During its most recent Quarterly Refunding, the United States Treasury Department met with the private sector members of the Treasury Borrowing Advisory Committee (TBAC) to discuss longer term issues related to the management of the Federal debt. Among several topics considered by the group was the possible issuance by Treasury of extremely long term bonds with maturities greater than the current 30-year long bond. Maturities of 40, 50 and even 100 years were proposed as vehicles for meeting currently un-served demand from long term investors such as pension funds and insurance companies.
We have brought together three PIMCO experts for a Q&A session on the topic of extremely long debt issuance by the U.S. Treasury and the potential benefits and risks therein.
Q: Treasury has never issued debt longer than 30 years, although some high quality corporate and sovereign issuers have done so sporadically. Is the market ready to accept a steady supply of very long debt?Rodosky: At this point, it still seems unlikely we'll see such long-dated securities being issued. That said, for any security there's a right price and a wrong price. At the right price, the market is certainly ready to accept more supply of long-dated debt. Of course, it must be considered that pricing is something of a zero-sum game for any individual bond: what is a good deal for the Treasury and taxpayers is less of a bargain for investors. The auction process serves the purpose of finding a price as close to neutral for all parties. The potential benefit of finding a new maturity point with currently unmet demand is that the investors, for structural reasons, will happily pay a price for this new asset that is better than what Treasury can achieve at the 30-year point.
Liability Driven Investing (LDI) has blossomed in the last few years as pension staffs have increased their awareness of the risks embedded in their business. Hedging of liability duration has taken place with the same menu of asset choices, however, indicating a growing disconnect between supply and demand. This suggests that there would be a market for high quality, very long term assets.
Additionally, there may be some benefits to the broader capital markets if Treasury were to go down this path. The presence of an ultra-long Treasury bond would provide a benchmark for pricing other debt instruments, such as corporate and municipal bonds, as well as interest rate derivatives. Indeed, one reason corporate issuance and derivatives volume is so low in the very long maturities is the lack of a "value-anchor" used to price such issuance.
Q: It is suggested that the natural investor for this type of instrument would be an entity with extremely long duration liabilities, such as an insurance company or defined benefit pension plan. What makes a new, very long Treasury bond attractive to these investors relative to the current 30-year bond?Moore: Defined Benefit pensions and life insurance annuity and structured settlement contracts have cash flows that run well past 30 years, stretching out some 50-75 years or more. Even though the baby boomers are on the doorstep of retirement, a typical pension plan, even if frozen to new benefit accruals, will not reach its maximum benefit payout stage for 20 years or more from inception.
While pension liabilities past the 30-year mark may represent just 10% or less of the total current value of all liabilities, these longer-dated liabilities generally represent 10-20% of the total duration and 25-35% of convexity for all liabilities. Most investors who do not deal with long-dated liabilities or levered books do not think a lot about convexity, or how duration changes with changes in interest rates or the second derivative of price change, but it can matter a great deal for life insurance risk managers and swaps dealers who find convexity dear.
Why is convexity so valuable? Mainly because as rates fall, a more convex bond will rally more than a less convex bond; and as rates rise, a bond with more convexity will typically sell off less than a less convex bond. One major swap dealer told me he'd give up 15-20 bps in yield for 50-year bond versus a 30-year bond in a flat yield curve environment as the 50-year has nearly twice the convexity and only 10-20% more duration.
The full benefit to the pension and insurance hedging community probably will not come from 50-year Treasuries alone, but also from the products that its existence spurs. At the end of December 2010, roughly 24% of all outstanding 15+ year Treasury bonds were stripped, and much of that pool was held by pensions and insurers. It is likely that there would be similar demand for 50-year strips.
Also, pensions and life insurers have demand for spread products. A 50-year reference point would likely spur additional creation of very long, high quality corporate bonds.
Q: Although this is currently just a proposal, how would the Treasury actually introduce such an instrument to its debt issuance calendar?Gross: The Treasury's debt management philosophy has always been based on three pillars: obtaining the lowest cost of financing over time for the U.S. taxpayer, maintaining regular and predictable debt issuance, and supporting deep and liquid capital markets. Any change to the debt issuance patterns as significant as the introduction of very long bonds would need to meet all three requirements.
Major changes to the debt issuance calendar are usually signaled well in advance, both through the Quarterly Refunding process and in other public venues where Treasury officials are speaking. If Treasury is serious about this proposal we would expect to see further public discussion of the merits in the context of the three goals described above.
Once the groundwork has been laid, the penultimate step of an introduction would be an announcement at a Quarterly Refunding, including the details of the instrument to be issued and the schedule of issuance. This ultimately would be followed by adding the auction (or other issuance mechanism) as part of a subsequent Quarterly Refunding.
Q: What arguments might we expect to see from the Treasury going forward? Gross: I would expect the Treasury to make arguments and present evidence in favor of very long bonds along the following lines:
Q: The TBAC presentation included evidence from the U.K. suggesting that very long bonds could be issued at yields lower than 30-year bonds. Is this a realistic assumption in the United States?Moore: The chart below shows the 50-year versus 30-year yield differentials for both the U.K. and French yield curves. Over the period since issuance, the spread has averaged -13 bps for the U.K. gilt market and -2 bps for the French market, with the U.K. market showing wider variation than the French bond spreads.
Two things are worth pointing out about the U.K. market. First, before November 2008, the U.K. yield curve was inverted, which had the effect of increasing the convexity benefits of extremely long bonds and making them more attractive to investors. The spread averaged -19 bps before November 2008 and -6 bps since. Second, the accounting and regulatory pressures for better asset liability matching were more stringent in the U.K. than in continental Europe, acting as a catalyst to LDI and tighter asset/liability matching "“ again leading to higher demand.
By December 2005, the French 50-year OAT, which initially came to market at a slight yield premium to the 30-year, began trading tight to the 30-year and has since traded in a relatively narrow range of 05 bps lower yield than the on-the-run 30-year issue. Much of the demand comes from continental insurance companies and Dutch pension plans.
Taken together, the post-2008 U.K. market and the longer French history probably give a reasonable expectation of where 50-year Treasuries might trade provided the issuance size is approximately right to attract those with hedging demand without being too large in absolute terms or relative to the 30-year supply. Q: Given what we know about market demand, is there a sweet spot for the maturity of very long term bonds?Rodosky: A large portion of demand in the long end is for securities in stripped form, typically the principal component of the whole bond. As the principal strips are created and sold to end users, the coupon stream winds up residing on dealer balance sheets until another source of demand shows up. Given balance sheet constraints in the dealer community, this creates a serious drag on the capacity of the market to absorb very long issuance. The more inventory held on a dealer's balance sheet, the less liquidity they'd be able to provide (or warehouse) in other sectors. This could, in turn, adversely impact the Treasury's objectives of obtaining the lowest cost of financing over time and of supporting deep and liquid capital markets
Given this, the least disruptive way to increase the longest maturity offered would be to start relatively close to the 30-year point and gradually introduce further points if the program is successful. Therefore, starting with a 40-year or 50-year bond would make the most sense, while a 100-year bond would be less realistic.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. The value of most bond funds and fixed income securities are impacted by changes in interest rates. Bonds and bond funds with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
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