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US debt issuance since 1951 and the fallacy of issuing floating rate notes

Peter Stella, Manmohan Singh 14 May 2012

Most of today’s debate turns on the amount of US debt issuance, but the nature of the debt is also under discussion. In the current environment of macroeconomic uncertainty, the demand for safe assets has bloomed and the definition of “safe” is evolving. Part of this is the debate on whether floating rate notes should be issued by the US Treasury. In a recent report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee (31 January 2012), reference was made to floating rate notes:

“… ways to explore the viability of Treasury issuing floating rate notes (FRNs). In particular, the presentation [attached] assessed potential client demand, optimal maturity, reference index, and reset frequency. The structural decline in the stock of global high-quality government bonds, coupled with an increase in demand for non-volatile liquid assets, should make US government issued floating rate notes extremely attractive. Pricing for a hypothetical two year floating rate note was estimated to be in the arena of 3 month Treasury bills plus 8 basis points .”

This column discusses two issues:

• Investors want safe assets with no duration risks. At present, given the scarcity of safe liquid assets, some investors are willing to pay for safety (i.e. negative yields), as seen recently in the case of Bunds. Also, governments may not want to pick up short-term rollover risk especially when long-term debt costs are zero in real terms.
• Investors holding US Treasury debt would like the government to cushion them from capital losses when interest rates adjust rapidly. The associated demand for short-term debt like floating rate notes suggests that the Treasury may be willing to accommodate the private sector losses as it has done in the past (but this will be a detour from the post-1981 stance of issuing debt at least cost).

Around end-2011, the short-term US Treasury yield curve was at 1 basis point (bp) for 1 month, 2 bps at 3 months, 6 bps at 6 months, and 12 bps at 12 months. Meanwhile, the Fed is currently paying banks 25 bps on overnight deposits. Given the near zero yield environment for short tenor, no US bank is going to bid in the T-Bill auction for its own account. This takes out quite a lot of demand. So for the market to be clearing at such low rates there must be a sizable demand coming from other non-bank investors (e.g. mutual funds, corporate treasuries, etc.) who are flush with liquidity. 1 However, this cash-rich pool continues to suggest there remains a shortage of T-Bills (or related short tenor instruments like floating rate notes) and lobby for more. 2

Under the Dodd Frank Act, the Federal Deposit Insurance Corporation (FDIC) allows temporary unlimited deposit insurance till end-2012 on non-interest bearing transaction accounts. Thus, there will be significant demand for T-Bill or similar assets starting in January 2013. The desire to pick up yield on assets that can be put to a central bank at par is what makes T-Bills, or related short tenor instruments, more attractive than deposit at banks. In the past, this “par return” was largely assumed, but at zero interest rates the insurance premium imposed by FDIC on bank deposits is material – banks pass on the FDIC premium to their clients for such unlimited insurance. Another relevant example was the Transaction Account Guarantee extension whereby the FDIC stipulated that those opting for (extended) deposit insurance would have to pay between 15-25 bps. Safety of principal is being offered by one of the two main US custodians – Bank of New York (charging 13 bps). If demand for 1 month T-Bills is indeed relatively inelastic (see Duffee 1998), the market can clear at much lower T-Bill spreads (i.e. up to negative 13 bps). 3 Thus, the “expiration” of unlimited insurance by end-2012 is the primary impetus that has resulted in the discussion of (but not justification for) the need for floating rate notes. 4

At the time of the discussions leading up to the Fed-Treasury Accord of 1951, which ended an extended period of artificially suppressed interest rates on Treasury bonds, there was much internal debate about the potential deleterious impact on bondholders from a “surprise” rise in rates. There was also concern about a potential buyers strike and fear that a new market equilibrium would entail a sharp spike in rates. This discussion was conditioned by a similar situation faced by the US Treasury in 1919 after it promised to stabilise bond prices during and after the First World War. This policy caused conflict with certain Fed policymakers, and the eventual losses on Liberty bonds were still remembered by Congress and the Treasury in 1951, 30 years later. As a consequence, at the time of the announcement of the Accord, buyback options were offered by the Treasury, i.e. the US Treasury offered to swap the outstanding stock of long-term debt with new long-term debt with higher coupons (coupled with restrictions on sales before maturity). The idea was to cushion the market from capital losses.

The total volume of debt issuance is determined by budgetary needs and financing options (long vs. short tenor). Prior to 1982, there were too many policy objectives that did not result in least-cost financing (i.e. there was no discernable relationship between issuance of US T-Bills relative to total debt issuance and the cost of long-term/short-term funding, see Figure 1). For example, Treasury issuance in the 1960s would be influenced by the desire to increase (or maintain upward pressure on) short-term interest rates to prop up the value of the US dollar, or to contain long-term interest rates to spur economic growth (Garbade 2007). The structural break (1982) in the series from 1960-2011 provides support to the inception of “regular and predictable” that became a pre-condition to least-cost financing (see our recent research, Singh and Stella 2012). 5 Figure 2 shows that the Treasury has been meeting its objective since 1982 – the correlation between bills/total issuance and 10-year minus 6-month spread is over 0.6.

Figure 1. Bills/total issuance relative to 10-year yields minus 6-month yields

Source. US Treasury; data removes Fed holdings of The US Treasury

Figure 2. Ratio of T-Bills/total issuance by US treasury since 1982

Source. Fed and Treasury; we remove Fed holding of US Treasury issues

The present discussion about 2-year floating rate notes issuance linked to 3-month T-Bills may pave the way to build the short end via longer dated floating rate notes in 2013 and 2014. Yet market turbulence might result if rates rise from near zero to a “neutral” Fed funds rate of 400 bps and a normal’ 5% yield on 2-year US Treasuries. Also, the long-end yields may be more elastic to duration demands by a pension fund/ insurer/sovereign wealth fund type investor base than monetary policy.

Since the eventual unwinding and normalisation of the yield curve will take time and inflict pain on holders of fixed-income debt, the market appears to be asking floating rate notes (and thus the Treasury considering) in earnest. Although floating rate notes may contribute to a smoother adjustment of the US Treasury curve, it is not clear why there is a need to shift interest-rate risk from the private sector to the public balance sheet. Also, analytical arguments suggest that when debt is high, the role of government policy – in reshuffling debt mix in favour of short tenor – is diminished (Greenwood et al. 2011). 6 From a (strictly) cost and duration perspective, the US Treasury may want to consider issuance at very long-dated tenor (e.g. 50 years or longer), since in the present environment the long end offers free money in real terms.

Duffee, G R (1998), The Relation Between Treasury Yields and Corporate Bond Yield Spreads, The Journal of Finance. 53(6), 2225-2241.

Garbade, K D (2007), “The Emergence of Regular and Predictable As A Treasury Debt Management Strategy”, Economic Policy Review. Federal Reserve Bank of New York, March.

Greenwood, R, S Hanson and JStein (2010), “A Comparative Advantage Approach to Government Debt Maturity”, Harvard Business School, Working Paper No. 11-035.

Treasury Borrowing Advisory Committee (2012), Report to the Secretary of the Treasury, 31 January.

Singh, M and P Stella (2012), “Money and Collateral”, IMF Working Paper 12/95.

1 Floating rate notes can be fine-tuned to “accommodate” so that investors can conform to liquidity constraints (e.g. proposed regulation under SEC Rule 2a-7 limits MMF investments to short-term, high quality debt securities and other instruments and their portfolios should have a weighted average maturity (“WAM”) of 60 days or less.)

2 This is exactly what the Fed “twist” did (T-bill supply increased while long tenor bonds decreased).

3 Thus one might raise the question why the Fed is paying 25 bps rather than charging 13 bps for accepting deposits. This is a 38 bps subsidy to the banks when compared to the shadow ‘market clearing’ price for safe assets for nonbanks.

4 It is useful to recall that the U.S. Treasury discontinued 30 year bonds in the early 2000s—the Treasury did not factor in the demand for duration coming from pension funds and insurers due to the primary surplus in the Clinton years. In fact, with no new 30 year bonds, the 30 year swap curve turned negative as pension/insurers were short of the 30 year bonds.

5 Chow Test substantiates the structural break in early 1980s.

6 Their suggestion of “replacing the entire stock of T-Bills with maturity greater than 100 days, with T-Bills of an average duration of 58 days” will entail rollover risk.