In short, the management of the Federal Government’s debt portfolio can be summarized as follows:
- achieving a target portfolio according to the cost and risk preferences of the issuer
- structuring the annual issuance calendar and using interest rate swaps
- measuring performance on the basis of total return costs
- improving the diversification of the portfolio
As service provider to the Federal Government as issuer, the German Finance Agency (Bundesrepublik Deutschland – Finanzagentur GmbH) is not only responsible for issuing Government securities to finance the Federal budget. Managing the debt portfolio and short-term liquidity fluctuations are also part of its core functions. The portfolio management activities extend from the annual issuance calendar through to money market activities and the use of derivatives.
The Federal Government raises funds in the money and capital markets, and is responsible for determining which instruments to use for the purpose. Active use of the new issue market combined with other financial instruments is aimed at reducing interest costs over the long term and limiting the risks which are inevitably inherent in any form of financing.
Decisions on the optimum mix of funding options are the product of a number of complementary approaches.
From Issuance Strategy to Portfolio Approach
An essential basis for secure funding is a functioning sales channel in the form of a liquid secondary market in outstanding, tradable German Government securities. The existence of a liquid market, where bid and offer prices are quoted for substantial volumes by a large number of market participants at any given time, is a considerable advantage for investors as well as for issuers. Investors can make investment decisions at any time according to their risk preferences and market assessment, while issuers are always ready to respond to market demand at fair prices. Large volumes can be issued in the primary market, with the secondary market providing reliable guidance for investors and issuers.
For many years, Germany has been committed to supporting the development of a highly liquid market. The result, today, is that German Government securities are firmly entrenched as the clear benchmark in the European bond market. The market owes this status to a number of factors. The issuance procedure is straightforward and clear, with a regular offering of securities for investors across all maturities from three-month “Bubills” through to strippable 10 and 30-year bonds. This primary market mechanism is supported by an efficient Auction Group and an automated bidding system. The new issue schedule, meanwhile, is transparent and dependable, with quarterly issuance calendars and advanced full year previews
Liquidity is supported by secondary market operations of the Finance Agency, as well as by the futures contracts traded on the Eurex futures & options exchange, which allows market participants to trade in notional Federal bonds (“Bunds”), five-year Federal notes (“Bobls”) and Federal Treasury notes (“Schaetze”).
As long as the market for German Government securities is the only available approach for optimizations of the debt portfolio an efficient sales- and information-strategy is the main factor. But focusing exclusively on an annual new issuance strategy, for example, can lead over time to the creation of a debt portfolio with a structure that does not necessarily meet the issuer’s objectives in terms of cost and risk. On the other hand, structuring a debt portfolio based purely on an issuer’s objectives rather than in response to investor demand could do irreparable harm to the borrower’s benchmark status. However, the Federal Budget Law has allowed the Government to access the swaps market, making it possible both to optimize the structure of its debt portfolio and to adhere to a transparent and efficient issuance policy that has stood the test of time. The use of swaps has allowed the fixed-interest structure of the dynamic debt portfolio to be modified and structured into an optimal debt. This involves combining an issuance approach with a portfolio approach, the essential prerequisite for which is a swap market that is at least as liquid as the market for German Government securities.
Mathematical portfolio optimizations are based on a number of assumptions that are not known ex ante, such as costs or possible fluctuations over the given time horizon. The structure of the optimum debt portfolio can therefore only be identified ex post and not before decisions are taken. Since the generation of realized savings is more useful than the construction of a theoretical portfolio, in practice an issuer will generally aim to improve rather than optimize a given portfolio through structuring.
Portfolio structuring measures need to be based on information that is considered reliable. Although the classic Markowitz approach is based on the analysis of historical data, it is worth evaluating how relevant historical patterns might be for the future. In asset management, macroeconomic data is analyzed in order to form an opinion about future market trends. Trading firms use flow and technical information as well. Information is only useful if it is not already fully priced in. Information can therefore only be used for a portfolio structuring measure if the market expectation implied by that information differs from the information that is already priced into the forward yield curve.
Information, and the market expectations it implies, only has relevance for a typical time scale. Historical analyses may be able to filter out statements about long-term averages. While flow and technical information can provide indications of short-term trends, the analysis of macroeconomic data can be a useful guide to likely developments over the medium-term. In structuring a debt portfolio, however, it is neither practical nor efficient to limit the analysis to a predetermined time horizon; instead, structuring needs to be based on a range of time scales.
Besides optimizing the debt portfolio in terms of costs and risk metrics with existing funding tools, the instruments themselves need to be kept under constant review. Issuance strategy needs to respond dynamically to changes in demand or the emergence of new market segments. In addition to managing the fixed-interest structure, the issuer should be ready to tap new markets if and when they offer funding opportunities at favourable levels on a long term horizon and/or diversification of the overall portfolio.
