COMMONWEALTH DEBT PORTFOLIO INTEREST RATE BENCHMARK REVIEW AND 2003-04 INTEREST RATE SWAP PROGRAM
The Australian Office of Financial Management (AOFM) today announced the adoption of a new interest rate benchmark for the management of the Commonwealth’s net debt portfolio. The Treasurer approved the new benchmark following a review by the AOFM. The AOFM Advisory Board oversaw the review and consulting firm Deloitte Touche Tohmatsu independently assessed the results.
The new benchmark represents an enhancement of the current approach to portfolio management. Since 1996, AOFM has managed to a benchmark modified duration target range of 3 to 3.5. The success of this approach can only be fully assessed over the longer term. As at 30 June 2003, the outcome of the interest rate swap program has been a realised gain of $1,439.9 million ($1,629.9 million in current dollar terms). On a broader economic return basis, the economic performance of the program has been a gain of $2,977.3 million as at 30 June 2003.
The decline in net debt in recent years has resulted in within-year financing flows and Treasury Indexed Bonds becoming a higher proportion of the net debt portfolio. This has contributed to the need to review the benchmark.
The new benchmark will guide the management of the Australian dollar share of the net debt portfolio. The portfolio’s foreign currency exposure continues to be eliminated over time in accordance with the Treasurer’s decision of September 2001.
Four key enhancements will be made to the debt management framework with the move to the new benchmark.
- First, for management purposes, the portfolio will be separated
into a Long-Term Debt Portfolio and a Cash Management Portfolio. The
Long-Term Debt Portfolio will be quarantined from the effects of large
swings driven by the Commonwealth’s seasonal within-year financing
- The Long-Term Debt Portfolio will hold all financial assets, liabilities and derivatives within the management and control of AOFM except those required for cash management. The average level of short-term assets/liabilities will form part of the Long-Term Debt Portfolio.
- Transfers between the Long-Term Debt Portfolio and the Cash Management Portfolio will be made to ensure that the Long-Term Debt Portfolio reflects the trend level of net debt. Transfers will be made transparently on the basis of publicly available information and will comply with a set of rules available on the AOFM’s website, www.aofm.gov.au.
- Second, the new benchmark targets will be defined in terms of the level of modified duration and short-dated exposure. The previous benchmark was only defined in terms of modified duration. Adding short-dated exposure, which is a measure of the proportion of the portfolio subject to immediate repricing, captures more information about short-term risks to debt servicing costs.
- Third, the new benchmark distinguishes between nominal interest
rate debt and Treasury Indexed Bonds (TIBs). This is important, as
the interest rate risk for TIBs is not the same for real rate and
- TIBs behave similarly to nominal fixed interest rate debt with regard to real interest rate movements.
- TIBs behave similarly to floating interest rate debt with regard to inflation rate movements.
To recognise these differences, the limit framework will be based upon the modified duration and short-dated exposure of the nominal component of the Long-Term Debt Portfolio. However, to ensure that information is retained on the risk of the overall portfolio, the modified duration and short-dated exposure of the Long-Term Debt Portfolio will also be reported under both treatments of TIBs.
- Fourth, completion of the review has provided the opportunity to enhance the governance arrangements related to the benchmark. AOFM will be required to manage within Operational Interest Rate Limits for the nominal component of the Long-Term Debt Portfolio. AOFM will require approval from the Secretary to the Treasury to vary the Operational Interest Rate Limits. Wider Policy Interest Rate Limits will also be defined. AOFM will require approval from the Treasurer to vary the Policy Interest Rate Limits.
The new benchmark and associated limits approved by the Treasurer are outlined in the attached Table 1 and will be reviewed periodically. As Table 2 indicates, as at 30 June 2003, the Long-Term Debt Portfolio had a higher modified duration and short-dated exposure than the new benchmark levels. Overall, the new benchmark is designed to result in broadly similar expected debt service costs but reduced risk to short-term interest rate increases.
The previous modified duration target range of 3.00 – 3.50 applied to the sum total of net debt managed by AOFM and was inclusive of the impact of TIBs. For the purposes of calculating the modified duration, TIBs were treated as being equivalent to nominal bonds. Therefore, the previous duration target was essentially a real-shock duration target. Based upon the current mix of nominal and inflation-linked debt, the new nominal modified duration target of 2.00 equates to a real-shock duration target of 2.90. Accordingly, the reduction in the modified duration of the benchmark has been relatively minor (3.25 versus 2.90).
AOFM estimates that a transitional period of up to 3 years may be necessary to alter the Long-Term Debt Portfolio so that its parameters are within the approved Operational Interest Rate Limits. Transitional interest rate limits will guide the management of the portfolio during this period. The Treasurer will approve these limits on an annual basis. However, these limits will not be made public as publication may prejudice the Commonwealth’s financial interests.
AOFM will need to maintain a portfolio of interest rate swaps to manage to the new benchmark. The total notional value of interest rate swaps outstanding is likely to be around the current level. In 2003-04, AOFM will be seeking to transact around $2-4 billion of swaps with terms of at least 7 years that require the Commonwealth to receive fixed interest rate obligations and around $4-6 billion of swaps with terms up to 4 years that require the Commonwealth to pay fixed interest rate obligations. This program is anticipated to achieve a modest reduction in portfolio modified duration and a reduction in short-dated exposure. AOFM’s participation in the swap market will be dependent upon prevailing market conditions.
AOFM will be liaising with financial market participants to further explain the details of the new benchmark prior to commencing swaps in the fourth quarter of this year. AOFM’s review of the interest rate benchmark and general approach to interest rate risk management will be further discussed in the 2002-03 AOFM Annual Report, which will be released by the end of October 2003.
18 September 2003
Mr Blair Comley
Mr David Alexander
Table 1: Long-Term Debt Portfolio benchmark parameters and limits*
* These parameters and limits apply to the Australian dollar Long-Term Debt Portfolio.
Table 2: Long-Term Debt Portfolio parameters as at 30 June 2003*
* These parameters apply to the Australian dollar Long-Term Debt Portfolio.