Diminishing Treasury Supply: Implications and Benchmark Alternatives - Statistical Data Included

Business Economics, Oct, 2000 by Steven A. Zamsky

THE TREASURY CURVE DISTORTION THROWS ANALYSTS A CURVE BALL AND SENDS MARKET PARTICIPANTS SCRAMBLING FOR NEW BENCHMARKS.

Over the last year, the fixed income markets have become increasingly subject to technical distortions as the development of a U.S. government surplus has resulted in a diminishing supply of U.S. Treasury securities. This technical pressure has substantially inverted the yield curve, increased levels and volatility in yield spreads between government bonds and other fixed income securities, and created a great deal of confusion among market participants regarding appropriate benchmarks. The supply-induced inversion affects corporate finance, risk management, valuation and asset allocation, and will force the adoption of alternative benchmarks.

For several decades, persistent federal government deficits forced significant issuance of U.S. Treasury securities. From 1980 to the peak in 1997, U.S. Treasury debt outstanding grew from $1.6 trillion to $3.8 trillion (an annualized growth rate of 5.2 percent). Accelerating economic growth throughout the late 1990's and relative fiscal austerity have resulted in declining levels of net federal borrowing since 1992, culminating in a budget surplus in 1999. The Office of Management and Budget now forecasts surpluses to continue, to the tune of $300 billion a year until 2010 and $400-550 billion through 2012. Treasury debt outstanding now stands at around $3.2 trillion, and is shrinking rapidly--particularly in comparison to private sector debt. (See Figures 1 and 2.) Given the extent of the budget surpluses, the U.S. Treasury has reduced the size and frequency of its borrowings. It is also repurchasing its own securities--over $30 billion of notes and bonds is likely to be repurchased this year alone. Late i n 1999, the magnitude of this shortage became apparent, particularly in the long end of the yield curve (beyond ten-year maturities). As a result, investors rushed into Treasuries, particularly into longer-dated securities. The Treasury curve inverted sharply--first from ten-year notes to thirty-year bonds, then eventually along the entire curve from two-year notes all the way out to the thirty-year bond. (See Figure 3.)

Other fixed income instruments have been significantly resistant to this inversion, even in relatively short maturities. This supply dynamic, in conjunction with fundamental concerns regarding credit quality and the late stage of the economic cycle, has resulted in a dramatic widening in the spreads between risky fixed income assets and Treasury securities (beyond even the panic-induced levels of the 1998 meltdown). (See Figure 4.)

Treasury debt will not disappear overnight, and, forecasts aside, it is far from certain that all Treasury debt will be completely retired, as that outcome depends on future economic growth and fiscal policy. However, the unusual supply-and-demand dynamic in the market, and the resultant discrepancy in yield levels and curve shape, have brought into question the Treasury's benchmark status. Among the most likely alternative benchmarks are U.S. agencies (Fannie Mae, Freddie Mac, and the Federal Home Loan Banks), large private borrowers, and the interest rate swap market.

Until recently, even sophisticated market participants have taken for granted the central role of Treasury securities in the global financial markets. These extremely liquid, risk-free assets play critical roles in measuring monetary conditions and inflation expectations, in valuing corporations, risky securities, and markets, and in facilitating trading and risk management on a global basis. Finding a suitable alternative benchmark will not be easy.

Why Treasuries Are a Good Benchmark

Treasury securities play three basic roles as a benchmark. First, backed by the full faith and credit of the U.S. government, Treasury yields can be considered the risk-free rate, thus becoming the critical input when discounting cash flows of other securities. Examples include valuing non-government debt, equity, derivatives, and currencies. The risk-free rate is also the basis for corporations and other investors evaluating projects or potential acquisition candidates using discounted cash flow analysis. This role transcends borders, as a key characteristic of a good benchmark is to facilitate such analysis across currencies.

Second, Treasuries provide the benchmark rate for asset allocation decisions. As investors evaluate relative risk and return, government bonds are typically considered the fixed income alternative to equity investments. Capital will flow from one asset class to another based on expectations of price return, yield, and volatility. Of course, the anticipated interest rate environment itself contributes to these expectations, and the shape of the Treasury yield curve is a benchmark for portfolio decisions on duration.

Finally, Treasury securities play an important role in the capital markets as tools of risk management, trade facilitation, and relative value comparison. Securities dealers use Treasury securities to hedge interest rate risk embedded in corporate bonds, mortgage-backed securities, and a vast variety of other fixed income instruments. Dealers and fixed income investors also use Treasury securities as benchmarks in the pricing of new bond issues and secondary transactions throughout the course of every trading day. Yield spreads relative to Treasuries, whether expressed in nominal terms or as derived by an option-adjusted spread (OAS) model for bonds with embedded options, are the most commonly used means of comparing the relative attractiveness of securities across the maturity and risk spectrums.