Activity report 2017

Transcription

1 March 2018 Federal Treasury Activity report 2017 Schweizerische Eidgenossenschaft Confédération suisse Confederazione Svizzera Confederaziun svizra Federal Department of Finance FDF Federal Finance Administration FFA Swiss Confederation

2 Imprint Published by: Federal Finance Administration FFA Photo: Federal Finance Administration FFA March 2018 The Federal Treasury activity report explains the strategies and results with respect to the Confederation s debt management, liquidity management and foreign exchange management in It is tailored primarily to the Federal Council, the Finance Delegation, and the Swiss Federal Audit Office. Once they have acknowledged it, the report will also be made accessible to interested members of the public.

3 Table of contents Page Summary 5 Guidelines and targets Treasury activity 11 Developments on the Swiss capital market 11 Funding requirements and liquidity trend 14 Funding in the money market 15 Funding in the capital market 17 Foreign exchange management 24 Presentation and evaluation of the risk situation 29 Interest rate risk 29 Refinancing risk 30 Forex risk 32 Counterparty risk 32 Outlook 33

4 85billion in debt is managed by the Federal Treasury. 77 billion of this is market debt (money market debt register claims and bonds) 0.15 percent was the interest on the bonds issued in By issuing long maturities, the federal budget will benefit from these low interest rates in the long term. 10years is the average term to maturity of the Confederation's market debt.

5 Summary Interest rates in Switzerland have been falling steadily for 25 years now. This trend seemed to have come to a halt in 2017, and interest rates trended sideways still predominantly in negative territory. Like in recent years, the Federal Treasury benefited from the low interest rates by issuing long-term bonds. Overall, bonds worth 4.4 billion with an average maturity of 21 years and a market yield of 0.15% were issued. The level of short-term debt (money market debt register claims) was kept stable at around CHF 7 billion. All in all, market debt was further reduced to around CHF 77 billion. The interest rate and refinancing risks decreased further thanks to the longterm focus of the issuance strategy and the sustained reduction in market debt. The proportion of debt requiring refinancing within the next 12 months relative to total marketable debt remained relatively stable (18% at the end of 2017). The term to maturity of the debt portfolio rose from 9.7 years to 10.0 years. From an international perspective, such refinancing risk can be described as appropriate and the pursued funding strategy as fairly conservative. This is also depicted by the risk analyses conducted using simulation calculations. As a result of the persistently low interest rates and a lack of investment opportunities, disposable funds are placed exclusively with the SNB. Accordingly, there are virtually no counterparty or credit risks. The liquidity held by the Federal Treasury is still above average on the whole. The trend toward paying withholding tax early and postponing refund requests intensified further, causing the new investor, the taxpayer, to become even more significant. In 2017, the Confederation adjusted the accounting for financial liabilities in line with international standards. As a result of this change, the debt recognized has risen on the one hand, and interest expenditure has been aligned with actual interest on the other hand, thereby increasing budget accuracy for bonds. In the case of budgeted foreign currency requirements, the opportunity costs have fallen to 0.5% of the hedged volume since the introduction of the hedging strategy in These costs will be offset again in the long term, as foreign currencies are systematically purchased for the following budget year. Therefore, purchases are simply delayed by one year relative to currency trends. The strategy of fully hedging multi-year, large-volume foreign currency purchases ( special transactions ) was reviewed in detail in As the Swiss franc s traditional tendency to appreciate is factored into the purchase rates and only unforeseeable shocks lead to deviations, the hedging strategy was not adjusted. 5

6 85billion in debt is managed by the Federal Treasury. 77 billion of this is market debt (money market debt register claims and bonds)

7 Guidelines and targets The central Treasury, run by the Federal Finance Administration (FFA), ensures the Confederation s ability to fulfill its payment obligations at all times (Art. 60 para. 1 of the Financial Budget Act). The three main tasks of the Federal Treasury stem from this statutory mandate: Debt management: coverage of the funding needs by means of funding in the money and capital market at the lowest possible cost and with an acceptable degree of risk The Federal Treasury ensures the Confederation's ability to fulfill its payment obligations at all times Liquidity management: assurance of an appropriate level of liquidity to even out liquidity fluctuations; low-risk short-term investment of liquidity at usual market interest rates or short-term coverage of liquidity shortfalls Foreign exchange management: central procurement and management of foreign currencies to ensure planning certainty Treasury statement of financial position and its impact on the 2017 federal budget Revenue (money and capital market investments) Assets/investments Liabilities/debt Expenses (interest payable) 0 mn Liquidity Cash, investments 14.7 bn Money market debt register claims 7.2 bn -72 mn 159 mn Treasury loans (SBB, ALV, railway infrastructure fund) 14.4 bn Bonds 69.5 bn 1.4 bn Savings bank for federal employees 2.7 bn 1 mn Deposit accounts 6.0 bn 0 mn 7

8 Debt management governance Federal Council, Parliament, market players Fiscal policy and economic framework conditions Federal Department of Finance Federal Finance Administration Asset & Liability Committee Requirements Targets Refinancing risk Interest rate risk Debt strategy Benchmark portfolio Issuance guidelines Tactical deviations Reporting Federal Treasury Debt management Issuance program Possibly derivatives The Federal Treasury manages a significant proportion of the Confederation s balance sheet with these activities, which involve substantial expenditure and receipts. Since the Confederation is a net borrower, this mostly concerns debt management with interest payable. The Federal Treasury has little leeway regarding the volume of debt, as the funding requirements depend primarily on the development of the federal budget and thus on fiscal policy. Nevertheless, the Federal Treasury s debt management has a significant impact on interest payable : since the interest rates for short maturities are generally lower than those for long ones, the Federal Treasury can reduce the average interest burden by issuing more short-term debt instruments. However, this increases the interest rate and refinancing risk, as the debt needs to be renewed more frequently. Conversely, it can reduce these risks by issuing long-dated instruments, but this leads to higher interest expenditure on average. The interest rate risk is a relevant variable for fiscal policy, as unexpected changes in interest expenditure affect the leeway for budgeting other expenditure. Consequently, the Federal Treasury has a risk limit which it may not exceed for debt management. This risk budget is part of the FFA s targets in performance management with the new management model for the Federal Administration (NMM). They are agreed with the Department on an annual basis. Within these risk guidelines, the FFA s Asset and Liability Management Committee (ALCO) specifies a debt strategy which the Federal Treasury then has to implement with its issuing activity. Monitoring and reporting are carried out by an independent middle office (Risk Control). Liquidity and foreign exchange management are also associated with risks, which are controlled by the ALCO and monitored by Risk Control. 8

9 NMM targets Limit Actual 2016 Refinancing risk: the FFA helps ensure that the Confederation's refinancing risk is bearable. Maturity profile of money and capital market debt under 1 year (%, maximum) Maturity profile of money and capital market debt under 5 years (%, maximum) Maturity profile of money and capital market debt under 10 years (%, maximum) Actual Interest rate risk: the FFA helps ensure that the interest rate risk is bearable for the federal budget in the short and medium term. Accumulated interest rate risk for following 4-year periods: additional interest expense that will not be exceeded in 9/10 cases (CHF mn) Debt management risks The Confederation is confronted by two inherent risks when managing its debt: Interest rate risk: in the event of a rise in interest rates, debt will end up being issued at a higher rate of interest. This leads to higher interest expenditure, i.e. to a burden for the federal budget. The interest rate risk can be quantified using simulation calculations. Refinancing risk: as a result of declining creditworthiness on the part of the Confederation or major financial market turmoil, (re)financing in the market could result in higher/unfavorable market interest rates, or, in an extreme situation, could even prove impossible. This could jeopardize the objective of ensuring the Confederation s ability to fulfill its payment obligations. The maturity profile of outstanding debt as well as ratings are key indicators for the refinancing risk. 9

10 .15 percent was the interest on the bonds issued in By issuing long maturities, the federal budget will benefit from these low interest rates in the long term.

11 2017 Treasury activity Developments on the Swiss capital market Interest rates on the Swiss capital market did not fall further last year. The yield on 10-year Confederation bonds more or less moved sideways, albeit still at a historically low level, with an annual average of -0.10% (2016: -0.35%). Europe managed to achieve an economic turnaround and visibly regained financial markets confidence. The economic upswing was broadly based, and investors became more willing to take risks after the French presidential elections in the spring. The European Central Bank (ECB) also became more and more optimistic about the economy. In view of the still subdued inflation in the eurozone, however, it did not announce an end to its bond purchase program. It nevertheless decided in November to reduce the purchase volume from 60 billion euros per month to 30 billion euros, as expected by the markets. In the wake of the ECB s persistently expansionary monetary policy, the Swiss National Bank (SNB) kept its monetary reins loose too. The key interest rate remained unchanged at -0.75%, and the SNB signaled its continued willingness to intervene in forex markets. It now speaks only of a highly valued Swiss franc. Meanwhile, monetary policy normalization continued in the United States. In view of sustained economic growth, declining unemployment and rising inflation, the US Federal Reserve (Fed) raised key interest rates three times in 2017 and began to reduce its balance sheet. The transatlantic interest rate differential expanded further. With the tax reform being adopted by Congress, the United States additionally received a substantial fiscal policy stimulus. The dollar depreciated against the euro. Despite the significant reduction in debt over the past 10 years, the Confederation is still the biggest individual borrower in the domestic segment of the Swiss capital market (the Pfandbriefe, or mortgage bonds, are spread between Pfandbriefbank schweizerischer Hypothekarinstitute and Pfandbriefzentrale der schweizerischen Kantonalbanken). Furthermore, it is considered a risk-free borrower, which is why Confederation bond yields are a key benchmark for the Swiss financial market. In 2017, Confederation bond yields remained negative up to a term to maturity of around 12 years. Investors thus stayed reserved toward them and looked for alternative investments, i.e. they tried to avoid negative yields by accepting The yield on 10-year Confederation bonds more or less moved sideways at -0.1% higher credit, liquidity or interest rate risks. Accordingly, Confederation bond turnover in the secondary market was also comparatively low last year. The extraordinary monetary conditions are also visible in the investor base. In particular, the proportion of pension funds has declined significantly compared with However, this could also be partly due to the fact that their investments are increasingly appearing under funds in the SNB s banking statistics if they are investing their assets to a greater extent via single investor funds for tax reasons. The decline in the case of banks is likely to be largely due to stricter regulations and internal risk requirements. The proportion of foreign investors is still high. This is due to persistent distortions in forex markets: there has been an oversupply of CHF liquidity since 2011 because of the SNB s expansionary monetary policy. In the case of a basis swap of CHF for foreign currencies (particularly USD), the counterparty (e.g. the USD holder) receives a premium by temporarily buying CHF against USD. Therefore, USD investors can still generate a positive return or a higher return relative to an alternative investment in equivalent USD securities, despite investing the temporarily acquired CHF in securities with negative interest. 11

12 Development of government bond interest rates in % y Confederation 10y US Treasuries 10y Germany Optimistic ECB, growing confidence in eurozone Fed balance sheet reduction 0.00 Fed rate move, robust global economic situation Macron election win in % Sabre-rattling between US & North Korea US tax reform Political uncertainty in US & Europe Imminent French elections US special investigator, concerns about Italy Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Bloomberg 12

13 Confederation bond trading volumes on secondary market % % % % % % 40% % % % 0.0 0% in CHF bn turnover 2017 turnover in % of volume (rhs) Ø 2010 turnover in % of volume in same maturity area (rhs) Source: SIX Outstanding bonds in CHF domestic segment 100% Confederation bond investor base 100% 90% 80% 80% 70% 60% 60% 50% 40% 40% 30% 20% 20% 10% 0% % Confederation Banks (incl. cantonal) Other Pfandbrief institutions Cantons Investment funds Pension funds CH bank holdings Insurers Other domestic Foreign investors Source: SIX Source: SNB 13

14 Funding requirements and liquidity trend In the 2017 issuance program of December 2016, the Federal Treasury estimated the funding requirements to be covered on the market at around CHF 8 billion. However, it then actually raised only just under CHF 5 billion, as the cash inflows from the federal budget were much higher than expected. This was due primarily to withholding tax: incoming payments were up sharply on the previous year and were brought forward, whereas refunds decreased or were postponed. The trend that set in in 2015 thus became accentuated, with inflows from the federal budget occurring earlier in the year and turning out to be higher. It can be assumed that negative interest rates played an important role in this regard: no interest is paid on withholding tax payments made in advance and refunds claimed at a later date, which makes them an attractive alternative to money market investments with negative returns. For the Confederation, though, these taxes which are not paid on an accrual basis ultimately represent an alternative form of indebtedness. The Federal Treasury reacted to the high inflow of funds with a cautious approach to funding in the market: it kept the level of outstanding money market debt register claims low at around CHF 7 billion; CHF 4.4 billion was raised by issuing bonds (planned: 5 bn). The level of outstanding market debt thus declined by CHF 1.5 billion in nominal terms in 2017, and like in previous years there was a shift from market debt to the new investor, the taxpayer. Despite the restrained approach to funding, the high fund inflows caused the Federal Treasury s cash holdings to rise significantly. They were above the target range from the second quarter onward. Because of the negative money market interest rates, the Federal Treasury once again invested its liquidity exclusively in the SNB sight deposit account in 2017, with a current interest rate of 0%. Still high level of liquidity due to tax receipts not being on an accrual basis Aggregate net cash flows federal budget in bn 2017 liquidity trend in bn Bond maturing January February March April May June July August September October November December - January February March April May June July August September October November December Target range Liquidity Calculation: daily change in SNB sight deposit account less financing activities 14

15 Funding in the money market Due to the low funding requirements, the Federal Treasury applied restraint when procuring funds on the money market. Coming in at CHF 7.3 billion at the end of 2017, the volume of outstanding money market debt register claims was only slightly above the previous year s level (6.9 bn). An increase to around CHF 10 billion had been planned in the issuance program. An average of CHF 475 million was raised per auction (2016: 450 mn). The average yield for the year was -0.92% (2016: -0.99%). The money market debt register claims issued in 2017 thus generated interest receipts of approximately CHF 70 million for the Confederation (2016: 73 mn). The yields on money market debt register claims were regularly lower than comparable money market rates such as the Libor or SAR (Swiss average rate). This reflects the high creditworthiness of the Swiss Confederation as a borrower, but it is also the result of its regular and predictable market activity. Due to the still restrained allocation, yields were at the lower end of the bids submitted. On average, the Federal Treasury raised 475 million at -0.92% per week Although yields were significantly lower than the SNB s key interest rate (-0.75%), auction demand remained intact. One important reason for this was the above-mentioned distortions on forex markets (basis swap), which make investments in money market debt register claims comparatively attractive for USD investors in particular. Nevertheless, a look at the number of auction participants shows demand restraint and the narrowing of the primary market due to negative interest rates. Money market debt register claims Money market debt register claims (T-bills) are interest-bearing debt instruments that are issued at a discount by the FFA. These are tradable debt register claims entered in a main register kept by SIX SIS Ltd. Money market debt register claims have maturities of three, six and twelve months. A total of 16 money market debt register claims are always outstanding (11 three-month ones, 3 six-month ones and 2 twelve-month ones). The auctions are held weekly on Tuesdays on the platform of SIX Repo Ltd (rate tender with Dutch or single rate allocation procedure). No nominal interest rate is specified in the case of money market debt register claims; the interest is in the form of a discount at the time of issuance. This means that money market debt register claims are normally issued at a price that is less than 100% of the nominal value. Redemption is then at 100%. However, money market debt register claims are currently being issued at a price of more than 100%, i.e. with a discount surcharge, which means a negative interest rate. The regular issuance of these money market instruments is an important pillar of the Confederation s refinancing policy. A liquid market for money market debt register claims that functions well enables the Confederation to raise even larger volumes of borrowed capital at favorable conditions at any time. 15

16 Money market debt register claims Auctions in bn Total bids Accepted bids Yields in % 0.0% -0.5% -1.0% -1.5% Auction bid rage Yield LIBOR SAR Outstanding in bn 14 Maturity profile end of 2017 in mn 600 Average number of bidders Bidders per auction Bidders considered per auction 16

17 Funding in the capital market In 2017, the Federal Treasury raised funds on the capital market with eleven auctions. Except in January, two securities were always issued. Overall, bonds with a face value of CHF 3.9 billion were issued (2016: 3.3 bn). Coming in at CHF 30 million, the sale of own tranches was even lower than the previous year (100 mn). Factoring in the 2017 bond that matured in June (5.6 bn), the volume of outstanding Confederation bonds decreased by CHF 1.7 billion in nominal terms (2016: -6.1 bn). Because of an accounting change, cash inflows in the form of premiums have also been allocated to financing activities since 2017 (see next section). They are now reported as part of funding in the capital market. Because market yields were low relative to the coupons of the bonds issued also in 2017, the Federal Treasury earned premiums of CHF 0.5 billion (2016: 1.1 bn). A total of CHF 4.4 billion was thus raised by issuing bonds. Approximately 60% of bonds were issued in the medium-term segment (between 9 and 14 years). Moreover, the Federal Treasury once again issued considerable volumes of long and very long-dated bonds in On average, the interest commitment of the bonds issued in 2017 was 21.0 years (2016: 23.5 years). 5 of the 21 bonds auctioned were issued with negative yields. The weighted average yield was 0.15% (2016: %). Auction demand was subdued by long-term standards also in 2017, reflecting the high prices/low yields of Confederation bonds. Nonetheless, with an average total of 360 million bids per auctioned bond, it edged up again relative to the record low interest year of 2016 (+60 mn). Taking the average of all auctions, the bid to cover ratio was 2.0, i.e. the Federal Treasury accepted on average 50% of the bids submitted. Relative to the previous year (1.6 and 63%, respectively), it was thus somewhat more restrictive in allocation terms, but was more or less in line with the long-term average ( : 1.9 and 54%, respectively). The comparatively low issuance volume was thus due mainly to low demand. Investors reluctance in the primary market for Confederation bonds is also highlighted by the fact that as in the case of money market debt register claims far fewer bidders participated in the auctions than in The Confederation issued bonds worth 4.4 billion with a maturity of 21 years at 0.15% 17

18 2017 bond auctions Auction results Auction Issue Coupon Maturity Issue volume (in CHF mn) Total outstanding (in CHF mn) Yield Spread to swap Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % Conf / % % div. Own tranches div. div Total % Maturities and yields % % % % % % % % % 20% 41% 39% 1 5 years 5 10 years years >15 years Issue volume (in CHF mn) Average yield (in %) -0.3% 18

19 Confederation bonds Confederation bonds are the Confederation s most important instrument for covering its long-term funding requirements. The auctions generally take place on the second Wednesday of every month and are carried out on the platform of SIX Repo Ltd: upon issuance, only the nominal interest rate (coupon) and maturity are defined, while the issue amount and issue price (and thus the yield) are determined on the basis of the bids submitted by the platform participants (banks and insurance companies). The Federal Treasury allocates the bonds according to the single rate ( Dutch ) procedure, i.e. uniformly at the lowest acceptable price. The SNB is responsible for the technical and administrative processing of the auctions. Confederation bonds are listed on the Swiss stock exchange (SIX Swiss Exchange). The Confederation holds a limited volume of securities as proprietary holdings (first time not yet placed). These so-called own tranches are retained from auctions and if needed can be sold directly on the market between the ordinary auction dates. An overview of the own tranches available can be found on the FFA and SNB websites. Confederation bonds contain a reopening clause. As a result, a bond can be reopened with several auctions, thereby increasing its liquidity on the secondary market. The outstanding Confederation bonds, with their respective terms to maturity and yields, form the yield curve for government bonds. These yields constitute the risk-free reference interest rates for market participants, which allows for an efficient primary and secondary market not just for bonds, but also for associated interest rate derivatives. The Confederation s issues accounted for 9% of the total volume on the Swiss primary market last year, which was slightly lower than the previous year s 10%, but higher than the ten-year average ( : 7%). The plunge in the proportion of foreign issuers was offset primarily by the Pfandbrief institutions, which, with a share of 25%, took over from the Confederation as the main provider on the primary market. By issuing long-dated bonds, the Federal Treasury once again locked in low interest rates for a long time in 2017, and also benefited from the still flat interest rate curve in the process. With the long interest commitment, it clearly stands out by international standards. Only the United Kingdom has a similarly high proportion of issues with a term to maturity exceeding 20 years. The long interest commitment of recent years has resulted in a significant increase in the average term to maturity of the total outstanding market debt (bonds and money market debt register claims). Nonetheless, it should be noted in this regard that the development of the term to maturity also depends on the change in the volume of debt: if nominal debt increases, a constant interest commitment causes the term to maturity of the outstanding debt to rise too. The rise in the term to maturity of the Confederation s market debt was thus curbed by the sustained reduction in debt. 19

20 Development of the primary market for Confederation bonds Bids and allocation Total bids (in CHF mn) Accepted bids (in CHF mn) Ø Bid-to-cover ratio (rhs) Average number of bidders 16 Share of Confederation bonds on CHF primary market 100% % 80% 70% % 50% 40% 6 30% 4 20% Bidders per auction Bidders considered per auction 10% 0% Confederation Pfandbrief institutions Banks (incl. cantonal) Cantons & communes Other Foreign Source: SIX 20

21 Interest commitment and term to maturity Interest commitment and yield of Confederation bonds commitment Yield at issue 6% 5% Comparison of government bond interest commitment 100% 90% 80% 4% % % % % % Average term to maturity of issues (in years) 70% 60% 50% 40% 30% 20% 10% 0% Switzerland Australia Austria Canada Denmark Germany Netherlands Sweden 1 5y 5 10y 10 20y >20y United Kingdom Ø Term to maturity of federal market debt Breakdown of term to maturity change (bonds) Money and capital market debt (CHF bn) Ø term to maturity in years Volume effect Interest commitment effect Ø term to maturity in years (rhs)

22 Issuing principles of the Federal Treasury 1. The Confederation is committed to an efficient Swiss capital market that functions well, thereby ensuring regular and reliable refinancing opportunities. By issuing bonds, it makes sure that the most important maturities of 1 to 13 years are covered with liquid bonds. In the case of extremely long maturities, intermittent anchor points are to be placed on the yield curve with individual bonds. 2. The Confederation s debt portfolio comprises around 20 underlying bonds. There is only one bond per maturity. 3. The issuance program, together with auction dates and the gross and net annual funding requirements, is publicly communicated in December of the previous year. 4. Bond auctions take place on a monthly basis, with a summer break in August. Two dates are optional (usually April and November). 5. A bond with a maximum volume of CHF 6 billion is to mature per year. A minimum volume of CHF 2 billion is sought with the 10-year benchmark bond. 6. If possible, bonds should mature in the months of May to September; new underlying bonds are launched accordingly during this period. 7. Reopenings are possible for all bonds with a term to maturity of more than one year. 8. Pricing at auctions (allocation) is based on the funding requirement, investor demand, absolute interest rates, bid and offer prices, and the swap spread of the underlying bond. 9. Subject to a funding requirement, own tranches can be acquired from the Federal Treasury at any time at market conditions (pricing same as for bond auctions). Maturities that are not (or no longer) covered by auctions in the respective year are preferred. 10. Bond redemptions can be carried out for yield considerations (commissions) and to increase the market liquidity of other bonds. 22

23 Recognition of bonds at amortized cost Effective since 2017, the Confederation has been applying the accounting principles in accordance with the International Public Sector Accounting Standards IPSAS for financial instruments. IPSAS 29 requires financial liabilities held to maturity to be recognized at amortized cost. Consequently, not only the face value, but also other cash flows (premium/discount, interest payments, commissions) on an accrual basis on the valuation date are allocated to the debt (previously they were recognized as prepaid/accrued expenses and accrued/deferred income). In contrast, changes in these accruals and deferrals are now recognized as expenditure and receipts. This change has the biggest impact on Confederation bonds: first, because it is the Confederation s most important financial instrument, and second, because some of the bonds still outstanding were issued with large premiums. As of January 1, 2017, the restatement resulted in a CHF 5.2 billion increase in recognized bonds. The change also means that premiums received at the time of issuance are no longer reported as receipts (or a reduction in expenditure) in the federal financial statements, but rather as part of financing activities. Conversely, the accrual approach to amortization over the term leads to a long-term reduction in expenditure. With the new accounting standards, premiums are no longer of relevance for fiscal policy: accrual accounting means that it no longer makes any difference to the federal budget whether a bond with a high coupon relative to the market environment and a correspondingly high premium is issued or one with a coupon close to the market interest rate and a low premium. In both cases, interest expenditure reflects the yield or market environment upon issuance. In addition, the new accounting standards will significantly increase budget accuracy for bonds: the budget underruns seen in the past for interest expenditure were largely attributable to premiums. Effective since 2017, premiums are shown as part of debt Outstanding bonds in nominal terms and at amortized cost 8 4.0% 7 3.5% 6 3.0% 5 2.5% 4 2.0% 3 1.5% 2 1.0% 1 0.5% 0 0.0% Nominal (CHF bn) Premium (CHF bn) Coupon (in %) Ø yield at issue (in %) -0.5% 23

24 Foreign exchange management The Federal Administration s foreign currency requirements have been covered centrally and systematically hedged by the Federal Treasury since From the FFA s perspective, exchange rate developments essentially cannot be predicted. Accordingly, the Federal Treasury pursues a passive approach and does not apply active strategies involving exposure to rising and falling exchange rates. Hedging gives the administrative units planning certainty, and overruns of approved credits due to negative forex fluctuations can be avoided. The Federal Treasury distinguishes between budgetary transactions and special transactions: Budgetary transactions In the case of budgetary transactions, the administrative units budgeted euro and USD requirements for the coming year are hedged. Foreign currencies are purchased forward in parallel with the budget process (February to July). The budgeted volumes are purchased on an ongoing basis in batches of 5-10 million. By following this approach, an average exchange rate that corresponds to market developments is achieved, i.e. the budget rate more or less corresponds to the average exchange rate for the first two quarters. The FFA makes the purchased foreign currencies available to the administrative units at the exchange rates fixed in the budget. Due to the strengthening of the euro in the second half of 2017, hedging led to opportunity gains : the hedging or budget rate was The average spot rate in 2017 was Without hedging, the procurement of the 519 million euros required would have cost CHF 100 million, or 1.8%, more. Purchasing the required USD 832 million forward was also cheaper than purchasing it on an ad hoc basis (CHF 8 mn, or 1.0%). In the year under review, a total of 527 million euros and USD 512 million was purchased forward for the 2018 budget year with budget rates of 1.10 for CHF/EUR and 1.00 for CHF/USD. Since the introduction of currency hedging in 1998, euro and USD sums of CHF 22 billion have been purchased within the framework of budgetary transactions in other words, the equivalent of 1.1 billion francs worth of euro and USD on average each year. Hedging over this period resulted in opportunity costs for the Confederation of CHF 120 million, or 0.5% of the hedged volume. Special transactions Special transactions are predetermined payments in foreign currencies made over a period of several years within the framework of a credit line. Like the budget requirements, they are fully hedged in a bid not to exceed the CHF amount of the credit line due to negative forex fluctuations and to ensure planning certainty for the administrative units. The foreign currency requirements are systematically hedged During the year under review, six new special transactions were carried out in USD (total: 599 mn), four in euros (1,664 mn) and one in SEK (139 mn). They concerned the task areas defense, education and research, as well as international cooperation. As of the end of 2017, a total of 28 special transactions with an aggregate value of CHF 3.1 billion were open (euro, USD and SEK). Relative to a non-hedging strategy, opportunity costs of CHF 336 million, or 3.6% of the hedged volume, have accrued for all payments arising from special transactions that have become due ( ). 24

25 Foreign exchange management CHF / EUR CHF / USD 1.40 EUR spot rate 1.30 Purchase period 1.20 Budget rate = Average rate for purchase period EUR budget rate 1.10 USD spot rate USD budget rate Source: Bloomberg 25

26 Analysis of opportunity costs in the case of special transactions In view of the relatively high opportunity costs in the case of special transactions, the Federal Treasury carried out an in-depth analysis of the strategy of full hedging. The Swiss franc traditionally tends to be strong. Is this tendency to appreciate the cause of opportunity costs in the case of special transactions? If so, the opportunity costs would be systematic, and refraining from hedging would be cheaper on average for the Confederation. The rate for a forward exchange transaction (forward rate) consists of the spot rate at the time of conclusion and the so-called forward discount. The discount is the result of interest rate differences between the two currency areas: as CHF interest rates are traditionally lower than euro or USD interest rates, the forward rate for euro or USD purchases in CHF is lower than the corresponding spot rate. If this were not the case, arbitrage would be possible. This covered interest rate parity implies that systematic appreciation resulting from macroeconomic factors (especially the interest rate differential) is generally expected by the market and should thus be factored into forward discounts. However, forward rates do not include shock appreciation or depreciation during the hedging horizon (e.g. due to changes in the macroeconomic context, uncertainty or crises). The longer the hedging horizon, i.e. the longer the term of the forward transaction, the greater the likelihood of such deviations in the forward rate from the future spot rate, and the more severe the rate fluctuations, the greater the likelihood of these deviations (i.e. possible opportunity costs). A look at the exchange rate trend shows that purchasing rates in the years prior to the financial crisis were not systematically lower than the spot rates applicable for ad hoc purchases. Consequently, no systematic opportunity costs occurred. However, the CHF appreciated significantly in the wake of the euro crisis from 2010 onward, and purchases at current spot rates instead of the rates hedged in earlier years would have been much cheaper. The opportunity costs that occurred were characterized by the crisis-related extraordinary and sharp appreciation of the CHF in this period. Moreover, the volumes to be purchased were extremely high during this period, which further increased the opportunity costs. Finally, it has be taken into account that the opportunity costs incurred ex post stand against an unquantifiable ex ante benefit, i.e. the eliminated exchange rate risk and the assurance of planning certainty. For these reasons, the Federal Treasury will continue to pursue the strategy of fully hedging special transactions. The franc's tendency to appreciate is priced into forward discounts 26

27 Spot rates, purchase rates and opportunity costs of special transactions Hedging volume (CHF 10 mn) USD/CHF spot rate (rhs) USD/CHF spot rate (rhs) Opportunity costs/gains (CHF mn) EUR/CHF purchase rate (rhs) USD/CHF purchase rate (rhs) 27

28 10years is the average term to maturity of the Confederation's market debt.

29 Presentation and evaluation of the risk situation The Confederation s risk policy is defined by the Federal Council. The Confederation is prepared to assume risks in a controlled and deliberate manner, provided that this is unavoidable for the achievement of objectives or the performance of tasks. Risks should be minimized (instructions on the Confederation s risk policy). Aside from interest rate and refinancing risks, forex and counterparty risks must also be taken into account by the Federal Treasury when performing its main tasks. Interest rate risk The interest rate risk for the Federal Treasury is determined by the existing maturity profile and the planned new transactions. It is managed mainly by means of issuing activity. The debt strategy stipulated by the ALCO determines the issuing activity and thus the maturities of new transactions. Dynamic cost/risk simulation analyses are used to analyze the effects of various issuance strategies and different interest rate scenarios. A cost-at-risk approach is used to examine the development of interest payable and its fluctuations. Information is thus obtained to optimize the debt strategy from a cost and risk perspective. Moreover, the degree to which interest payable can fluctuate can be estimated, also with regard to the budget and financial plan. The interest rate risk is closely linked to the refinancing risk. High short-term maturities entail high interest rate risks, while long maturities dampen the risk of interest rate fluctuations. Analysis of the interest rate risk The analysis concept pursues both a prospective and a retrospective approach. The prospective approach consists in simulating and analyzing various issuance strategies with different interest rate trends over a period of up to ten years. On the one hand, selected deterministic interest rate scenarios are used. On the other, stochastic interest rate models are also used to generate a large number of interest rate paths. This enables a random distribution of potential interest payable to be calculated for different debt portfolios for a given planning period. This in turn makes it possible to establish average expected interest payable, as well as possible deviations and their probability (cost-at-risk approach). Based on this data, different issuance strategies can be compared with respect to the expected interest payable (cost dimension) and its future fluctuation ranges (risk dimension). In the retrospective analysis, differently composed debt portfolios are analyzed on the basis of actual interest rate developments and compared with effective interest payable. This means that the issuance strategy followed can be evaluated ex post and measured against other strategies. Moreover, this approach is also suitable for analyzing the different portfolios in typical sub-periods of interest rate development (rise in interest rates, inverted yield curve, etc.) and thereby gaining insights for strategy formulation. 29

30 An interest expense projection shows the trend of interest payable under various interest rate scenarios with an unchanged issuance strategy (i.e. issuing activity like in the past 3 years). In the process, the development of debt in accordance with the budget and financial plan is factored in. The interest rate paths from the stochastic simulation are based on an interest rate model that was calibrated for a period with rising interest rates. The mean is derived from this, as are the 10% and 90% quantiles for the development of interest payable. The baseline scenario is derived from macroeconomic assumptions and the corresponding interest rates of the federal government s economic forecasts expert group. A continuation of the very low interest rate environment is expected in the short term, with negative interest rates for short maturities. Interest rates are expected to normalize in the medium term, i.e. it is assumed that they will rise gradually. This scenario with a moderate rise in interest rates serves as a basis and is expanded upon in this analysis. The extreme scenarios include interest rates remaining low (constant interest rates), as well as an exceptionally sharp and rapid rise of 4 percentage points in interest rates (interest rate shock). Based on the baseline scenario, the Federal Treasury expects interest payable to remain more or less unchanged over the next few years. Only in the event of an interest rate shock would interest payable rise rapidly. This scenario is not very likely at the moment. In such a case, the additional interest receipts from the investment of liquidity would partly offset the increase in interest payable. Highest interest rate risk permissible The cumulated risk budget for interest rate risks is CHF 500 million for four years. This takes into account the Confederation s fiscal policy risk capacity and risk tolerance, i.e. the extent to which an increase in interest expenditure can be offset in another way without radical measures. This means that the fluctuations in interest expense forecast for the budget and financial plan time horizon may deviate from the mean by a maximum of CHF 500 million (90% quantile less mean). In the worst case, the corresponding risk can also occur within a year. The annual average for this interest rate risk was CHF 218 million in The risk budget is not fully utilized Due to the persistently low interest rate environment and the fact that a normalization of interest rates will not occur until the medium term, the ALCO decided to deviate temporarily from the issuance strategy defined as optimal (with shorter maturities). In the current environment, long maturities can continue to be financed at relatively low costs. Refinancing risk The maturity profile of outstanding market debt and the Confederation s rating are important refinancing risk indicators. The current maturity profile of money and capital market debt shows a moderate refinancing risk. 18% of market debt is due to mature within a year, and the average term to maturity of the debt portfolio has risen to 10 years. Consequently, the targets (or maximum shares) within performance management with the new management model for the Federal Administration (NMM) are clearly undershot. The maturity structure of the debt portfolio could thus be shortened significantly within the NMM specifications. On average, 20% of money and capital market debt is renewed yearly The Confederation s creditworthiness is given the highest rating by all relevant rating agencies. In the wake of the financial crisis, only very few countries maintained this top level of creditworthiness. Even in the case of unfavorable market conditions, the Confederation was able to raise the necessary funds on the money and capital market. 30

31 Interest expense projection in mn Maturity shares of money and capital market debt 100% % 80% 70% 60% 50% 40% 85% 60% % 20% 30% Mean 90% quantile 10% quantile Interest rate shock Baseline scenario Constant interest rates 10% 0% Dec 10 Apr 11 Aug 11 Dec 11 Apr 12 Aug 12 Dec 12 Apr 13 Aug 13 Dec 13 Apr 14 Aug 14 < 1 year (year s Ø) < 5 years (year s Ø) < 10 years (year s Ø) Limit < 1 year Limit < 5 years Limit < 10 years Dec 14 Apr 15 Aug 15 Dec 15 Apr 16 Aug 16 Dec 16 Apr 17 Aug 17 Dec 17 Stochastically simulated interest rate paths (10 years swap rate) 8% 7% 6% 5% 4% 3% 2% 1% 0% -1%

32 Hedged forex risks lead to greater adherence to the budget Forex risk The Federal Treasury purchases foreign currencies for the administrative units. The foreign currency requirements for the budget year for the main currencies of euro and USD and the payment obligations arising from special transactions are hedged. Since the Confederation constantly has certain foreign currency requirements, it is generally exposed to exchange rate developments. The primary objective when managing forex risks is thus to ensure adherence to the budget and planning accuracy for expenditure. Overruns of approved credits due to negative forex fluctuations are to be avoided. Forex risk Due to the uncertainty regarding future exchange rate trends, the procurement costs for covering administrative units foreign currency requirements are uncertain and subject to risk. The value of existing, unrestricted foreign currency positions can change due to exchange rate fluctuations. From the FFA s perspective, exchange rate developments essentially cannot be predicted. Accordingly, forex risks are systematically hedged using a passive approach. As a result, the Federal Treasury is not exposed to any substantial forex risks. Counterparty risk Counterparty risks for the Confederation arise primarily as a result of shortterm deposits (liquidity) and positive replacement values from outstanding currency and interest rate derivatives. These receivables are exposed to default risk. Treasury loans are granted to institutions affiliated with the Confederation and therefore are not part of the counterparty limit system; the amount of the loans is managed by means of treasury agreements. Treasury balance, assets side, in bn A credit limit concept forms the basis for avoiding losses and risk concentrations. The credit limits are established on the basis of predefined criteria, namely rating, equity, financial strength (in the case of cantons), diversification and instrument type. Risk Control regularly reviews the established counterparty limits and monitors compliance with the limits on a daily basis. The development of permitted counterparties credit quality is continually reviewed (e.g. rating changes, interim financial statements and other reports). The limits were complied with at all times in Liquidity amounted to CHF 14.7 billion at the end of It was placed exclusively with the SNB (at 0%, including the SNB sight deposit account) and thus without any risk The positive replacement values from outstanding currency and interest rate hedging transactions doubled last year, going from CHF 149 million to reach CHF 296 million at the end of December On the one hand, longer-term derivative positions (e.g. currency and interest rate hedging instruments) are entered into with counterparties that have signed a Credit Support Annex with the FFA. On the other, such transactions are also conducted with cantonal banks which have a state guarantee. 2 0 Liquidity Positive replacement values 31 Dec Dec 17 Treasury loans There are no significant counterparty risks for the Confederation 32