The Demise of the 30-Year Treasury Bond as a Benchmark or Pricing Fixe — Income Securities - Statistical Data Included

Business Economics, Oct, 2000 by David M. Jones

THERE ARE SOME GOOD ALTERNATIVES.

With all the drama and finality that the prestigious Wall Street Journal could muster, it declared this past May 3 that the reign of the 30-year Treasury bond as the benchmark for pricing fixed-income securities in the $14.7 trillion U.S. bond market had ended. Without missing a beat the Wall Street Journal shifted the "benchmark" crown to the brow of the 10-year Treasury note, already the basis for the rate that is charged on most home mortgages. This article will examine the reasons for the demise of the 30-year Treasury bond as the U.S. bond market benchmark and consider possible substitutes to be used as the new benchmarks for pricing fixed-income securities. This search for a new benchmark is important because of the crucial role that long-term interest rates play as an influence on aggregate demand, particularly business investment and housing activity, and in timely portfolio shifts between bonds and stocks.

For much of the twentieth century, U.S. bond market participants used a collection of top-notch corporate bonds, such as telephone or railroad bonds, as the benchmarks for pricing fixed-income securities. But in 1977, there was a sudden change as the U.S. Treasury began regularly auctioning 30-year bonds. The U.S. government's debt outstanding was, at the time, starting to show sustained expansion against the background of mounting annual Federal budget deficits. In order to finance this expanding government debt burden, the Treasury found it necessary to issue new securities in all maturity sectors including the long-term end of the Treasury debt market. Of course, the 30-year Treasury bond (as well as other U.S. Treasury securities) is backed by the full-faith and credit of the U.S. government; it is considered a credit risk-free investment with no peer.

The 30-year Treasury bond hit its zenith as the fixed-income market's benchmark during the period of heaviest Treasury borrowing--the mid-1980's through the early 1990s. Helping the 30-year Treasury bond gain stature as a benchmark was a surge in sales and trading activity. In 1991, for example, a peak amount of $47 billion of 30-year Treasury bonds was auctioned by the U.S. Treasury.

More recently, however, the supply of 30-year Treasury bonds has been shrinking at an astounding rate, thanks to mounting Federal budget surpluses in 1998, 1999 and projected for 2000. Over the coming decade, the Congressional Budget Office projects that a continuation of these annual surpluses will result in a dramatic shrinkage in Treasury debt held by the public from $3.6 trillion at the end of fiscal 1999 to only $0.9 trillion at the end of fiscal 2009. Reflecting these declining Treasury demands on the U.S. capital market, only $20 billion in 30-year Treasury bonds were auctioned in 1999; and this year these bond sales are expected to whither away further to $15 billion, dramatically reducing trading activity and liquidity in the long-term sector of the Treasury securities market. In addition, the Treasury has announced a "buy back" plan amounting to $30 billion in 2000 aimed at phasing out long-term bonds sporting the highest interest rates and at maintaining efficiently large auction size and liquidit y of the most recent (on-the-run) issues. The powerful pull of shrinking supply on the 30-year Treasury bond yield caused it to drop below the yield on 10-year Treasury notes at the start of 2000, defying the normal relationship between these yields implied by an upward sloping yield curve. Some market observers are speculating that the Treasury will eliminate its 30-year bond offering altogether, as budget surpluses mount and government borrowing needs contract further.

The demise of the 30-year Treasury bond as a benchmark is indicated in Figure 1. Beginning in September, 1999, futures contracts on the 10-year Treasury note pulled ahead to garner more "open interest" than previously dominant contracts on the 30-year bonds. "Open interest", or contracts outstanding, represent interest by investors in a particular futures contract that they favor holding, prior to sale or expiration. Rising "open interest" thus implies increased investor preference for, and rising trading activity in, particular futures contracts. In this case, the ascent of the 10-year Treasury note as a possible new benchmark for pricing fixed-income securities is suggested. The main problem with the 10-year Treasury note as a new benchmark, however, is that Treasury debt paydowns and especially this year's buybacks are causing the 10-year yield to be distorted downward along with the yield on the 30-year bond, as the market supply of these issues threatens to dry up. As a result, the spreads between the 1 0-year Treasury note and both corporate bond yields and mortgage rates are widening and, owing to declining liquidity, especially in longer-term Treasury issues, becoming more volatile.

After he was elected in November 1992, President Bill Clinton realized that in order to gain the confidence of global bond market investors and facilitate a much-needed decline in stubbornly high long-term interest rates, he had to find some common ground of macroeconomic policy cooperation with the Chairman of the Federal Reserve, Alan Greenspan. This common ground proved to be an emphasis on cutting the structural Federal deficit. Following the pattern of deficit reduction measures established by the Bush administration in 1990, the Clinton deficit-cutting plan of 1993 raised taxes, mainly on the rich, cut defense spending, and reaffirmed tight caps on nondefense discretionary spending. Subsequently, the balanced budget agreement of 1997 validated the Bush and Clinton deficit cutting plans, with particular emphasis on maintaining tight caps on nondefense discretionary spending. The result was a pronounced decline in the ratio of the Federal deficit to GDP, falling from 4.7 percent as recently as 1992 to 0. 3 percent in 1997 (see Table 1). As strong economic growth and spectacular capital gains on equity holdings have generated additional tax revenues, a federal budget surplus emerged in 1998. Subsequently, the ratio of the surplus to GDP has grown from 0.8 percent in 1998 to 1.4 percent in 1999 and an estimated 2.0 percent in 2000.