Risks related to the central government’s borrowing and debt can typically be grouped under the following broad risk categories:
Market riskRelates to changes in market prices such as interest and exchange rates
Refinancing riskRefers to the risk that debt will have to be refinanced at an unusually high cost or, in extreme cases, cannot be refinanced at all
Liquidity riskRefers to the risk that the government cannot meet its financial obligations, for example as a result of a lack of access to capital markets
Credit riskRefers to the will and ability of counterparties to fulfil payment obligations.
Market risk comprises the risk of higher debt servicing costs and increases in the market value of debt arising from movements in market prices such as interest rates, exchange rates and consumer prices. The central government’s market risk management has typically been focused around the risk of higher interest costs rather than changes in the market value of the debt. It is, however, also relevant to stabilise the market value of the debt, since increases in the market value are realised directly as capital losses on buybacks or indirectly as higher interest expenses over the term of the debt than the current interest rate level would indicate.
The primary market risk factor for the government debt is interest rate risk. The strategic interest rate risk management focuses on stabilising the government’s long-term interest costs as well as the market value of the debt. Typically, there will be a trade-off between stabilising interest costs and the market value of debt. An important element in the risk management is therefore to balance the risk of higher interest costs if the interest rates rise more than expected, against the risk of locking in high interest rates in a market where interest rates fall.
The interest rate risk management follows the asset liability management (ALM) approach, which means that cash flows on assets and liabilities administered by Danmarks Nationalbank are managed together. In practice, this for example means that interest rate risk on government bonds is partly offset by relending to government-owned companies.
The interest rate risk is managed through the use of interest rate swaps, as the central government’s issuances and buybacks are largely tied to demand and liquidity considerations. The use of derivatives is necessary to differentiate the interest rate risk strategy from the funding strategy. As interest rate swaps are used to hedge risk on the debt portfolio, the swap book’s performance should not be assessed on an isolated basis, but as part of the entire debt portfolio’s performance.
The interest rate risk on the central government debt is formally measured by the average time to refixing of the debt portfolio – i.e. the duration. The decision-making on the interest rate risk is, however, to a large extent based on simulation and scenario calculations of the development of interest rate costs and the market value of the debt.
Exchange rate risk is the risk of higher costs due to changes in exchange rates. When the central government raises foreign loans in currencies other than euro, the currency exposure on interest payments and redemptions is swapped to euro or Danish kroner using derivatives. The end-exposure of the central government’s foreign debt portfolio is therefore solely in euro. This entails a very low exchange rate risk due to Denmark‘s fixed exchange rate policy towards the euro.
Inflation risk is the risk of higher costs caused by movements in consumer prices. A small share of the government’s debt is issued as inflation-linked bonds, which means that the principal is linked to the Danish consumer price index. Fluctuations in consumer prices will therefore affect the government’s debt and interest costs. The inflation risk arising from the inflation-linked bonds is limited as the inflation-linked bonds only make up a small amount of the government’s total outstanding debt.
The central government’s refinancing risk covers the risk that debt will have to be refinanced at an unusually high cost or cannot be rolled over at all. This could, in the end, include the risk that the central government cannot meet its financial obligations. The refinancing risk thus differs from the central government’s interest rate risk, which exclusively relates to the effect of changes in the interest rate level. Generally, the refinancing risk is higher when a large part of the debt is concentrated on a few, specific maturity dates, as well as when the average maturity of the debt is short, such that large amounts of debt must be refinanced within a short amount of time. To mitigate the refinancing risk, the central government diversifies its financing sources and its investor base. In addition, the funding strategy seeks to avoid concentrations of redemptions, while buybacks and switch operations further contribute to smoothing the maturity profile. The refinancing risk is monitored using various indicators of the concentration of the government debt, including the maturity profile, the short-term refinancing amount and the average term to maturity. In order to facilitate access to updated information on the Danish government debt structure, these indicators will be published on the first banking day of each month.
The maturity profile provides an overview of the volume and concentration of payment obligations that the central government faces in the coming years.
- The indicator only includes redemptions and interest payments on domestic debt.
- Interest payments are stated as actual interest payments on a non-accrual basis.
- Future payments on the inflation-linked bonds are uncertain due to the inflation indexation. It is assumed that the index coefficient increases by 2 per cent per year, calculated from the value of the index coefficient at the end of the previous month.
The short-term refinancing volume is defined as the redemptions on existing domestic debt over the next 12 months, and thus expresses repayments payable by the central government in the short term. The indicator is a useful tool to monitor the government’s imminent refinancing risk.
To limit the central government’s short-term refinancing risk, an upper limit has been set for the short-term refinancing volume of 30 per cent of the gross debt.
- The short-term refinancing volume include redemptions on domestic bonds, T-bills, EMTN loans and commercial papers.
- Redemptions on the inflation-linked bonds are uncertain due to the inflation indexation. It is assumed that the index coefficient increases by 2 per cent per year, calculated from the value of the index coefficient at the end of the previous month.
The average time to maturity (ATM) summarises the entire maturity profile of domestic liabilities in one figure. It is calculated as a weighted average of the time until maturity and coupon payments, the weights being the payments’ shares of the total nominal payments.
This indicator is published both with and without T-bills.
- The indicator includes all maturing domestic bullet loans, including T-bills, and coupon payments on bonds.
- Future payments on the inflation-linked bonds are uncertain due to the inflation indexation. It is assumed that the index coefficient increases by 2 per cent a year, calculated from the value of the index coefficient at the end of the previous month.
Liquidity risk covers the risk that the government cannot service its financial obligations, for example due to a lack of market access to refinance existing debt. Liquidity risk and short-term refinancing risk are therefore closely related, but liquidity risk can also stem from other causes, such as large, unexpected financing requirements, and is therefore often treated separately.
The central government’s liquidity profile is characterised by large gross in- and outflows each year. The primary liquidity risk scenario for the central government is therefore a scenario where several large payments fail or are overdue – as was the case during covid-19.
To mitigate the liquidity risk, the central government holds a liquidity buffer in cash, maintains market access to short-term borrowing in the international money markets via the commercial paper programmes and diversifies the investor base through bond issuances in foreign currencies. In the daily liquidity risk management, forecasts of the central government’s account balance are monitored to ensure that the central government has liquidity to cover expected payments as well as a buffer to cover unexpected payments.
Credit risk is the risk of a financial loss caused by a counterparty’s default or missing ability to fulfil payment obligations. The central government uses swaps to manage the interest and exchange rate risks on the debt portfolio. If the market value of a swap agreement is in favour of the central government, a credit exposure arises.
The central government manages the counterparty credit risk by, among other things, requiring that counterparties have a sufficiently high credit rating and by setting limits on the credit exposure to the individual banks. To further reduce the credit risk, the central government has entered collateral agreements (CSAs) with all of its counterparties. Under these agreements, the central government pledges and receives daily collateral for the market value of the swap portfolio. The credit exposure to the individual counterparty is therefore reduced to the current market value of the swap portfolio less the collateral provided by the counterparty.
Characteristics of CSA agreements:
- Two-way obligation to pledge collateral.
- Only accepted collateral is a cash deposit of kroner.
- Pledged collateral accrues interest at the Danish T/N (Tomorrow/Next) rate. The interest rate may be negative.
- Threshold value of zero, i.e. full collateral for the market value.
- Minimum transfer amount of kr. 500,000.