Debt Management Strategy 1999-2000: 1
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Overview

Effective management of the federal debt is important to all Canadians as the annual cost of servicing the debt currently takes about 27 cents of each dollar of revenue collected by the federal government.

In 1998-99, the government achieved its objective of prudently restructuring the debt stock by reducing the share of the federal debt that is maturing or repriced within a year. As a result, the government can better manage unexpected changes in interest rates -- a 100-basis-point increase in interest rates today would raise public debt charges by $0.9 billion in the first year, while in the mid-1990s, the first year impact of a 100-basis-point increase was estimated at about $1.8 billion.

Based on results to date, over the fiscal years 1997-98 and 1998-99, a total of almost $20 billion of market debt is expected to be retired. With a commitment to a balanced budget or better in each of the next two fiscal years, the stock of outstanding market debt is expected to continue to decline.

In this context, the debt strategy priority in 1999-2000 will be the maintenance of a well-functioning Government of Canada securities market, which provides low-cost financing for the government. Key initiatives in this regard include consultations on the possible restructuring of the Treasury bill program and the continuation of the pilot bond buyback program into 1999-2000.

The report is divided into the following sections:

• Debt Management Framework, outlining the objectives and key principles of the federal debt management strategy;

• Debt Management Environment, outlining the fiscal outlook over the next two years, and the impact on the debt structure and Government of Canada securities market;

• 1999-2000 Debt Management Strategy, highlighting overall debt strategy and providing an overview of initiatives for the next year; and

• 1999-2000 Federal Debt Programs, providing outlooks for each of the debt programs for 1999-2000.

Debt Management Framework

This section outlines the federal government's objectives in managing the federal debt and the key principles underlying the pursuit of these objectives.

Debt management objectives

In the current environment of declining market debt, the task of debt management is to refinance maturing debt. In this context, the debt management objectives are to:

• provide stable, low-cost funding for the government; and

• maintain and enhance a well-functioning market for Government of Canada securities.

Domestic debt management

Principles

• Funding required for the government's domestic operations is raised in the domestic market.

• The government borrows on a regular, pre-announced basis.

• The government focuses on liquidity, transparency, regularity and market integrity in order to maintain a well-functioning market.

• Given the key role played by federal government securities in Canada's fixed-income market, adjustments to the domestic debt programs are made in consultation with market participants.

General strategy

• The debt stock is structured prudently to ensure reasonable cost stability under a range of potential interest rate environments. The target debt structure is not based on a particular interest rate outlook.

• Large benchmarks in Treasury bills and Government of Canada bonds are maintained to provide market liquidity.

• Bond benchmarks are built at the 2-, 5-, 10- and 30-year maturities, and a Real Return Bond benchmark is also maintained.

• The government maintains a broad investor base and active relations with investors and credit rating agencies.

Foreign currency debt management

Principles

• The government borrows in foreign currencies as required to fund Canada's foreign exchange reserves.

General strategy

• The government raises foreign exchange reserves through a range of programs, including short-term discount notes, medium-term notes, public bond issues and cross-currency swaps of domestic obligations. The liabilities are managed in conjunction with the assets to limit the cost of carrying reserves, and to maintain a prudent maturity structure.

Debt Management Environment

Fiscal outlook: implications

Over the past five years, Canadians and their governments have made tremendous fiscal progress, measured by both domestic and international standards. In 1993-94, the federal deficit was $42 billion and the net public debt as a share of gross domestic product (debt-to-GDP ratio) was rising. Canadians wanted their governments to act. The federal government responded with a measured and responsible plan to eliminate the deficit. That plan was based on a fundamental reform with accompanying reductions of program spending, complemented by a prudent approach to budget planning.

The plan has worked. A budgetary surplus of $3.5 billion was recorded for 1997-98 -- the first surplus since 1969-70. A balanced budget or better is expected for 1998-99. As well, the government is now committing to balanced budgets or better for both 1999-2000 and 2000-01.

The Debt Repayment Plan and continued economic growth will ensure that the debt-to-GDP ratio remains on a permanent downward track. The debt-to-GDP ratio is expected to fall to just under 62 per cent by 2000-01, about 9 percentage points lower than the peak of 71.2 per cent five years earlier in 1995-96.

The budgetary deficit/surplus -- the budgetary balance -- is the most comprehensive measure of the government's financial situation as it includes liabilities incurred by the government regardless of when the actual cash payment is made. It is largely presented on an accrual basis of accounting. However, it is only one measure of the government's financial position.

Another important measure is financial requirements/surplus. This measures the difference between cash coming into the government and cash payments made for programs and public debt charges during the year. Canada recorded a financial surplus of $1.3 billion in 1996-97, $12.7 billion in 1997-98, and on the basis of the current budget plan, is expected to record a surplus of $11.5 billion in 1998-99.

Financial requirements/surplus are broadly comparable to the measures of the budgetary balance used by other major industrialized countries, including the United States. Within the G-7, Canada was the first country to record a financial surplus in this decade and only Canada and the United States are expected to continue to record financial surpluses over the near term.

Financial requirements/surplus provide a broad indication of the change in market debt actually outstanding and held by investors. In 1997-98, the government retired $9.6 billion of market debt, and based on results to the end of December 1998, is expected to retire a similar amount in 1998-99, for a cumulative total of about $20 billion over the two years. With a commitment to a balanced budget or better in each of the next two years, which will result in financial surpluses, the stock of outstanding market debt is expected to continue to decline. However, the actual decline will depend not only on the government's financial surplus but also on foreign exchange transactions and changes in the government's cash balances. As a result, market debt programs will need to be gradually restructured.

Changing debt structure and holdings

In order to reduce exposure to unexpected changes in interest rates, the federal government has increased the portion of the debt in fixed-rate form¹ from 53 per cent, in 1993-94, to two-thirds in 1998-99. The federal government is committed to maintaining a prudent debt structure.

The federal government's market debt is made up of four major components: marketable bonds, Treasury bills, retail nonmarketable debt (primarily Canada Savings Bonds) and foreign currency denominated debt. In recent years, the composition of the federal government's market debt has undergone significant changes, with the share held in short-term instruments, primarily Treasury bills, declining, while the share held in longer-term instruments has increased. However, the composition of market debt is expected to remain largely the same over the next few years. The following chart shows the forecast composition of market debt for March 31, 1999.

Forecast composition of federal market debt
March 31, 1999

Federal government debt is held by a wide range of institutional and retail investors. Of note is the fact that non-resident holdings of Government of Canada debt have been steadily declining in the last few years, from a peak of 28 per cent of total market debt in 1993 to less than 25 per cent today.

Government of Canada securities market

A well-functioning Government of Canada securities market provides low-cost financing for the government. It is also of general benefit to the domestic capital market, where benchmark federal securities are key investments. Because these securities are actively traded, they act as pricing and hedging tools in the fixed-income market.

Liquidity², transparency, and regularity are the principles underlying the maintenance of a well-functioning market. Borrowing in the domestic market on a regular, pre-announced basis and building bond benchmarks, for instance, reflects these principles (further details of the 1999-2000 debt program plans are provided in a later section of this report).

As market debt declines, a high priority for the federal government is maintaining the attractiveness of the Government of Canada market to investors. The objective is to ensure that the Government of Canada securities market continues to be one of the most liquid and efficient sovereign markets in the world, featuring tight bid-offer spreads, large transaction volumes and high turnover ratios.

Initiatives taken in 1998-99 to ensure a well-functioning market include changes to the government's auction rules and the development of an Investment Dealers Association (IDA) Code of Conduct. The modified auction rules reinforce the integrity of the auction process for Government of Canada securities, and encourage participation in auctions by reducing the potential for manipulative behaviour prior to and during auctions. The IDA Code of Conduct, which is actively supported by the federal government and the Bank of Canada, establishes standards for the trading of debt securities in the secondary market³.

The federal government will continue to promote the development of the futures market for Government of Canada securities. The federal government's and the Bank of Canada's work with the Montreal Exchange and the investment community has contributed to the development of the highly successful futures contract based on 3-month bankers' acceptance rates (the BAX contract) and active 10- and 5-year Government of Canada bond futures contracts (the CGB and CGF contracts).

The federal government and the Bank of Canada continue to support the development of a screen-based information system on prices and trades in the secondary market in Government of Canada securities. The system would help improve market price transparency in the secondary market.

1999-2000 Debt Management Strategy

Providing stable low-cost financing -- maintaining a prudent debt structure and diversified investor base

While market debt is being reduced, the stock nonetheless remains large. Canada's debt stock is exposed to interest rate changes originating in Canada and around the world. Interest rate shocks can significantly affect the level of annual debt charges, as the portion of debt that is rolling over must be issued at the new prevailing market interest rates. Some $216 billion of the federal market debt will be maturing or repriced over the 1999-2000 fiscal year.

Maintaining a prudent debt structure is essential in protecting the government's fiscal position from unexpected increases in interest rates, as well as moderating refinancing risk. A prudent debt structure is one that provides reasonable cost stability under a range of economic scenarios. Such a structure also maintains investor and credit rating agency confidence.

The federal government's target of two-thirds for the fixed-rate share of the debt, set at the beginning of the 1998-99 fiscal year, has been achieved. This means that a 100-basis-point increase in interest rates would now raise public debt charges by $0.9 billion in the first year; in the mid-1990s, the first-year impact of a 100-basis-point increase was estimated at about $1.8 billion. As a result, the government can better manage unexpected changes in interest rates.

The federal government is committed to maintaining a prudent debt structure by keeping the target fixed-rate share of the debt at two-thirds. Fluctuations in the ratio will periodically occur due to operational considerations such as large maturing benchmarks.

A diversified investor base ensures that funding costs are kept low. The federal government pursues diversification of its investor base through the maintenance of a liquid and transparent domestic debt program, and internationally through the use of a broad array of sources of funds. In addition, Canada Investment and Savings, the government's retail debt agency, provides diversification by offering  savings products designed to suit the needs of individual Canadians.

Maintaining and enhancing a well-functioning market

Debt program design

To maintain transparency and regularity in its debt operations, the government will continue to borrow in the domestic market on a regular, pre-announced basis. This approach ensures market awareness of future debt operations, attracts a wide range of investors, and promotes liquidity. In 1999-2000, the government will continue to hold regularly scheduled quarterly auctions of 2-, 5- and 10-year bonds, and semi-annual auctions for the 30-year bonds. Quarterly auctions of Real Return Bonds will also be held.

To enhance liquidity in Government of Canada bonds, a pilot bond buyback program was implemented in 1998-99. The purpose of this program is to buy back existing less liquid bonds to support the maintenance of a liquid new bond issue market. By buying back less liquid bonds, the government's ability to maintain its strategy of building large benchmark bonds at key maturities is facilitated.

The pilot phase for the program will be extended into 1999-2000. The bond program for 1999-2000 has been designed incorporating buyback activity. Buyback transactions will occur in conjunction with selected bond auctions and will be announced with the auction size.

The Treasury bill program had to be adjusted significantly as the debt structure moved to a fixed ratio of two-thirds and following the success of the government in achieving financial surpluses. Treasury bill stock has declined from $166 billion at the end of fiscal year 1995-96 to $87 billion in December 1998. However, the impact of this decline on money market liquidity has been mitigated by growth in the bankers' acceptance (BA), commercial paper (CP), forward rate agreements (FRA) markets, and by the existence of a liquid bankers' acceptance futures contract (BAX).

In order to enhance liquidity in the Treasury bill market, the federal government changed the Treasury bill issuance to a bi-weekly pattern (from weekly) in the fall of 1997. In the fall of 1998, in expectation of a gradual continuing decline in the Treasury bill program size, the government commenced consultations with market participants regarding possible options for further Treasury bill program restructuring. These consultations are ongoing, and the government will announce its plans later in 1999.

The government also proposes to update the Financial Administration Act (FAA) through the 1999 budget legislation. The relevant sections of the FAA, which date back to the 1950s, need to be amended to modernize the federal government's debt and risk management capabilities, and clarify borrowing authority and the authority for setting the terms of distribution of federal government securities.

Looking further ahead, the government's plan is to adjust domestic debt programs over time to maintain liquidity in the Government of Canada securities market. The government will be proceeding on a gradual basis, in close consultation with market participants.

Foreign currency borrowing has become a more significant element of debt operations, reflecting the government's announcement in the 1996 and 1998 budgets of its intention to raise the level of reserves, and the increased intervention activity in the foreign exchange market in 1998. There is an active array of funding programs, including Canada bills and Canada notes, Global and Euro bonds, and Euro Medium-Term Notes.

Enhancing market integrity

The federal government and the Bank of Canada have been working closely with market participants on a number of initiatives to enhance market integrity.

In 1999-2000, the federal government and the Bank of Canada will be promoting adoption by institutional investors of a code of conduct similar to the one adopted by the Investment Dealers Association.

The proposed amendments to the FAA to clarify the government's authority for setting the terms of distribution of federal government securities are consistent with the changes in the auction rules made in 1998-99, which were directed at enhancing market integrity in the Government of Canada securities market.

The federal government and the Bank of Canada will also continue to support improved secondary market price transparency.

A note on the year 2000 issue

Since the last months of debt management operations for fiscal year 1999-2000 will take place in the new millennium, the potential impacts of the Year 2000 (Y2K) issue on debt operations have been carefully reviewed by the federal debt managers.

The Bank of Canada is responsible for providing fiscal agency services for the federal government. The Bank began planning for the year 2000 in October 1996. In April 1997, an internal Y2K impact assessment was completed by the Bank, which indicated that its systems will be fully Y2K ready.

Notes

¹ The fixed-rate share of the debt is the percentage of the gross debt that matures or is being repriced in more than 12 months. The target for the fixed-rate share of the debt is based on gross debt, which includes market debt and non-market debt. However, debt management activities focus on market debt only (see glossary for further information).

² A liquid market is a market with good trading volumes, where trades of medium and even large sizes can be effected quickly without materially affecting the price.

³ This initiative is directly linked to the auctions of Government of Canada securities through the new terms of participation in auctions for government securities distributors and customers.

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