dollar denominated swap legs and Commonwealth cash balances held on term deposit with the RBA. Chart 12 illustrates that the underlying duration trend of the AUD portfolio was marginally upwards (as evident in the 'without swaps' profile). A number of factors underpinned this trend.
- The Treasury Fixed Coupon Bond issuance in 1998-99 of around $3.9 billion face value was directed at building liquidity at the long end of the yield curve, which added to portfolio duration.
- The $5.3 billion of scheduled Treasury Fixed Coupon bond maturities, the $3.4 billion of early debt purchases and the run down in Treasury Notes during 1998-99, led to a reduction in the proportion of shorter to medium term debt in the Commonwealth debt portfolio, thereby increasing the modified duration of the portfolio.
- Partly offsetting the above factors was the steepening of the yield curve over 1998-99, whereby higher longer term interest rates tended to decrease the modified duration of the domestic portfolio, by decreasing the market value of longer&45;term debt and therefore its weighting in the portfolio.
The Commonwealth implemented a domestic interest rate swap program over the course of 1998-99 to move the Australian interest rate exposure towards the benchmark modified duration range of 3 to 3½. Swaps transacted under this program typically swapped fixed rate Australian dollar exposures to floating rate Australian dollar exposures. While the modified duration of the Australian dollar exposure hovered around the top of the benchmark range for the first half of the year, it was well within the range in the latter half of the year. The impact of the interest rate swap program on the duration of the Commonwealth's domestic debt portfolio is highlighted in the 'with swaps' profile in Chart 12.
Chart 13: US Dollar Exposure, 1998-99
Chart 13 illustrates the United States dollar exposure of the Commonwealth debt portfolio and the impact of the Commonwealth's cross-currency swap program through the course of 1998-99. The exposure is measured as the Australian dollar value of the market value of United States dollar denominated loans and swaps legs as a percentage of the Commonwealth debt portfolio. The Commonwealth's United States dollar currency exposure was relatively stable and remained within the benchmark range of 10 to 15 per cent throughout 1998-99. Chart 13 illustrates there was a marginal downward trend in the underlying United States exposure in 1998-99 (as evident in the 'without swaps' profile). There were a number of factors behind this trend.
- The broad recovery of the Australian dollar over 1998-99 (particularly during July to October) caused the Australian dollar value of the Commonwealth's United States dollar denominated loans and swap legs to decline, and hence tended to lower the foreign currency exposure of the portfolio.
- Similarly, throughout the course of 1998-99 a series of cross-currency swap maturities also acted to reduce the United States dollar exposure of the portfolio.
- The impact of the appreciating Australian dollar and cross-currency swap maturities on United States dollar exposure in the portfolio, was partly cushioned by the decline in the overall Commonwealth debt portfolio (reducing the overall level of United States dollar denominated debt required to maintain benchmark exposure).
The Commonwealth implemented a small cross-currency swap program during the second and third quarters of the year to move the United States dollar exposure towards the middle of the benchmark range of 10 to 15 per cent of the portfolio. These cross-currency swaps were out of Australian dollar exposure and into United States dollar exposure. The impact of the cross-currency swap program on the United States dollar exposure of the Commonwealth portfolio is highlighted in the 'with swaps' profile in Chart 13.
Chart 14: US Interest Rate Exposure, 1998-99
Chart 14 shows the exposure of the Commonwealth debt portfolio to United States interest rates and the impact of the Commonwealth's cross-currency swap program through the course of 1998-99. Interest rate exposure is measured here by the modified duration of all United States dollar denominated loans and cross-currency swap legs. The modified duration of the Commonwealth portfolio's United States dollar exposure remained well within its benchmark range of 1 to 1½ throughout 1998-99.
The impact of the cross-currency swap program on the modified duration of the United States dollar exposure in the Commonwealth portfolio is highlighted by a comparison of the 'without swaps' and 'with swaps' profiles in Chart 14. A balance was struck between fixed interest rate and floating interest rate legs on new cross-currency swaps to shift the modified duration towards the middle of the benchmark range.
Market Value of the Commonwealth Portfolio at 30 June 1999
The market value of the Commonwealth portfolio (after swaps) takes into account the net present value or market prices of all cash flows on CGS and Commonwealth swap transactions. This represents a very broad indication of the liquidation cost of buying back all Commonwealth debt and unwinding the Commonwealth swap portfolio. The market value and risk characteristics of the Commonwealth portfolio are presented below in Table 3. This data differs from other CGS data in the Appendices of this report, in that it is primarily on a fair market value rather than face value basis and incorporates the effects of Commonwealth swaps (i.e. it is on an after swaps basis). The CGS data underlying this table excludes CGS issued on behalf of the States and Territories, that held by the Loan Consolidation and Investment Reserve (part of the Reserved Money Fund) and non-marketable CGS (Peace Savings Certificates, overdue CGS and Income Equalisation Deposits). In addition, the table now includes Commonwealth cash balances that have been placed on term deposit with the Reserve Bank of Australia.
The market value of the Commonwealth portfolio after swaps at 30 June 1999 was around $91.8 billion with a corresponding face value of $82.6 billion.
At 30 June 1999, the domestic currency exposure of the Commonwealth portfolio (after swaps) had a market value around $80.0 billion. The majority of the domestic currency component of the portfolio consisted of Treasury Fixed Coupon Bonds, with the other significant elements being Treasury Notes, Treasury Indexed Bonds, Treasury Adjustable Rate Bonds and the Australian dollar receive side of Commonwealth cross-currency swaps. The modified duration of the domestic currency component of the Commonwealth portfolio (after swaps) was around 3.4.
At 30 June 1999, the foreign currency exposure of the Commonwealth portfolio (after swaps) had a market value around $11.8 billion. Over 97 per cent of the foreign currency exposure was denominated in United States dollars. Some residual currency exposures still remain to Sterling, Netherlands Guilders and Japanese Yen. The modified duration of the United States dollar component of the Commonwealth portfolio (after swaps) was around 1.2.
Table 3: Broad Characteristics of the Commonwealth Portfolio (After Swaps)
(a) The Commonwealth portfolio is defined here as all Commonwealth Government securities on issue excluding those issued on behalf of the States and Territories or held by the Reserved Money Fund. Also excluded are Peace Savings Certificates, overdues and Income Equalisation Deposits. Commonwealth cash balances held on term deposit with the Reserve Bank of Australia are included.
(b) Not all totals may sum exactly due to rounding.
(c) The average term to maturity is weighted by face value.
(d) Currency shares are based on market values.
(e) Includes Treasury Interest Indexed Bonds and liabilities assumed from the Pipeline Authority, the Australian National Railways and the Federal Airports Corporation.
Swap Transactions
As noted in the previous section, the Commonwealth utilises swaps to assist in portfolio management. In 1998-99, seventy six new swaps were transacted with eighteen counterparties. Table 5 of Appendix 4 provides summary details of these swaps.
- Sixty-four of the new swaps were $A interest rate swaps. The notional principal value of these swaps was $9.2 billion. This was the second year that the Commonwealth has transacted a significant volume of $A interest rate swaps (in 1997-98 the Commonwealth transacted $A interest rate swaps with a notional principal value of $6.9 billion). For each of these swaps the Commonwealth will receive a fixed rate cash flow in exchange for undertaking to pay a floating rate cash flow. In the absence of these swaps, the duration of the domestic currency component of the portfolio would have been much higher than benchmark duration.
- Twelve of the new swaps were $A/$US cross currency interest rate swaps. The notional principal value of these swaps was $1.3 billion. These swaps were transacted to maintain the foreign currency component of the portfolio close to benchmark.
At 30 June 1999, the aggregate Commonwealth swap portfolio consisted of two hundred and eight swaps with twenty five counterparties. The outstanding notional principal value of these swaps was around $A30 billion. Details of the composition of the Commonwealth's swap portfolio at 30 June 1999 are provided in Table 6 of Appendix 5.
The management of counterparty credit risk associated with swaps is governed by a comprehensive Swap Counterparty Credit Policy, approved by the Treasurer. The policy establishes minimum credit rating standards for acceptable counterparties and defines limits on the level of credit exposure the Commonwealth may have with individual counterparties. The policy requires that the Commonwealth deal only with highly rated counterparties. Additionally, exposure limits are set at relatively conservative levels, offering a further level of protection.
Table 4 provides details of the Commonwealth swap portfolio by counterparty credit rating at 30 June 1999 measured by notional principal amounts.
Table 4: Swap Portfolio by Counterparty Credit Rating
|
Standard & Poor's Rating |
Per cent of |
Moody's |
Per cent of |
|
AAA |
12 |
Aaa |
10 |
|
AA+ |
30 |
Aa1 |
20 |
|
AA |
26 |
Aa2 |
17 |
|
AA- |
32 |
Aa3 |
48 |
|
A+ |
0 |
A1 |
5 |
|
A |
0 |
A2 |
0 |
|
A- |
0 |
A3 |
0 |
|
BBB+ |
.. |
Baa1 |
0 |
|
BBB |
0 |
Baa2 |
.. |
|
100 |
100 |
.. less than 1 per cent