Sovereigns’ use of swaps has risen in tandem with their vast new funding requirements, despite concerns over counterparty risk and short-term rate exposure thrown up by the banking crisis. Lucy Fitzgeorge-Parker looks at how issuers are using interest rate and cross-currency swaps — and why they’re not.
Minimising interest rate and foreign currency risk, reducing the cost of funding and building liquid benchmarks are key objectives for all sovereign borrowers.
Few can achieve all of these through direct issuance, so in the past decade public debt managers have increasingly turned to the swaps market to fine tune their portfolios. For some, the inherent risks still outweigh the potential upside, but for most swaps have become an essential part of the debt management toolkit.
Sovereigns are primarily active in interest rate and cross-currency swaps — although some have ventured into the inflation and swaptions markets.
At the low-risk end of the spectrum, cross-currency swaps provide a simple and cost-effective way for sovereigns to fund in currencies other than their own without taking on exchange rate exposure, or to build foreign currency reserves while maintaining benchmark liquidity in their domestic currencies.
Interest rate swaps are more controversial — most issuers are active in the market, using these swaps to manage portfolio duration, smooth maturity profiles and reduce the cost of short-term funding, but at the price of exposure to interest rate and spread fluctuations.
What’s the target?
In a positive yield curve environment, the challenge for all debt managers is to achieve a balance between stability and cost. "We use swaps to lower costs by swapping bonds to a shorter maturity," says Thomas Olofsson, head of Sweden’s debt management department. "We issue long bonds but we don’t want to pay the high yield that we have to pay compared to, for example, T-bills, so we try to achieve a very short maturity where we can to lower costs."
Many debt managers operate this programme in the context of a duration target, although some — Sweden included — prefer to use a proprietary model. "Our target is 3.2 years but that is not in duration, it is in interest rate fixing period," says Olofsson. "That is basically a measure of duration where we keep interest rates fixed and set it at zero, so in effect that is a measure of the average time to maturity of all cashflows."
For most countries, this target is set annually but some have moved to a more dynamic system. Portugal, for example, uses a benchmark derived from an optimisation model that indicates the maturity buckets the country should issue in to achieve an optimal funding structure in terms of cost and risk. "When we issue we are not constrained in terms of duration targets because we want to respond to investor demand," says Sofia Torres, head of debt and cash management at the Portuguese Treasury and Government Debt Agency.
"So we measure the difference between the duration of the benchmark at any time during the year and the duration of our outstanding debt, and because we have limits for that deviation we adjust that difference by using interest rate swaps. The benchmark has a lot of constraints, but it incorporates historical information that goes beyond 20 years, so it catches an entire economic cycle."
Teppo Koivisto, director of finance at Finland’s State Treasury, which introduced a similar model in 2005, cites another advantage to this type of system. "The benchmark portfolio enables the government to evaluate the performance of operative debt management carried out by the State Treasury," he says.
Denmark is a big user of interest rate swaps, primarily for duration targeting and to maintain its ability to issue liquid benchmark bonds, but also to avoid high interest-risk concentrations. "We use swaps to manage our interest rate fixing in different years, so we don’t have too much exposure in one year," says Ove Sten Jensen, head of government debt management at Danmarks Nationalbanken, which runs the government’s borrowing programme.
Denmark has quite a small government borrowing requirement with net debt standing at around just 10% of GDP after several years of high revenues from offshore energy production. However, it still needs to issue liquid benchmarks to ensure the efficient functioning of its domestic capital markets. For that reason, it concentrates issuance on a small number of long-dated benchmark bonds rather than T-bills and then uses swaps to achieve its duration targets and to cut funding costs.
Part of this cost-saving is achieved simply by moving up the yield curve but, like other sovereign issuers, Denmark can also achieve consistent savings by selling longer-dated paper and then transacting a standard fixed-floating swap, because the swap spread is wider than the spread between T-bill and Libor rates.
"Our normal strategy has been to borrow in longer maturity segments, for instance having a good 10 year bond, and then swapping it downwards to six month’s exposure, and in that way getting a lower duration," says Jensen. "This would then be cheaper than to go out in a big treasury bill programme."
In most years, Denmark would expect to make of the order 5bp-20bp on this aspect of its swaps programme. Under normal market conditions, this strategy is quite a low-risk way of cutting overall funding costs. But it has inherent risks, as was demonstrated last year when interbank rates spiked and the spread to T-bills reached unprecedented levels in the wake of Lehman Brothers’ collapse. Denmark avoided the worst of the crisis by partially exiting the swaps market.
"Already in 2007 and in 2008, we felt that the markets were not working as well as before, so we didn’t use the swap market very much on the interest rate side," says Jensen. "It would have been nicer if the short-term interest rate had been lower during the crisis, but to say that it added to our cost of funding is wrong, because even given that Libor was a little higher, the cost still would be lower than if you have a longer duration. Of course there was this development in the short end of the market, which turned against issuers like us. But it’s not the same as saying it was a bad deal. As the swap market was not so liquid we would rather let the issuance give us the duration than use swaps in that period."
Others were not so lucky. "As the short end of the swaps, the Stibor and so on, increased more than the swap spreads, swaps became less profitable for us during this last year," says Oloffson at Sweden’s debt management department. "But as we engage typically in swaps of some six, seven or 10 year maturity, for the new swaps it is only for one year that we make losses, as the TED spread is larger than the swaps spread, so we will see when our swaps mature how that will look. Swaps usually are very profitable for us."
The surprise of the crisis has been that even sovereigns who have traditionally struggled to raise sufficient longer-term debt and have used swaps to term out their duration rather than shorten it, have found it possible to fund in volume further down the yield curve in the past year. "Italy has achieved an average life of almost seven years and has marginally increased from 2008," says Greg Arkus, who runs frequent issuer and public sector DCM coverage at Credit Suisse in London. "Short term debt has gone up for some countries but has been used as part of the bank recovery process, e.g. the Netherlands that supported the bank treasuries through increased short term funding."
No swaps please, we’re British
Officials at the UK’s Debt Management Office, however, remain unconvinced by the supposed advantages of using swaps. "There have been some suggestions that we should use the swap market to help lower the government’s cost of funding," says Robert Stheeman, DMO chief executive. "But the government’s debt management principles are based on predictability and transparency and not short-term gain. If we were to use swaps, it might impact on the swap curve and move to the government’s detriment. In any event, the swap curve is volatile and the current position may be short-lived. We are not an opportunistic issuer, and selling swaps would mean adding operations to an already crowded calendar."
As one of the largest and most liquid borrowers, the UK can manage its portfolio duration through issuance alone, so its resistance to swaps is perhaps less surprising. But even some smaller borrowers are sceptical about the benefits of using swaps. Poland, for example, has used interest rate swaps in the past to smooth debt repayments, as Bogdan Klimaszewski, deputy director of the public debt department at Poland’s finance ministry, explains: "We prepaid some interest payments in one year and then we received payments in the following year, to reduce the cost of debt servicing for the following year. These types of swaps have usually very short maturity — up to one year."
But Poland is no longer active in the swaps market and prefers to manage the structure of its debt through issuance. "We do not preclude the use of derivatives in debt management but so far our objectives can be realised using standard instruments — short, medium and long term bonds on the domestic and foreign markets," says Klimaszewski. "We have more than 15 ISDA agreements with international and domestic banks, we have the technical infrastructure to set up swap transactions with the market participants — but so far, from a strategic point of view, there has been no rationale to actively and broadly use swaps to manage interest rate and foreign currency risk."
Poland has a duration target for its domestic debt of between 2.5 and four years, and is now close to 2.8 years. So, even though its policy is to issue longer-term maturities to meet market demand, it sees no need for derivatives transactions to manage interest rate risk.
Klimaszewski says this is not the only reason for eschewing swaps. "We do not swap fixed rate bonds issued on the domestic market to floating rate because of two additional elements — the important issue for debt management is not only the minimisation of debt costs but also their predictability. The second element comes from the market situation, which hasn’t provided the rationale for doing so."
At the other end of the risk spectrum, some sovereigns have moved into the swaptions market. Portugal has recently resurrected its covered swaption programme. "If we have some positions in swaps that we have targets to exit, we can sell options based on those targets and monetise some premia," says Torres. "So it reduces a bit our flexibility, but it enables us to take advantage of the very high level of volatility in the market currently. Although it’s not by any means the majority of the trades we do, the majority is plain vanilla interest rate swaps."
Foreign currency swaps
Many sovereigns are also active in cross-currency swaps, generally seen as lower risk and less controversial instruments. As with interest rate swaps, there is no standard practice among issuers — some use the product to hedge exchange rate risk, while others, such as Sweden and Canada, take on foreign currency exposure to boost central bank reserves. "Providing liquidity [in the domestic market] is a focus for us," says Olofsson. "One reason why we use swaps to achieve foreign currency exposure is that in that market we don’t need to provide liquidity, so we could use swaps to issue some extra nominal bonds and then swap into foreign currency exposure, instead of issuing euro bonds."
Most sovereigns, when they raise funds in foreign currencies, prefer to swap the proceeds into their domestic currency. Again, Poland is the odd one out, in that its government is happy to wear the risk associated with issuance in foreign currencies. "Our objective is to build a liquid yield curve on the euro market," says Klimaszewski. "Therefore there is no substantial reason to use cross-currency swaps to exchange this euro denominated debt into Polish zloty. Almost each year in the past we have been present on the yen market and Swiss franc market but the size of the issuance was quite small.
"The dominant role of euros and the minor share of other currencies — we can afford to take this exposure and benefit from low interest rates — are the main reasons we haven’t adopted a large programme of currency swaps. In 2009 we have increased the role of US dollars, and we may consider changing it into euros or Polish zloty, but still we keep in mind limitations coming from the credit risk of counterparties."
Counterparty risk
Counterparty risk has been the hot topic for all capital market participants over the past year, and sovereigns are no exception. "Before Lehman Brothers defaulted, counterparty exposure was less of an issue for sovereigns," says Sean Taor, head of SSA syndicate at Barclays Capital in London. "Their volume of issuance was generally lower than it is now — European sovereign funding this year is up around 45% from last year and it is expected to be up again next year. As the volume of issuance has risen, the volume in the swap market has risen, and Lehman Brothers really showed that if you have too many eggs in one basket, regardless of the counterparty rating, then you’re potentially in trouble. All issuers, particularly sovereign issuers, have been a lot more prudent about where they have single bank risk on the swaps side."
Arkus at Credit Suisse agrees: "There is increased conservatism in terms of structures used with more focus on plain vanilla interest rate swaps and a focus on counterparty risk," he says. "Following Lehman Brothers and adjustments to swap counterparties and costs to the portfolio as a result of its bankruptcy, sovereigns are placing more weight on a bank’s rating and capital ratios."
At least one large European sovereign had substantial swaps exposure to Lehman Brothers, which has prompted many to review their policy on counterparty credit risk — particularly as traditional credit ratings proved so ineffective. "We have introduced additional metrics to manage our counterparty risk limits, so besides ratings we use CDS spreads and equity prices," says Portugal’s Torres. "Currently we cannot do any transaction with a counterparty that has not signed a CSA [credit support annex] agreement with us. The main changes were the incorporation of other information in our counterparty limit by introducing other metrics than in the past, when it was mainly a ratings-driven system."
Indeed Portugal went so far as to unwind existing swaps where it was not comfortable with the risk associated with its counterparties. "Not only did we decrease swapping activity during the worst period of the crisis but also we went to some of our counterparties and we cancelled some of the outstanding swaps," says Torres. "Around this period there was not a lot of liquidity in the market, but now the situation has fully normalised and we have the positions that we would like to have."
It was not the only one to do so, despite the expense this entailed in an illiquid market. "Since the Lehman crisis every sovereign is getting very sensitive about the single exposure topic and some of them have actually unwound swaps with specific banks as it was very difficult to novate existing swaps to other, preferable bank institutions," says Kentaro Kiso, head of frequent borrower origination at Barclays Capital in London. "That sort of flurry of activity went through from Q4 2008 to Q1 this year, but it’s quietened down."
The issue hasn’t gone away, however, and sovereigns as well as other swap market participants are increasingly looking for a better way of managing counterparty risk. Regulators around the world are promoting, and in some cases mandating, the use of central clearing houses for many derivatives that are currently traded over-the-counter. That includes many interest rate swaps.
"Given that the single exposure problem is still out there, the discussion about central clearing or adopting two-way CSA is an imminent conversation that a lot of people are very much interested in," says Kiso.
Jensen at Danmarks Nationalbanken, which also stepped up its credit scrutiny during the crisis, agrees that central clearing could work to sovereigns’ advantage. "There could be a central counterparty solution between the banking sector and the issuers," he says. "That could maybe be a solution on this debate between banks and issuers."
However, this could backfire on sovereigns, which have unilateral collateral requirements — counterparties are required to post collateral with them when the sovereign is in the money but not the other way round. This could change under a clearing house arrangement. "At the moment, the majority of sovereigns don’t have two-way CSA, but going into next year, a central clearing system is by default demanding that you take a two-way CSA, and a sovereign will be no exception," says Kiso.
Whatever the outcome of the regulatory debate, sovereigns’ appetite for swaps seems unlikely to diminish in the coming years. The sheer volume of funding and refinancing that will be necessary is likely to see a concomitant increase in the use of swaps, as well swaptions and other less vanilla products, particularly if counterparty risk concerns can be limited.
But despite the many attractions of swap-based strategies, the vulnerabilities to short-term rates exposed by last year’s crisis will remain — and another wave of volatility could yet prove the debt management swaps nay-sayers right.