The Killer B's Econoday Focal Point 6/15/00 By Damir Fonovich and Evelina Tainer

Borrowing, Buybacks and Benchmarks

Government borrowing diminishes in 1990s…
Borrowing money is a practice used by most consumers, whether to get a loan for a new car or a mortgage on a new house. The U.S. government has similar needs, financing its operations by borrowing from the public. The U.S. Treasury sells marketable securities from short-term bills (such as the 3-month bill) to long-term bonds (the 30-year bond) as well as non-marketable debt such as U.S. savings bonds. The U.S. of course accumulated massive amounts of debt in the 70s and 80s with budget deficits peaking in the early 90s. Reducing the size of the debt and spending money more efficiently were important goals of the Clinton administration. Thanks to a booming economy brimming with tax receipts, their plans worked better than anticipated. In 1998, the United States achieved a rare milestone -- bringing in more money than it spent. While Congress and President Clinton argued over better uses for this surplus, both sides were in agreement that public debt was too large. This agreement eventually led to the U.S. Treasury using the surpluses to buy back high-yielding Treasury securities.

Government surplus generates Buybacks…
The U.S. Treasury announced in February that it planned to concentrate its buyback operations at the longer-end of the maturity spectrum. That means buying back 30-year bonds. After this first announcement, Treasury officials indicated that perhaps some of the buybacks would occur across the entire spectrum of the yield curve. Yet bond investors suspected that the 30-year bond would remain the focal point. Immediately, prices of 30-year bonds rallied and yields fell sharply, reflecting the outlook for decreased supply and increased demand.

To gain better perspective on why yields have fallen so sharply, let’s keep in mind that total U.S. debt is currently over $5.6 trillion. On May 31, the monthly statement of the public debt showed $639.7 billion of Treasury 30-year bonds were outstanding. This accounts for nearly 21 percent of total marketable debt. The average interest rate on these bonds was 8.5 percent – a full 2.5 percentage points higher than the average interest on Treasury notes (remember, Treasury notes range from 2-year to 10-year maturities). It makes sense for the Treasury to reduce its interest costs!

The first buyback of U.S. securities took place on March 9, 2000, with the Treasury buying back $1 billion of outstanding issues scheduled to mature between February 2015 and February 2020. The initial Treasury projection was to buy back $30 billion worth of securities for the year, which is less than 5 percent of the amount outstanding. The U.S. Treasury has accepted $11 billion worth of securities through May. The estimated dates for buyback operations through August are listed below.

 

Treasury Debt Buyback History
	* in billions of dollars
Date	Offers Received	Offers Accepted
3/9/00	8.627	1.000
3/16/00	6.446	1.000
4/20/00	8.525	2.000
4/27/00	10.831	3.000
5/18/00	9.771	2.000
5/25/00	8.114	2.000
6/22/00
6/29/00
7/20/00
7/27/00
8/17/00
8/24/00
Total		11.000
Source: Market News International

The newly revised 10-year budget estimates from the White House’s Office of Management and Budget and the Congressional Budget Office (to be released later this summer) are projecting higher than expected surpluses. These surpluses could exceed $4 trillion within 10 years, which could mean the elimination of the public debt by 2008. Budget forecasts can be wrong and there is no guarantee the Treasury will complete the payment on the debt. Yet, there will almost certainly be a drastic reduction in the amount of debt and a definite reduction in interest obligations. The net effect of these buybacks will lead to a new problem – a shortage of risk-free Treasury bonds.

Impact on the Bond Market
This potential shortage of Treasury securities is causing market participants to become concerned, particularly in the case of the 30-year bond, whether Treasury prices accurately reflect a risk-free rate of return. The market, in particular companies which finance their operations by selling long-term debt, calculates rates of return and forecasts future earnings potential against this ‘risk-free’ investment in 30-year securities. The 30-year bond has been considered a benchmark against which private and other public securities have been valued. With buybacks past and buybacks to come, investors are concerned that the lack of Treasury securities is distorting the risk-free rate of return, casting doubts on the effectiveness of the 30-year bond as an appropriate benchmark.

Impact on the Fed
The Fed uses Treasury securities to conduct open market operations which are aimed at maintaining stability in the banking system. The Fed also uses open market operations to affect U.S. monetary policy – that is to raise or lower interest rates. With a reduced supply of Treasuries, the Fed may now have to change its operations and find other securities to fund them. This will create a need for a new benchmark that will accurately portray the fixed-income market – a replacement for the 30-year bond.

Benchmarks…
The issue of establishing a market benchmark has led to many new developments. Since the 70s, when the 30-year bond was first auctioned and the 20-year bond was discontinued, the 30-year bond has been considered the benchmark. But the current trend in the market is to value all corporate and agency bonds on the basis of the 10-year note, and not the 30-year bond. The Wall Street Journal has even started updating the 10-year note on its daily charts instead of the 30-year bond.

Since long-term U.S. Treasury securities may no longer be the most accurate portrayal of risk-free investing in the bond market, investors are turning to other vehicles. For example, The Fed has started buying agency securities, such as those issued by Fannie Mae and Freddie Mac, to conduct its open market operations.

This use of Fannie Mae and Freddie Mac, the private but still government-supported housing and mortgage agencies, has come under close scrutiny from the market, as these two organizations have been increasing in power and clout. They had already planned to increase their offerings of long-term securities late last year when the Treasury first hinted at the buyback operation. This was seen as an effort to establish themselves as benchmarks, a status that would increase demand and lower borrowing costs for their securities. Some market analysts are critical of the Fed for giving these organizations more clout than necessary. Despite the lack of a government guarantee, they are considered nearly risk-free. With the blessing of Federal Reserve Chairman Alan Greenspan himself, the Fed is currently conducting open market operations with the purchase of Fannie Mae and Freddie Mac securities. Future open market operations may include any number of securities, including some private securities with no ties to the government.

Future of market…
So what does the future hold for the U.S. Treasury market? Well, it should be noted that Treasuries are the only securities in the United States that are fully guaranteed by the government. U.S. Treasury securities have consistently been used as a safe-haven for both domestic and international investment, as the U.S. has never defaulted on its debt. This is the main factor why U.S. Treasuries are so valuable to global investors. So, the death of Treasury securities has been greatly exaggerated. The Fed will continue to use Treasury securities as the primary source for initiating and regulating monetary policy.

Yet it isn’t inconceivable that the Fed would start buying other securities, such as Fannie Mae or Freddie Mac, more frequently in order to conduct monetary policy. Fed chairman Greenspan noted the Fed might eventually choose corporate bonds in addition to and sometimes in place of Treasuries in affecting monetary policy. They have used corporate bonds in the past.

THE BOTTOM LINE
So where does this leave the individual investor? Treasury securities are not likely to disappear from the investment world altogether. However, reduced supply coupled with domestic and global institutional demand may leave smaller quantities of these securities for individual investors. But then again, individuals may find that they prefer to buy higher yielding securities – such as agency issues and certainly corporate bonds. In May, investment grade bonds were running 155 basis points over 10-year Treasuries, for instance.

updated 6/15/00