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

As already noted, the new benchmark must have, at a minimum, a stable relationship with other fixed-income securities. Michael J. Fleming of the Federal Reserve Bank of New York, has found that, for the period from July 3, 1997 to October 29, 1999, the correlation of weekly changes between the 10-year dollar swap rate and the yield on the 10-year Treasury note was an impressively high 0.970. For the same period, the correlation between the 10-year dollar swap rate and the yield on investment grade corporate debt was slightly lower at 0.938, and for mortgage-backed securities 0.946. It should be emphasized that this relatively high correlation between the dollar swap rate and the yield on the 10-year Treasury note covers a time-frame prior to early 2000. During this period, the yields on longerterm Treasury issues were being distorted sharply downward by contracting new supply and announced buy-back operations. Thus, it could be argued that the dollar swap rate is the best benchmark to replace the Wall Street Journal's favored 10-year Treasury note yield, now that it is being increasingly distorted, along with the 30-year Treasury bond yield, by sharply contracting supply.

Conclusion

In sum, the dollar swap rate should serve as the new benchmark for pricing other fixed-income securities. The main advantages of the dollar swap rate are that it has a high correlation with other fixed-income market yields and that there is substantial activity in dollar swap agreements, including their use for hedging positions taken in other fixed-income securities. The main disadvantage of dollar swap agreements as a benchmark is their counter-party credit risk. To mitigate counter-party credit risk, some dealers execute dollar swap agreements out of credit-enhanced subsidiaries and structure the swap agreement itself so that it will automatically unwind if either counterparty's top credit rating is lost.

In the future, the dollar swap agreement will continue to be especially useful for hedging positions taken in other markets, including those for agency debt, corporate debt, and mortgage-backed securities. Serving to enhance the effectiveness of swaps for hedging purposes is the absence of an underlying asset, which allows dealers to take unlimited long or short positions without having to obtain securities in the repo market. These same features mitigate security-specific problems that might cause a particular maturity swap to deviate sharply from the performance of the whole swaps curve. In addition, the dollar swap rate can be used, just as the long-term Treasury bond yield had formerly been used, in evaluating, analyzing and predicting the performance of other fixed-income markets.

David Jones is Vice Chairman and Chief Economist, Aubrey G. Lanston & Co., Inc. He received his Ph.D. and MA in economics from the University of Pennsylvania and his BA from Coe College.

REFERENCES:

Coy, Peter. 2000. "From Anchor to Pogo Stick." Business Week. May 8.

Fannie Mae. 1999. "Fannie Mae Announces Monthly Calendar for Issuance of Bullet Benchmark Securities Spanning the Yield Curve." News Release. October 21.