Swaps and the AOFM’s Objective in Managing Debt
The AOFM aims to manage the Australian Government net debt portfolio, for which it is responsible, at least cost over the long-term, subject to an acceptable level of risk. It also contributes to the operation of financial markets by supporting efficient Treasury Bond and Treasury Bond futures markets.
Issuing debt for long terms with fixed interest rates ensures that future debt service costs are reasonably certain but, on average, they are likely to be higher than if the debt is issued for short terms. Long-term interest rates tend to be higher on average because investors demand a premium for holding debt for relatively long periods. Issuing debt with shorter terms would be expected to incur lower debt service costs on average, but these costs would be more variable. In analysing these considerations, it is necessary to consider the slope of the yield curve over time (that is, the term premium in interest rates) and the potential variability in interest rates.
Based on such analysis, the AOFM establishes a target (benchmark) portfolio that encapsulates the preferred trade off between lower expected debt service costs and greater variability in those costs. The benchmark portfolio is constructed to achieve interest cost savings, while being prudent with regards to risk, specifically the variability in interest costs. Interest rate swaps are used to facilitate the transition to, and subsequent compliance with, the benchmark.
Interest rate swaps are an important instrument allowing borrowers to tailor the cost and risk of their portfolios. They are important to the Australian Government, the pre-eminent borrower in Australian financial markets, in managing its net debt portfolio. There are risks associated with swaps, however, these are managed closely and are considered to be acceptably low. Interest rate swaps allow the Australian Government, through the AOFM, to issue sufficient Treasury Bonds to maintain efficient Treasury Bond and Treasury Bond futures markets while managing the net debt portfolio so that it more closely matches the benchmark portfolio.