(Extract from page 5 of BIS Quarterly Review, December 2011)
This box describes the estimation of Italian government debt service costs in various yield curve scenarios. The baseline yield curve uses the average issuance cost prevailing in the first half of 2007, before the global financial crisis erupted. Two scenarios shift the entire baseline yield curve up by 200 and 500 basis points, respectively, while an additional scenario uses the Italian yield curve observed on 9 November 2011 (Graph 2, centre panel).
The next step consists in constructing a database of all debt securities outstanding at each point in time. To do so, we first calculate a time path of future interest payments on and redemptions of existing debt, and subtract the government's forecast of future primary surpluses to obtain gross issuance needs. In meeting those needs, we assume that the Italian Treasury maintains the issuance policy followed in the years 2010-11, namely rolling over the same share of total issuance in 2010-11 for every maturity. This presumes that the Treasury does not dynamically adapt its issuance policy by altering maturities in response to changes in the yield curve. Our estimates are thus likely to overestimate debt service costs somewhat.
The yield curves of the different scenarios are then applied to the relevant debt securities over a three-year horizon. Whereas higher yields raise the debt service costs of newly issued fixed rate bonds, they affect both existing and newly issued floating rate notes.1 The overall debt service costs for each scenario, aggregated by year, are then expressed relative to the baseline costs, resulting in the additional debt service costs shown in Graph 2 (right-hand panel). The simulation is based on the assumption that Italy retains continued market access.
1 Regarding inflation-linked securities, inflation expectations are held constant at current levels, with real yields running parallel to nominal yields in every scenario.