Debt Management Report 2000-2001: 1
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Foreword by the Minister of Finance

The federal government paid down $17.1 billion of its debt in 2000-01, its largest debt paydown ever. In the last four years the federal government has reduced its debt by $35.8 billion. Net public debt now stands at $547.4 billion. This represents 51.8 per cent of gross domestic product (GDP), compared to almost 71 per cent in 1995-96.

Reducing the debt by this amount is saving the Government $2.5 billion each year in interest payments. Reducing Canada’s debt burden makes our country less vulnerable to economic shocks, such as higher interest rates or slowdowns in economic activity. This added measure of financial security is particularly crucial today given the current slowdown in the global economy. Canada is not immune to the effects of this slowdown.

Against this backdrop, it is important that Canadians be equipped with timely, comprehensive and transparent information about how the debt is managed so that they can hold the Government accountable for its decisions – decisions that affect the long-term financial security of the nation and the well-being of individuals.

The Debt Management Report fulfills this need by providing a detailed account of the federal government’s debt operations, including the composition of the debt, its distribution, and the mechanisms and activities through which it is prudently managed in the interests of Canadians.

I want to take this opportunity to assure Canadians of the Government’s unwavering commitment to prudence in the management of public finances. Sound financial management is a key part of our strategy to sustain an economic environment that can offer Canadians more jobs, higher incomes and a better quality of life.

The Honourable Paul Martin, P.C., M.P.
Minister of Finance
Ottawa, November 2001

Purpose of the Report

The Debt Management Report provides a detailed account of the federal government’s borrowing and cash management operations in the past fiscal year (April 1, 2000 to March 31, 2001).

Debt-servicing costs are the largest spending program of the federal government, and the effective management of the programs that give rise to these costs is important to all Canadians. The Report provides a comprehensive account of the context within which the debt is managed, its composition and changes during the year, and strategic initiatives. The Report’s major reference point is the Debt Management Strategy, published before the start of the fiscal year.

Timely and transparent information of this kind is of use to market participants and ensures public accountability. To this end, both reports are tabled annually in Parliament and are available on the Department of Finance Web site at www.fin.gc.ca.

Highlights of 2000-01

The net public debt has been reduced by some $36 billion since 1996-97.

The Government undertook a number of initiatives to enhance the Government of Canada securities market.

Foreign exchange reserves were increased and a risk management framework developed.

• In 2000-01 the federal government continued to reduce its level of indebtedness. The Government’s net public debt was reduced by $17.1 billion to $547.4 billion, and it is down $35.8 billion from its peak in 1996-97. Net public debt as a percentage of GDP dropped to 51.8 per cent in 2000-01 from a peak of 70.7 per cent in 1995-96. In 2000-01 alone the net debt-to-GDP ratio dropped by 6.1 percentage points, the largest drop since 1948-49. This is the fifth consecutive year in which the debt-to-GDP ratio has declined, and it is at its lowest level since 1985-86.

• The Government’s principal debt strategy objectives for 2000-01 were to maintain a prudent financial position and to maintain and enhance the functioning of the Government of Canada securities market.

• The structure of Canada’s debt stock was managed in keeping with a continuing target of having two-thirds of the Government’s total interest-bearing debt in fixed-rate form. Maintenance of a two-thirds debt structure balances prudence and continuing access to lowest-cost sources of funds.

• A number of initiatives were undertaken in 2000-01 to enhance the market for Government of Canada securities and improve the Government’s treasury operations, including:
  • in April 2000 the pilot bond buyback program was implemented on an ongoing basis to assist in the maintenance of primary bond market liquidity;
  • in June 2000 a market proposal to remove the ceiling on the reconstitution of government bonds with common maturity dates was approved and implemented in February 2001, enhancing liquidity in the secondary market;
  • in July 2000 a new framework for the investment of the Government’s cash balances aimed at broadening participation by investors and enhancing risk management was issued for comment; and

  • in January 2001 a pilot cash management bond buyback program was launched in order to smooth the Government’s cash needs and usage of the Treasury bill program.

• With respect to the management of the Government’s foreign debt and assets, the following actions of note were taken in 2000-01:
  • the level of international reserves was increased to US$33.5 billion at March 31, 2001, from US$31.1 billion at March 31, 2000, substantially meeting the Government’s objective of bringing the level of reserves in line with that of comparable sovereigns;
  • in April 2000 the Government announced its intention to adopt collective action clauses in its future foreign currency bond and note issues, providing leadership to the international community with respect to the development of an orderly framework for debt restructuring by debtors and creditors; and
  • a comprehensive risk management framework for the foreign asset/liability portfolio was developed, including a collateral management system to manage the Government’s credit risk with private sector counterparts.

2000-01 Debt Management Environment

Changes in the level of the Government’s debt and its annual debt costs are affected by developments on two fronts: the Government’s fiscal results and the path of interest rates over the year. This section provides a brief summary of these developments and their consequences.

Fiscal Developments

Budgetary Results

The Government recorded a budgetary surplus of $17.1 billion.

In 2000-01 the Government recorded a budgetary surplus of $17.1 billion. This follows surpluses of $3.5 billion in 1997-98, $2.9 billion in 1998-99 and $12.3 billion in 1999-2000. Over the past four years the Government’s net public debt has been reduced by $35.8 billion. It stood at 51.8 per cent of GDP in 2000-01, down from a peak of 70.7 per cent in 1995-96. This ratio is generally recognized as the most appropriate indicator of the debt burden as it measures debt relative to the ability of the Government and the country’s taxpayers to finance it. In 2000-01 alone the net debt-to-GDP ratio declined by 6.1 percentage points, the largest drop since 1948-49. This is the fifth consecutive year in which the debt-to-GDP ratio has declined, and it is at its lowest level since 1985-86 (see Chart 1).

Financial Requirements/Source

There was a financial source, including foreign exchange transactions, of $10.2 billion.

The budgetary surplus of $17.1 billion, combined with a net source of funds from non-budgetary transactions of $1.8 billion, produced a financial source (excluding foreign exchange transactions) of $19.0 billion, following a financial source of $14.6 billion in 1999-2000. The results for 2000-01 mark the fifth consecutive year that the Government has recorded a financial source (excluding foreign exchange transactions). Including foreign exchange transactions, primarily relating to supplementing foreign exchange reserves, the net financial source was $10.2 billion for 2000-01. Of this amount, $10.0 billion was used to reduce market debt and $0.2 billion was held in cash.

Financial requirements/source (excluding foreign exchange transactions) is a measure of the Government’s financial position that is broadly comparable to the measure of budgetary balance used by other major industrialized countries, including the United States. On this basis, Canada is the only Group of Seven (G-7) country to report a financial source for five consecutive years.

Composition of the Federal Debt

There are several measures of the debt. 

Gross and net public debt, as well as market debt, have all declined in recent years.

Reports on the federal government’s debt and debt management strategy use certain terms to describe the debt: gross public debt, market debt, non-market debt and net public debt.

Gross Public Debt

Gross public debt is made up of two major components: market debt and non-market debt. Gross public debt at the end of March 2001 totalled $632.9 billion, down from a peak of $640.7 billion in 1996-97 (see Chart 2).

Market Debt

Market debt is the portion of debt that is funded in the credit markets and actively managed by the Government. It consists of marketable bonds, Treasury bills, Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs), foreign-currency-denominated marketable bonds, short-term paper bills, and non-marketable bonds held by the Canada Pension Plan (CPP). At March 31, 2001, market debt outstanding was $446.4 billion. In 2000-01 the level of market debt declined by $10.0 billion (see Chart 2).

Non-Market Debt

Non-market debt includes liabilities held by the Government outside the credit markets. This includes money owed to public sector pensions, the CPP and other accounts, and the Government’s current liabilities and allowances. In 2000-01 non-market debt was $186.5 billion, up from $182.3 billion in 1999-2000.

Net Public Debt

Net public debt is gross public debt minus financial assets. Financial assets include cash, foreign exchange accounts and loans. Net public debt declined from $564.5 billion in 1999-2000 to $547.4 billion in 2000-01. The Government’s financial assets increased by $11.3 billion to $85.5 billion in 2000-01, primarily due to a continued increase in the Government’s foreign exchange reserves.

The net public debt-to-GDP ratio is generally recognized as the most appropriate indicator of the debt burden as it measures debt relative to the ability of the Government and the country’s taxpayers to finance it. This ratio dropped to 51.8 per cent in 2000-01 from a peak of 70.7 per cent in 1995-96.

Market Developments

The yield curve reverted to a positive normal slope over the year.

The domestic financial market environment was stable for the first three quarters of the 2000-01 fiscal year, and then became more volatile towards fiscal year-end. The fourth quarter of the fiscal year was marked by declines in equity prices, a global economic slowdown and US dollar strength. In Canada economic growth was healthy through 2000 and core inflation remained within the 1 to 3 per cent target range. Short-term interest rates rose modestly during the first half of 2000 as the Bank of Canada raised its target rate for overnight loans from 5.25 per cent to 5.75 per cent, then fell in 2001 as the Bank reduced the target rate from 5.75 per cent in January 2001 to 5.00 per cent in March 2001. These developments are consistent with those in the US.

Government yield curves (i.e. the structure of interest rates from short-term to long-term rates) in Canada and the US began the year in the unusual situation of being inverted or downward sloping (for Canada see Chart 3). This reflected a number of factors, including expectations regarding the direction of monetary policy, concerns about reductions in the supply of government securities in an environment of budgetary surpluses, especially at longer terms to maturity, and a high degree of confidence in long-term inflation performance. By the end of the year government yield curves had returned to a normal upward sloping curve, much of which is attributable to a sharp drop in yields at the short to medium ends of the curve. Relative to US rates, Canadian interest rates were lower until November, when US rates moved below Canadian rates across all maturities (see Charts 4, 5 and 6).

Public Debt Costs

Public debt charges have continued to fall relative to GDP.

The Government spent about 24 cents of every dollar of revenue in 2000-01 to pay the interest on the public debt, down from its peak of 36 cents in 1995-96, and now at its lowest rate since 1981-82. Public debt charges as a percentage of GDP declined to 4.0 per cent in 2000-01 from 4.3 per cent in 1999-2000 (see Chart 7).

Report on 2000-01 Debt Programs

Market debt declined from $456.4 billion in 1999-2000 to $446.4 billion in 2000-01.

As of March 31, 2001, market debt outstanding comprised $279.9 billion in fixed-coupon marketable bonds, $15.1 billion in real return bonds (RRBs), ^[1] $88.7 billion in Treasury bills, $26.1 billion in CSBs and CPBs, $3.5 billion in CPP bonds and $33.2 billion in foreign-currency-denominated securities (see Table 1). In addition, the Government had $2.7 billion in interest rate swaps and $24.9 billion in cross-currency swaps outstanding as of March 31, 2001. Taking into account the effect of cross-currency swaps, foreign currency obligations were 12.3 per cent of market debt.

This section provides details on the operations of each major debt program. In 2000-01 the stock of Treasury bills decreased by $11.2 billion while the stock amounts of other instruments remained largely unchanged. For information on the federal debt management framework, see Annex 1. For descriptions of the individual programs, see Annex 2.

Table 1
Composition of Federal Market Debt, 2000-01

Domestic Debt

Gross issuance of bonds was $38.5 billion.

$1.4 billion in RRBs were issued.

The Treasury bill stock fell by $11.2 billion.

The retail debt stock fell by $400 million.

Fixed-Coupon Marketable Bonds and Bond Buybacks

Fixed-coupon marketable bonds are issued at 2-, 5-, 10- and 30-year maturities on a regular basis. These bonds are non-callable and pay semi-annual coupon payments. Bond buybacks occur with every bond auction and allow the Government to buy back bonds in order to assist in the maintenance of primary bond market liquidity. In 2000-01 gross issuance of bonds of $38.5 billion consisted of $14.1 billion in 2-year bonds, $10.5 billion in 5-year bonds, $10.1 billion in 10-year bonds and $3.8 billion in 30-year bonds. $33.9 billion of bonds matured during the year. Bond buybacks and cash management bond buybacks totalled $5.3 billion. Net new issuance of fixed-coupon marketable bonds during the year, taking into account buybacks and maturities, declined by $0.7 billion (gross issuance less repurchases less maturing issues), bringing the stock of outstanding marketable bonds down to $279.9 billion as at March 31, 2001.

Real Return Bonds

Government of Canada RRBs are issued at the long end of the maturity curve. Unlike standard fixed-coupon marketable bonds, interest payments on RRBs are adjusted for changes in the CPI, i.e. inflation. 2000-01 issuance of RRBs totalled $1.4 billion, increasing the level of outstanding RRBs from $12.1 to $13.5 billion (from $13.3 to $15.1 billion including the CPI adjustment) as at March 31, 2001 (see Reference Table X).

Treasury Bills

Treasury bills are auctioned every two weeks in 3-, 6- and 12-month maturities and pay out at maturity at par (face) value. The stock of outstanding Treasury bills declined by $11.2 billion during the 2000-01 fiscal year to a level of $88.7 billion at March 31, 2001. In 2000-01 the Government issued $174.3 billion in new Treasury bills, down from $213.6 billion in 1999-2000 (see Reference Table VI).

Retail Debt

There are two types of retail debt: CSBs and CPBs. CSBs are available in regular interest and compound interest forms. They provide minimum guaranteed interest rates and may increase if market conditions warrant. CSBs can be registered only in the name of residents of Canada. CPBs offer a higher rate of interest at the time of issue compared to CSBs on sale at the same time. CPBs’ announced interest rates for the posted periods do not change once the issue date has passed. In 2000-01 the level of outstanding debt held by domestic retail investors – CSBs and CPBs – decreased from $26.5 billion to $26.1 billion.

Foreign Debt

Canada Bills outstanding rose by US$500 million.

Canada Notes outstanding rose US$300 million due to a US$400-million yen bond issue that was very well received.

EMTNs outstanding fell US$260 million.

No global bonds were issued.

Canada is the only G-7 nation to record a financial source for five consecutive years.

US$2.5 billion was raised by 37 cross-currency swaps.

Canada Bills

Canada Bills are promissory notes denominated in US dollars and mature not more than 270 days from their issue. These securities are issued for foreign exchange reserve funding purposes only. In 2000-01 the level of outstanding Canada Bills increased from $6.0 billion (US$4.1 billion) to $7.2 billion (US$4.6 billion)

Canada Notes

Canada Notes are promissory notes denominated in foreign currencies for terms of nine months or longer at a fixed or floating rate. They are issued for foreign exchange reserve funding purposes only. The stock of outstanding Canada Notes rose from $1.1 billion to $1.6 billion during 2000-01. Public market borrowing by Canada during the year (apart from Canada Bills issuance) took the form of a single issue: a five-year 50-billion yen (equivalent to some $625 million or US$400 million) note launched in March. The issue was successfully placed with U.K., European and US institutional investors and received favourable public comments.

Euro Medium-Term Notes

The Euro Medium-Term Note (EMTN) program was introduced in March 1997 to diversify the sources of cost-effective funding for Canada’s foreign exchange reserves. Notes issued under the new program can be denominated in a range of currencies and structured to meet investor demand. Obligations are usually swapped to US dollars, the primary currency held in the foreign exchange reserves. In 2000-01 there were no new EMTN transactions, and the total outstanding decreased from $4.1 billion (US$2.60 billion) to $3.7 billion (US$2.34 billion).

Foreign-Currency-Denominated Bonds

Apart from the yen bond issue under the Canada Notes program, there was no new global bond issuance in 2000-01. A total of $800 million of foreign currency bonds matured in 2000-01.

Cross-Currency Swaps

At the beginning of a cross-currency swap, the Government of Canada receives a principal amount in US dollars or euros from the counterparty in exchange for a Canadian-dollar principal payment sourced from domestic bond issues. At the end of the swap contract the Government repays the US-dollar principal amount and receives the Canadian-dollar principal payment. In 2000-01 the federal government raised $3.9 billion (US$2.5 billion) by entering into 37 cross-currency swaps (see Reference Table XI).

Debt Management Strategy: 2000-01 Initiatives

Key strategic objectives are to maintain a prudent debt structure and a well-functioning market.

The fundamental debt management objective is to raise stable, low-cost funding for the Government. Key strategic objectives are to maintain a prudent debt structure and a well-functioning market for Government of Canada securities. (Debt Management Strategy 2000-01 outlined the debt management plan for 2000-01 and is available on the Department of Finance Web site at www.fin.gc.ca.)

The following sections report on the Government’s initiatives designed to address these strategic goals. The section entitled "Maintaining a Well-Functioning Market" details the initiatives taken to maintain a well-functioning market in Government of Canada securities. The section entitled "Maintaining a Prudent Debt Structure" reports on the key measures and analysis used in determining the target debt structure. "Maintaining a Diversified Investor Base" reports on developments in the investor base of Government of Canada bonds, including domestic and non-resident holdings. And the section entitled "Foreign Debt and Assets Management Strategy" reports on the management of foreign debt and assets.

Maintaining a Well-Functioning Market

The Government continues to place emphasis on the principles of transparency, liquidity and regularity.

Market participants are consulted regularly.

A number of initiatives were undertaken in 2000-01 to enhance the functioning of the Government of Canada securities market.

A well-functioning Government of Canada securities market helps to ensure low-cost financing for the federal government over time by providing efficiency for investors, thereby attracting broad participation in the market. The Government’s operating principles of transparency, liquidity and regularity are operationalized by borrowing and repurchasing securities in the domestic market on a regular, pre-announced basis in key segments of the market, building large bond benchmarks and maintaining transparent rules for participation at Government of Canada securities auctions.

Federal government securities play a key role in Canada’s fixed-income market by providing the benchmark against which other instruments are priced, hedged and traded. The Government monitors auction results, secondary market turnover and transaction costs in the Government of Canada securities market as indicators of liquidity and market efficiency. It also works closely with market participants to address issues of market function and integrity. Market participants are consulted regularly on the Government’s debt strategy and adjustments to its domestic debt programs. Through this approach the Government seeks to maintain a high standard of transparency, improve the attractiveness of the market for investors, and take into account market views in decisions on debt management operations.

In recent years the Government has made a number of adjustments to its operations to enhance the liquidity of the market, such as moving to biweekly Treasury bill auctions, increasing benchmark bond target sizes and introducing a bond buyback program.

In 2000-01 the federal government undertook a number of initiatives to maintain and enhance a well-functioning market in its securities, including:

• increasing target benchmark bond sizes for 5-, 10- and 30-year bonds from $7 billion-$10 billion to $9 billion-$12 billion to enhance liquidity;
• approving new rules related to stripping and reconstitution of Government of Canada bonds to improve secondary market liquidity;
• implementing the pilot bond buyback program on an ongoing basis and expanding the range of eligible securities to support the maintenance of a liquid new bond issue market;
• implementing a pilot cash management bond buyback program to reduce the peak levels of government cash balances and improve the functioning of the Treasury bill program;
• reviewing the structure of the Treasury bill program to ensure it meets investor needs; and
• continuing discussions with market participants and regulators on the regulatory framework for electronic trading systems in the domestic fixed-income market.
• These initiatives are discussed in more detail in the following sections.

Bond Program

Bond benchmark targets were increased for 5-, 10- and 30-year bonds.

In consultations held before the 2000-01 debt strategy was established, market participants were generally pleased with the design and functioning of the Government of Canada bond market, but indicated that benchmark targets could be increased to maintain Canada’s position in an environment of ever-higher global standards. Accordingly, in its 2000-01 debt strategy the Government increased target benchmark sizes for 5-, 10- and 30-year bonds from $7 billion-$10 billion to $9 billion-12 billion.

Annual Government of Canada bond turnover decreased to 11.5 times the outstanding stock in 2000-01 from 11.7 times in 1999-2000. While the level of trading activity globally has diminished over the past two years, Canada’s bond market remains one of the most active sovereign bond markets in the world based on indicators of the liquidity of the market. These include the volume of transactions and turnover ratios comparable to those of other G-7 countries, with the exception of the US (see Charts 8 to 12).

An active repo market is a hallmark of a well-functioning government securities market. The total turnover for Government of Canada bond repos in 2000-01 decreased to $17,511 billion from $18,037 billion in 1999-2000. Furthermore, the annual turnover ratio for bond repos in 2000-01 was 58.6 (see Chart 11). The Treasury bill repo market volume in 2000-01 was $1,235 billion and the annual turnover ratio was 14.8 (see Chart 12).

Futures contracts are important complements to an efficient Government of Canada securities market. In Canada the trading volume of futures contracts maintained the levels of previous years. There is an active futures contract based on benchmark 5-and 10-year Government of Canada bonds (the CGF and CGB contracts). Open interest of the futures contract on 10-year Government of Canada bonds increased to 55,469 in 2000, an 88-per-cent increase from 1999. The CGB contract continues to be an actively traded contract, setting a new daily trading volume record on November 27, with 50,880 contracts traded, surpassing the two-year-old record of 41,649 set in 1998.

Bond Buyback Program

The bond buyback program was implemented on an ongoing basis and the range of maturities expanded.

To enhance liquidity in the market of Government of Canada securities, a pilot bond buyback program was implemented in 1998-99. The program allows the Government to buy back less liquid bonds, thus supporting a liquid new bond issue market. More specifically, repurchases of outstanding bonds are funded by issuance of new benchmark bonds, increasing the size of the bond program beyond the level needed to meet the Government’s financial requirements.

An internal evaluation of the pilot, which included feedback from market participants, took place in late 1999. The evaluation indicated that the program has been successful in meeting its objectives. As a result, in its 2000-01 debt strategy the Government implemented the bond buyback program on an ongoing basis. The program was expanded to include bonds with maturities across a wider range of the yield curve in order to encourage the participation of a wider range of market participants. Specifically, the program was expanded from bonds with maturities up to 2011 to include bonds with maturities up to 2022.

The repurchase program has enabled the Government to conduct larger auctions in 1998-99, 1999-2000 and 2000-01 than would have been the case in the absence of a buyback program (see Table 2). An additional benefit of the program was improved secondary market liquidity, as trading increased in less liquid bonds targeted for repurchases under the program.

The size of the annual bond buyback program and the number of transactions depend on several factors, including the desired size of the new issuance and buyback program, market feedback and financial requirements. The size of the program was also affected by the quality of offers received. To protect the integrity of the program, the Government retains the right to repurchase less than the target amounts in cases where offers are not competitive.

Table 2
Bond Buyback Program

Treasury Bill Program

The Treasury bill program structure was reviewed to ensure it continues to meet investor needs.

The Treasury bill stock was reduced sharply in the latter half of the 1990s as the Government increased the fixed-rate share of the debt stock. Liquidity and trading activity has fallen over the period. Annual Treasury bill turnover declined to 12.3 times the amount of the stock in 2000-01 from 13.2 in 1999-2000 (see Chart 10 for quarterly results). In the spring of 1999 and again in the fall of 2000, the Government asked market participants for views on a restructuring of the program to improve liquidity. The majority of market participants continued to indicate that they prefer to maintain the existing biweekly auctions of three tranches of Treasury bills; as a result, no changes were made.

Stripping and Reconstitution of Bonds

The Government approved the removal of the ceiling on the reconstitution of Government of Canada bonds to enhance secondary market liquidity.

Stripping involves separating bonds into individual interest and principal payment components, while reconstitution involves collecting individual components to create synthetic whole bonds – the opposite of stripping. Market participants use these techniques to match the supply and demand for certain securities.

In June 1999 the Investment Dealers Association of Canada (IDA) requested that the federal government approve the removal of the ceiling on the reconstitution of Government of Canada securities to improve secondary market liquidity. The ceiling limited the amount of a given bond, held in the Canadian Depository for Securities Limited (CDS), that could be reconstituted to the amount previously stripped.

In June 2000 the federal government announced its support for the IDA’s request, viewing the initiative as an additional tool for enhancing liquidity in the Government of Canada securities market, particularly for benchmark securities, and as a complement to the regular bond buyback program. The new rule was implemented by the CDS in February 2001. Market participants stripped and reconstituted a total of $4.5 billion and $5.8 billion face value of securities respectively during the first week following the rule change, clearly indicating that the initiative has been helpful to the market.

Pilot Cash Management Bond Buyback Program

A pilot cash management bond buyback program was implemented.

To help in smoothing the Government’s cash requirements and to aid the functioning of the Treasury bill program, a pilot program of cash management bond buybacks was implemented in January 2001. The purpose of the program is to reduce the peak levels of government cash balances needed to redeem upcoming large bond maturities. This involves buying back large bonds with less than 12 months before they mature. The program also helps to smooth out seasonal fluctuations in Treasury bill issuance by reducing cash requirement peaks.

The first cash management buyback of $500 million was held on January 16, 2001. Following this, $1 billion worth of bonds were repurchased in February and March, for a total of $2.5 billion for fiscal year 2000-01.

Market Transparency and Electronic Trading

The Department of Finance and the Bank of Canada actively contributed to discussions on the development of a regulatory framework for alternative trading systems.

The Government supports improving market transparency to provide assurance that transaction pricing is fair and to enhance the attractiveness of the fixed-income market for a wide array of investors. In particular, this has involved the development of a screen-based, real-time information system (CanPx) that was established by dealers and inter-dealer brokers in 1999. CanPx provides market participants with best bid and offer prices and trading volumes in a range of benchmark fixed-income securities, and gives Canada a transparency standard that is in line with the practices of comparable sovereign countries.

Electronic commerce in wholesale fixed-income markets is growing rapidly internationally. The Government has a strong interest in the development of wholesale market e-commerce initiatives that would promote the maintenance of a liquid and efficient domestic fixed-income market. In 2000-01 the Department of Finance and the Bank of Canada actively contributed to discussions with Canadian securities regulators and market participants on the design of a regulatory framework for alternative trading systems that encourages their development and contributes to enhanced market transparency and efficiency.

Retail Debt

The Retail Debt Program continues to provide Canadians access to safe and secure savings instruments.

Canadians were able to purchase both CSBs and CPBs during a six-month period between October 2, 2000, and April 1, 2001. The CSB featured one-year pricing and cashability of the principal at any time, with no interest payable if cashed within three months of its purchase date. The CPB featured longer-term pricing higher than the CSB, but with cashability reduced to once a year. Both bonds have registered retirement savings plan and registered retirement income fund options. CPBs made up the larger share of total sales, contributing to the diversification of the Government’s investor base.

The Retail Debt Program continues to provide Canadians access to safe and secure savings instruments. To increase access and improve the distribution of retail products for the Government, several initiatives were undertaken. The direct option of purchasing CSBs and CPBs by telephone was enhanced and provided the Department of Finance with valuable information. In the payroll channel, an on-line application form was successfully piloted. As well, a Web site transmission option was introduced that allows small and medium-sized businesses to submit employee payroll deduction data directly to the Bank of Canada. For further information on retail debt plans and operations, see the Canada Investment and Savings Web site at www.csb.gc.ca.

Maintaining a Prudent Debt Structure

The Government maintains a debt structure that balances prudence with continuing access to lowest-cost sources of funds.

While the debt stock is on a downward trend, it remains large. Managing a large stock of debt exposes the Government to financial risk arising from changes in interest rates. The Government’s strategic objective is to maintain a debt structure that balances prudence with continuing access to lowest-cost sources of funds.

This section describes the Government’s approach to maintaining a prudent debt structure and reports on analytical work done in 2000-01. The capacity of the Government debt managers to assess risk is continually being upgraded in line with the best practices of other sovereigns. In keeping with comments made by the Auditor General of Canada in his April 2000 report on the Government’s debt management programs, "Managing Canada’s Debt: Facing New Challenges," this section of the report has been expanded to enhance understanding of the measures used by the Government and to present current analytical results.

The Cost/Risk Trade-Off

There is a trade-off between keeping costs low and ensuring they are stable over time.

The Government takes a long-term strategic view in choosing a target debt structure.

In establishing its debt structure, the Government trades off keeping borrowing costs low against ensuring that any additional debt-servicing costs resulting from unexpected increases in interest rates do not exceed its tolerance for risk. This trade-off reflects the fact that longer-term debt instruments are generally more costly and less risky than shorter-term debt instruments. To be more specific, long-term maturity instruments such as Government of Canada bonds typically have higher debt-servicing costs (i.e. pay higher coupon rates) than short-term instruments such as Treasury bills. On the other hand, the fixed-coupon rates of outstanding bonds are known with certainty, and therefore result in lower interest rate risk compared to Treasury bills, which mature each year and need to be refinanced at the then-prevailing market interest rates (see Chart 13).

The Government takes a long-term strategic view in choosing a target debt structure in order to have reasonable, and lasting, cost stability under a range of potential interest rate environments. Although the fiscal situation has improved considerably in recent years, the stock of outstanding debt that is exposed to interest rate changes remains very large. Roughly one-quarter of the federal government’s budgetary expenditures are debt-servicing charges, and sharp movements in interest rates have the potential to disrupt budgetary planning. An example of such a movement occurred in the late 1980s (see Chart 14). 

Between March 1987 and March 1990, interest rates on Treasury bills nearly doubled while interest rates on 10-year government bonds increased only by about one-third. Debt costs were significantly affected as the debt structure at that time had a high proportion of short-term debt.

Assessing the Cost/Risk Trade-Off – Measures and Targets

The Government uses a number of tools to assess the cost/risk trade-off.

Debt managers gauge and describe the sensitivity of the debt structure to unexpected changes in interest rates by using various measures. Measures such as the fixed-rate share of the debt, average term to maturity and duration characterize the composition of the debt and indicate how much of or how often the debt structure is exposed to interest rate variations. Other measures, such as a simulation methodology called Cost at Risk, quantify directly the risk of incurring additional debt costs given a particular debt structure. These measures, consistent with the best practices of comparable sovereign borrowers, are used by the Government to evaluate the performance of past debt management and guide future debt management.

Targets for the main operational measure – fixed-rate share – have been established for many years and reported in previous Debt Management Reports. Average term to maturity and maturity profile are two other measures that have been used in previous years to complement the fixed-rate share analysis. Recently the range and sophistication of analysis of the cost/risk trade-off has been enhanced with the introduction of Cost at Risk. Work is currently ongoing on the addition of a duration measure to the toolkit.

The sections below describe each of the measures/targets used by the Government in managing the debt. Table 3 provides a quick reference to the four measures.

Table 3
Current Cost/Risk Measures

Fixed-Rate Share

The Government currently targets a debt structure that is two-thirds fixed and one-third floating.

The two-thirds fixed structure is prudent in view of potential interest rate volatility.

The key operational measure and target that the Government uses is known as the fixed-rate share. The fixed-rate share is computed as the proportion of interest-bearing debt having fixed rates – debt that does not mature or need to be re-priced within a year – relative to the entire interest-bearing debt stock.

Generally speaking, debt-servicing costs increase (decrease) and financial risk decreases (increase) with a higher (lower) fixed-rate share. The fixed-rate share is a popular indicator among central governments because it is an intuitive measure that is fairly easy to compute and understand.

Following the sharp increase in interest rates in the late 1980s, the Government took measures to reduce the exposure of the debt stock to volatility in interest rates. The share of the debt stock at fixed rates increased from one-half in 1989-90 to an operational target of two-thirds in 1998-99. Since that time the debt has been managed to maintain a quarterly average fixed ratio within a range of ±1 per cent of the two-thirds target. The change in the composition of the debt structure was generally accomplished by reducing the stock of Treasury bills. For the past two fiscal years the debt has been managed around a target fixed-rate portion of two-thirds of the debt (see Chart 15).

As noted before, there can be a trade-off between risk reduction and debt-servicing costs. In the 1980s and early 1990s, when the debt had a high floating-rate component, debt-servicing costs tracked movements in interest rates (see Chart 16). Annual debt-servicing costs as a proportion of total debt generally floated between short- and long-term interest rates but varied significantly from year to year.

By establishing a more prudent two-thirds fixed-rate debt structure, the Government has reduced the sensitivity of its annual debt-servicing costs, and hence underlying balance, to changes in interest rates. This is illustrated in Chart 16 by the relatively stable debt-servicing cost line over the past five years.^[2] Currently debt-servicing costs exceed the present level of interest rates because a substantial portion of fixed-rate debt was borrowed in times of higher interest rates. In due course, however, it can be expected that overall debt-servicing costs will decline as debt that matures is refinanced at lower interest rates.

Maturity Profile

The maturity profile is managed to limit refinancing risk over time.

The Government manages the maturity profile of the debt (i.e. the amount that matures, or comes due, in any given year) to limit its refinancing risk. A well-distributed maturity profile reduces the risk that a relatively large proportion of the debt will mature and need to be refinanced in a period of higher interest rates.

The maturity profile of domestic government bonds is shown in Chart 17. The profile consists of a portion related to borrowing in previous years and a portion attributed to future refinanced borrowing. Initiatives to regularize bond refinancing into predictable benchmark securities have led to a gradual smoothing out of the maturity profile of the bond stock. In particular, there have been moves to build large benchmark bond issues for four maturities of domestic bonds (2-, 5-, 10- and 30-year) and issue bonds at regular quarterly intervals.

Treasury bills, unlike bonds, mature within a year of their issuance and are therefore excluded from the maturity profile depicted in Chart 17. The decline in Treasury bill issuance in the late 1990s has also contributed to lowering the Government’s refinancing risk. For example, in 1995 the Government was required to refinance, on average, $8 billion per week in maturing Treasury bills, compared to an average of $3.6 billion per week in 2000.

Since the maturity profile characterizes the distribution of maturing debt, it cannot be summarized with a simple numerical measure. Because of this drawback, maturity profile analysis is combined with measures such as average term to maturity or duration.

Average Term to Maturity

ATM is used as an indicator of how quickly changes in interest rates will affect debt costs.

The average term to maturity (ATM) is the average lifespan of the financial instruments that make up the debt. Measured in years, ATM represents the average length of time before debt instruments mature and are subject to refinancing risk. Longer ATMs mean that debt instruments are rolled over less frequently, which implies less uncertainty regarding future debt costs. Debt structures with a high proportion of long-term debt have higher ATMs. Since long-term debt is usually issued at fixed rates, ATM is a complementary measure to the fixed-rate share indicator.

The ATM of marketable debt has increased from roughly 4 years in 1990 to 6.4 years in March 2001 (see Chart 18). The upward trend in ATM resulted from the increase in the fixed-rate share and a reduction in the stock of Treasury bills. These changes have brought the term structure of Canada’s debt more in line with the debt structures of the other G-7 countries. The ATM should now gradually stabilize as the higher fixed-rate structure target has been achieved.

Duration is another way of measuring the length of time before refinancing risk occurs. Similar to ATM, higher duration values reflect lower refinancing risk. Compared to ATM, duration is a more sophisticated and accurate way of measuring refinancing risk because, in addition to capturing the risk of refinancing principal amounts at maturity, it looks at the refinancing risk associated with coupon or interest payments that occur through the life of debt instruments. Because duration considers financial flows through the life of the debt instrument, the duration will be shorter than the ATM of the same structure. At the end of March 2001 the Government’s debt had a duration of 4.4 years, excluding swaps.

Cost at Risk

Cost at Risk measures the debt cost variability associated with different debt structures.

The Government has recently enhanced its long-term cost/risk sensitivity analysis by introducing a more comprehensive measure known as Cost at Risk (CaR). CaR contributes to the Government’s debt management decisions by quantifying the risk directly in terms of potential debt cost. This measure is similar to the well-known Value at Risk measure used extensively throughout the financial community.

CaR is a sophisticated and rigorous way of identifying whether the risk of higher debt-servicing costs, measured in dollars, falls within the Government’s tolerance level for risk. CaR analysis involves simulating future debt costs using approximately 1,000 possible interest rate scenarios. The analysis is performed with various debt structures in order to better determine the relationship between debt structure, debt costs and risk. The purpose of the simulations is to identify the dollar amount of additional debt costs that would occur with a certain probability.

The CaR analysis framework is depicted in Figure 2. First, a large number of interest rate scenarios are generated, based on a theoretical model from the economic literature, to represent the full range of plausible developments in the interest rate term structure. The outstanding stock of debt is considered and several issuance strategies are developed. The simulation is then performed for all interest rate scenarios to generate a statistical distribution of possible debt costs and the cash flows for each issuance strategy. The average debt cost and CaR statistic are extracted from the obtained distribution along with projected cash flows. The cash flows are then used to forecast the fixed-rate share and maturity profile indicators.

The statistical distribution for the debt costs has the general shape of the distribution in Figure 3. As a rule of thumb, scenarios with a large positive (negative) shock to interest rates lead to high (low) future debt costs. However, the central tendency is for most shocks to be small in nature. The debt structure is seen as prudent when there is only a 5-per-cent probability that an increase in interest rates causes debt costs to exceed the defined tolerance level. In other words, when evaluating different debt structures (or issuance strategies), a key factor is whether or not CaR falls within a risk tolerance range that is acceptable to the Government.

It should be noted that unlike other measures such as fixed-rate share, ATM and duration, CaR is not an objective measure because it depends on several assumptions. In particular, experience has shown that results are very sensitive to the interest rate scenarios employed. The Government is continuing to develop the CaR analysis.

2000-01 Cost/Risk Analysis Results

Cost at Risk analysis indicates that the current two-thirds fixed-rate debt structure helps to control interest rate exposure.

Sensitivity analysis shows that there is a low probability that interest rate shocks would disrupt the fiscal framework.

Analysis was done in 2000-01 on the cost/risk trade-off using the current two-thirds fixed-rate structure and two alternative debt structures – one with a 5-per-cent higher and one with a 5-per-cent lower fixed-rate debt share. Assuming no changes to interest rates, the 62-per-cent fixed-rate debt structure is the less costly among the three debt structures. However, in the event that interest rates increase by 100 or 300 basis points (i.e. 1 per cent or 3 per cent), the 62-per-cent debt structure becomes more costly than the two other higher fixed-rate debt structures. (Note that the comparisons of alternative debt structures are only indicative because it is impossible to specify what debt issuance decisions would have been taken had the Government been operating with alternative fixed-rate share targets.)^[3]

The analysis indicates that increasing the fixed-rate share of the debt to two-thirds has significantly reduced interest rate exposure. For example, the first-year impact on net debt-servicing costs ^[4] of a 100-basis-point shock in interest rates in 2000-01 would be $900 million under the current structure, compared to $1.8 billion at the time of the 1995 budget. Such a shock would add approximately 15 basis points to the effective interest rate on the debt in the first year. That is, net debt-servicing costs to net debt would increase by 0.15 per cent. It is estimated that net debt-servicing costs under a 100-basis-point shock would increase by $1.1 billion^[5] under a lower fixed-rate share of 62 per cent – some $200 million higher than under the current two-thirds fixed-rate share.

With a more severe 300-basis-point shock, the degree of protection afforded by a higher debt structure is proportionally larger. For example, the impact on net debt-servicing costs would be about $500 million higher with a 62-per-cent fixed-rate share than with a 67-per-cent fixed-rate share.

The analysis also indicates that the reduction of interest rate exposure from raising the fixed-rate share of the debt has a cost. Fixed-rate debt issued since 1996-97 generally paid higher interest rates than Treasury bills in 2000-01, so costs might have been lower by about $100 million in 2000-01 (2 basis points) had the Government not increased the fixed-rate share beyond the 62-per-cent level achieved in 1996-97. It is important to note that this cost differential may vary substantially from year to year based on the term structure of interest rates. 

The difference in costs depicted in Chart 19, for example, reflects a relatively flat term structure (i.e. a smaller difference between short-term and long-term interest rates) compared to historical averages, which would tend to reduce the cost difference between shorter- and longer-term securities.

Results of the most recent CaR analysis, based on upgraded assumptions and methodologies, indicate that with the two-thirds fixed-rate structure in place on March 31, 2001, there is a high probability that the impact of most interest rate shocks would not disrupt the fiscal framework.

Maintaining a Diversified Investor Base

Diversified Investor Base

A diversified investor base is maintained to ensure active demand for Government of Canada securities, thereby reducing funding costs.

A diversified investor base helps to reduce funding costs by ensuring that there is active demand for Government of Canada securities. The federal government pursues diversification of its investor base by maintaining a liquid and transparent domestic wholesale debt program that is attractive to a wide range of investors, and in foreign borrowings through the use of a broad array of sources of funds. In addition, Canada Investment and Savings, the Government’s retail debt agency, contributes to a diversified investor base by offering savings products designed to suit the needs of individual Canadians.

Domestic Holdings of Government of Canada Debt

In 2000 (the latest year for which figures are available) life insurance companies and pension funds accounted for the largest share of domestic holdings of Government of Canada market debt (31.2 per cent), followed by public and other financial institutions such as investment dealers and mutual funds (see Chart 20). Taken together, they accounted for 52.6 per cent of domestic holdings.

There was a significant shift in the distribution of holdings of Government of Canada market debt in the 1990s. Life insurance companies’ and pension funds’ share grew from 21.6 per cent in 1990 to 31.2 per cent in 2000. Bonds and bills held by public and other financial institutions also increased sharply over the 1990-2000 period – from 10.6 per cent in 1990 to 21.4 per cent in 2000. Much of the increase is attributable to a significant increase in holdings by mutual funds. Chartered banks’ share of holdings of market debt increased from 9.5 per cent in 1990 to 17.6 per cent in 2000, while the share of persons and unincorporated businesses decreased by more than 23 percentage points to 9.4 per cent of domestic holdings. The latter change can largely be attributed to the shift towards more interest in equity investments by Canadians, particularly in recent years.

However, in the past year there have been no major changes in the distribution of holdings of government debt. Reference Table IV shows the evolution of the distribution of domestic holdings of Government of Canada debt since 1976.

Foreign Debt and Assets Management Strategy

Foreign debt is used exclusively to raise foreign exchange reserves.

The Government of Canada borrows in foreign currencies exclusively to raise foreign exchange reserves for the Exchange Fund Account. The reserves in the Exchange Fund Account are maintained as a source of liquidity and can be used to promote orderly conditions in the foreign exchange market for the Canadian dollar. Further details on the management of international reserves is available in Exchange Fund Account - Annual Report, available on the Department of Finance Web site at www.fin.gc.ca.

The key objectives of Canada’s reserve program are to:

• ensure that an appropriate level of reserves is maintained while minimizing the cost of carrying reserves;
• immunize to the extent possible currency and interest rate risks by selecting reserve assets that match the liabilities in currency and duration; and
• maintain diversified funding sources and a prudent liability structure to help manage refinancing needs.

Level of Reserves

The level of foreign exchange reserves has been increased in recent years.

In recent years the Government has made a steady effort to increase Canada’s international reserves with the objective of bringing the level more in line with that of comparable sovereigns. Reserves have been increased from US$11.9 billion at December 31, 1992, to US$33.5 billion at March 31, 2001 (see Chart 21). With the increases, the Government has made substantial progress in meeting its objective.

In 2000-01 international reserves increased by US$2.4 billion while foreign currency debt increased by US$0.4 billion.^[6] Foreign exchange reserves increased as a result of cross-currency swaps of domestic obligations and purchases of US dollars in the spot foreign exchange market.

The Gap Between Foreign Currency Assets and Liabilities

The gap between foreign assets and liabilities is being reduced over time.

Foreign currency liabilities came to exceed liquid foreign currency assets (i.e. cash, deposits and securities) in the Exchange Fund Account in recent years, largely as a result of extensive foreign exchange intervention and important commitments to the International Monetary Fund in 1998. Consistent with the Government’s policy of immunizing currency and interest rate risk in Canada’s reserve program, the Government is taking steps to bring foreign currency liabilities in line with foreign currency assets.

In December 1998 the Department of Finance, in collaboration with the Bank of Canada, implemented a program of purchases of US dollars in the foreign exchange markets. The proceeds of sales of Canadian dollars are used to reduce US-dollar-denominated liabilities. This program is conducted by the Bank in its role as fiscal agent for the Government in its management of the federal debt.

Purchases of US dollars are small in relation to the large daily flows in foreign exchange markets and are undertaken with sensitivity to market conditions. The objective is to close the gap between foreign currency assets and liabilities over the next few years. When the program was implemented, the gap was some US$13 billion, and substantial progress has been made in closing it: as of March 31, 2001, the gap between foreign currency liabilities (US$36.6 billion) and liquid foreign currency assets (US$30.2 billion) stood at some US$6.3 billion.

Collective Action Clauses

Canada has led the world in introducing collective action clauses to promote international financial stability.

In April 2000 Canada announced that it was adopting collective action clauses in its future foreign currency bond and note issues. Collective action clauses in bond contracts facilitate debt restructuring by providing an orderly framework for debtors and creditors.

By bringing in collective action clauses, Canada indicated that it was helping to lead the process of having collective action clauses adopted by all countries. These clauses are part of Canada’s effort to promote international financial stability and reduce the risk and severity of global financial crises. In recent years there has been a growing consensus that the wider use of collective action clauses in international bond contracts could contribute to a more orderly resolution of financial crises.

The documentation governing Canada’s two foreign currency note programs (the Euro Medium-Term Note and Canada Note programs) has been modified to ensure that all future issuance under these programs includes collective action clauses. Future global bond issues by Canada will also include these clauses.

Risk Management Framework

The Government is developing a collateral management framework to better manage the Government’s credit risk.

The Government has in place a comprehensive risk management framework for identifying and managing treasury risk, including market, credit, operational and legal risks related to the financing and investment of the foreign exchange reserves. The Government’s risk management policies call for prudent management of treasury risks based on best practices. Standards for risk tolerance are very prudent, with market risks generally immunized and high credit quality and diversification standards followed.

In June 2000 the Minister of Finance approved a new framework and limits governing credit exposure to commercial financial institution (FI) counterparties with respect to the Government’s foreign currency reserve portfolio. The framework is consistent with best practices in credit risk management and includes a rigorous, comprehensive credit risk system and credit exposure limits on counterparties across all lines of business.

In this context, the Government is proceeding with the development of a collateral management framework to better manage the Government’s credit risk to FI counterparties associated with cross-currency swaps and forward contracts. Collateral management systems are increasingly the norm in capital markets as a way of managing credit risk associated with swaps. The effect of collateralization is to limit the exposure to the FI counterparty to the transaction by holding collateral when there is a material risk of loss.

Management of the Government’s Cash Balances

The main cash management objective is to ensure that the Government has sufficient cash available to meet its operating and liquidity requirements.

The main objectives of the federal government’s cash management operations are to ensure that the Government has sufficient cash available to meet its operating and liquidity requirements, and to invest cash in a prudent, cost-effective manner. Currently the federal government invests its cash balances with a limited number of deposit-taking institutions (participants in the Large-Value Transfer System) through a twice-daily auction process.

Management of the Government’s cash balances requires forecasting and monitoring of its daily receipt and disbursement flows, as well as an ongoing borrowing program to refinance maturing debt and maintain the balances at targeted levels. There are inherent and large uncertainties in forecasting daily changes in cash balances owing to the scope of the Government’s financial operations, periodic large maturities of Government of Canada bonds, the operations of the Bank of Canada and changes in market conditions. An adequate level of cash balances must be maintained at all times to meet these operational requirements and provide an appropriate liquidity cushion for the Government’s financial operations.

The level of the Government’s daily cash balances averaged $10.2 billion in fiscal 2000-01, up from $8.4 billion in fiscal 1999-2000. Earnings on term deposits averaged 5.61 per cent versus 4.78 per cent the previous year. Compared to the weighted cost of Treasury bill borrowings, the Government earned a positive spread by 4 basis points in 2000-01.

Proposed New Cash Management Investment Framework

A new cash management framework is being implemented.

In 1999-2000 the Department of Finance and the Bank of Canada undertook a review of the investment framework for the Government’s domestic cash balances, as part of ongoing efforts to ensure that the Government’s financing and investing operations are efficient and cost-effective and meet the standards of best practices appropriate for a sovereign government. The review led to the release of a discussion paper in July 2000 on changes to the auction framework and subsequent consultations with market participants.

The proposed changes to the framework are designed to increase competition in the auction of cash balances and to strengthen the management of risks, in particular the credit risks involved in the investment of cash balances. In summary, it was proposed that access to the auctions be opened to all significant participants in the domestic money market to ensure competitive returns are earned on cash balances and to diversify the Government’s counterparties. The Government also proposed to introduce a credit risk management system through the use of credit ratings, credit lines and collateral agreements. At the end of 2000-01 work was continuing on the refinement of these proposals.

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