The objective of this blog post is to illustrate the increased sensitivity of public debt charges to interest rate shocks and summarize the status of the Government’s plan to borrow at longer maturities.
Sensitivity of public debt charges to interest rate shocks
Large budgetary deficits in 2020-21 immediately raise the level of federal debt throughout the medium term. These deficits will be financed primarily through the issuance of interest-bearing market debt—that is, Treasury bills and bonds. All else equal, a larger stock of market debt increases the sensitivity of public debt charges to future changes in interest rates.
PBO regularly provides estimates of the sensitivity of the fiscal outlook to various shocks, including a permanent increase in interest rates of 100 basis points. Based on our September 2020 Economic and Fiscal Outlook, a permanent 100-basis point increase in interest rates would increase public debt charges by $4.5 billion in the first year (2021-22).[i] By the fifth year of the outlook (2025-26), annual public debt charges would be $12.8 billion higher than our baseline projection.
Compared to past fiscal outlooks, public debt charges are more sensitive (in absolute terms) to a permanent increase in interest rates. Recall, this is mainly because the Government must now service a higher stock of interest-bearing market debt than was projected in pre-pandemic outlooks.
Interest rates in advanced economies are currently near historical lows, so despite the record increase in federal debt, we project that the Government’s debt service ratio (that is, public debt charges relative to tax revenues) will reach 7.0 per cent in 2023-24, its lowest recorded level. Even under a scenario where interest rates permanently rise by 100 basis points higher than our current outlook, the Government’s debt service ratio would rise to 11.6 per cent, well below its peak of 48 per cent, and in line with the debt service ratio observed in 2013-14.[ii]
Sensitivity of other revenues and expenses to interest rate shocks
Changes in interest rates most materially affect federal finances through public debt charges on market debt. When interest rates rise, the Government, as a net debtor, faces higher expenses. However, a hypothetical increase in interest rates would also lower other federal expenses, thereby partially offsetting higher public debt charges. Most materially, higher interest rates require smaller provisions for actuarial gains/losses on future benefits.
The Government held $291 billion in net pension and benefits obligations for federal employees in 2019-20. At each fiscal year-end the present value of these future obligations is revalued using market-based interest rate expectations.[iii] A higher outlook for interest rates would decrease the present value of the Government’s pension and benefits obligations. The smaller obligation would require smaller annual provisions to make up the pension and benefit funding shortfall, shown as amortized gains/losses expenses. Decreases to amortization expenses for gains/losses would decrease total expenses and improve the federal budgetary balance.[iv]
In brief, the amortization of pension and benefit expenses is sensitive to interest rates in the opposite direction from market debt, functioning as a partial hedge within the Government’s fiscal framework.
Assessing progress on the Government’s debt management objectives
In the 2020 Fall Economic Statement, the Government signaled its intent to “borrow at longer maturities and lock in historically low interest rates, as well as enhance the predictability of debt servicing costs.” In practice, this means increasing the net issuance of long-term bonds relative to medium-term bonds and short-term Treasury bills.[v]
From 2000 to 2019, the Government systematically decreased relative issuance of debt at short maturities (less than one year), and increased issuances of 1- to 5-year maturities. Issuance longer than 5 years has comprised a stable but small share of Government borrowing since 2000—7.7 per cent of the Government’s market debt has been issued at maturities longer than 5 years (typically 10- and 30-year bonds). In 2020, the Government planned to issue 15.1 per cent of its market debt at maturities longer than 5 years.
Through the first 9 months of 2020-21, the Government’s debt issuance has largely conformed to the plan set out in FES 2020. That said, borrowing is tilted toward shorter maturities than planned because the large volume of Treasury bills issued at the onset of the pandemic have not been fully unwound.
Total gross issuance is at 79 per cent of the annual target. Treasury bills (the shortest maturity type of debt) are relatively over-issued (85 per cent of the annual target), and 30-year bonds (the longest maturity) are somewhat under-issued relative to the annual target (72 per cent).
Over time, larger relative volumes of long-term debt issuances would lengthen the time-to-maturity of the outstanding debt stock. To date, the stock of federal market debt is slightly shorter in time-to-maturity compared to recent history, mostly because the large volume of Treasury bills issued at the onset of the pandemic have not been fully unwound. PBO will continue to monitor the implementation of the Government’s 2020-21 Debt Management Strategy in future reports.
[ii] In our September 2020 outlook, short-term interest rates were projected to remain near current levels through 2023 and then gradually increase (the 3-month treasury bill rate was projected to increase from 0.2 per cent to 1.45 per cent by the end of 2025-26). Longer-term interest rates were projected to gradually increase from current levels, with the 10-year Government of Canada benchmark rate rising to 2.1 per cent by the end of 2025-26. Despite this increase, we projected interest rates (in 2025-26) to remain below their long-term levels (estimated at 2.20 per cent for 3‑month treasury bills and 3.0 per cent for the 10-year government bond rate).
[iii] For unfunded pension and other future benefits, the Government’s cost of borrowing is derived from the yields on the actual zero-coupon yield curve for Government of Canada bonds, which reflect the timing of the expected future cash flows.
[iv] The Government also earns interest revenues, which would increase under a scenario of higher interest rates. Higher interest revenues contribute to smaller budgetary deficits, albeit to a smaller magnitude than market interest and future benefit amortization expenses.
[v] The dual objectives of federal debt management are to: (i) raise stable and low-cost funding to meet the financial requirements of the Government of Canada and (ii) maintain a well-functioning market for Government of Canada securities.
Achieving stable and low-cost funding involves striking a balance between the costs and risks of different debt maturity structures. Generally, interest rates increase with the maturity of debt – also known as an upward sloping yield curve. Therefore, the marginal cost of debt increases with the longer time horizon that debt is ”locked-in” to a fixed interest rate. The Government must aim to balance low marginal borrowing costs with minimizing the marginal risks of rolling over maturing debt.