III. The Role of Government Securities in the Danish Financial Market

III.1 GOVERNMENT SECURITIES AS A BENCHMARK

Pricing of financial instruments plays an important part in well-functioning financial markets. Good pricing contributes to efficient capital allocation.

Most models for pricing of financial instruments are based on a valuation of the subcomponents of the financial instrument. The price of a bond may, for example, be divided into the risk-free interest rate and the price of risk.^[1]

With AAA ratings, Danish government securities have a high credit standing and can thus be applied as an estimate of the risk-free interest rate. Furthermore, government securities are liquid, standardised instruments. Were the yield curve to be based on illiquid securities or more complex instrument types there would be a risk that pricing would be disturbed.

If no government securities are available, pricing will have to be based on other financial instruments. The three closest substitutes will be considered in the following: the swap market, the mortgage-credit market and highly rated euro-denominated government securities.

The swap market as a benchmark
The swap market has increasingly been used as a reference in the pricing of instruments in recent years. The primary reasons are that liquidity in the swap market has increased considerably and that the total outstanding in the swap market (notional value) by far exceeds the total outstanding volume of fixed-income securities in Europe, cf. Chart III.1.1. Besides, interest-rate swaps are standardised instruments that cover the most important points on the curve. The euro-swap market contributes to providing a reference curve across the European countries and thus makes comparison possible.

It may, however, be a challenge to use the swap curve instead of the government yield curve. As swap rates include counterparty risk, the swap curve depends on the credit standing of the underlying banks. When uncertainty and risk aversion increase in the market, the spread between the government yield curve and the swap curve – the swap spread – will typically widen. It may be inexpedient to use the swap curve for price comparison over time due to its higher vulnerability to uncertainty and risk aversion.

Especially in periods of financial turmoil there is a tendency for differences between government securities and other securities to become more apparent. For example, the turmoil in the financial markets in the 2nd half of 2007 resulted in a widening of the swap spread, cf. Chart III.1.2. Since 1999, the 10-year swap spread has fluctuated between 10 and 70 basis points.

Mortgage-credit bonds as a benchmark
The mortgage-credit market has previously been a benchmark in the Danish bond market. The Danish mortgage-credit market is characterised by a large outstanding volume and low credit risk. Furthermore, there is typically a concentration of liquidity in the short and very long securities.^[2] Liquidity in each maturity segment is dispersed among several issuers.

The yield spread between government bonds and mortgage-credit bonds is normally limited. In connection with the market turmoil in the 2nd half of 2007, the yield spread between government and mortgage-credit bonds widened in line with the development in the swap market, cf. Chart III.1.3. In these situations it is more difficult to use mortgage-credit bonds as an estimate of the risk-free interest rate.

Euro-denominated government securities as a benchmark
Denmark's fixed-exchange-rate policy vis-à-vis the euro implies that euro-denominated government securities may largely be comparable to Danish government securities in kroner. Investors may therefore, as an alternative to the Danish yield curve, use government securities from euro area member states with a high rating as an estimate of the risk-free interest rate in connection with pricing in the Danish fixed-income markets. The euro-denominated government security market is very liquid, cover the most important points on the yield curve and is largely free of credit risk.

Structure and support of efficient markets
Markets for government securities are often said to be a prerequisite for building up a well-functioning domestic financial market. Government securities may also play a part in well-developed markets, e.g. as an underlying asset for other types of financial instruments. In 2002 Australia decided to maintain a market for government bonds with reference to its futures market.^[3] Government bonds are the underlying assets in interest-rate futures contracts and therefore necessary for maintaining a futures market.

In Europe, there is a large and liquid market for futures on German government bonds that plays a considerable part in respect of pricing in the European fixed-income markets. This market is dependent on continued issuance of German government bonds.

III.2 GOVERNMENT SECURITIES AS INVESTMENT OBJECTS

Traditionally, government bonds have made up a large part of the portfolios of the Danish pension funds, e.g. due to regulatory conditions. The pension funds have obligations with long duration. The interest-rate risk can be hedged by investments in government securities with long duration.

In recent years, the pension funds have extended their investment universe to comprise a wider range of instruments. Especially the derivatives market has attracted more investors since the end of the 1990s. Today, the pension funds undertake a large part of their risk management via the Danish and European interest-rate swap markets.

Danish government securities are still an investment object in the pension funds' asset portfolios. The interest-rate swap market cannot be used to cover the pension funds' need for placements in assets as such.^[4] The overall compilation from the pension funds shows that Danish government securities make up a relatively large part of the total bond portfolio. Approximately 15 per cent of the bond portfolio was placed in Danish government securities in 2006.^[5]

According to several pension funds, the interest for Danish government securities reflects that they from time to time yield returns at the same level or slightly higher than other European highly rated government securities. For a number of years, the pension funds have restructured their portfolios on the basis of fluctuations in the yield spread. High tradeability in the Danish government-securities market underpins the opportunity for extensive portfolio restructuring. Since the pension funds' obligations are denominated in kroner, there is thus an incentive to invest in Danish securities (home bias).