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Implications of the Treasury Buy-Back Program.

As the government surplus swelled in the U.S. in 2000, the Treasury began repurchasing long-dated bonds. The buy-back program had a dramatic impact on the financial sector, significantly reducing liquidity in the market for thirty-year Treasury bonds. In addition, Treasury repurchases pulled down yields on thirty-year bonds, causing the yield curve to invert. Market participants viewed the inversion as "artificial" because of repurchasing activity and since there was no parallel inversion in corporate and agency debt yields.

The liquidity reduction in the thirty-year bond was sufficiently severe that it forced traders to largely abandon the security as a benchmark for pricing other securities. Marketmakers, however, need a continuous flow of transactions for benchmarking purposes. As discontinuities developed in thirty-year bond trading, reliance shifted more heavily to the ten-year Treasury as a benchmark reference.

This was a critical change for financial markets. Since its introduction in the 1970s, the thirty-year government bond had always played a key benchmark role. Besides being used as a basis for pricing numerous other long-dated securities such as corporates, municipals, and sovereign debt, it was used for interpolating prices for off-the-run Treasuries. In addition, it was the basis for pricing options and other derivative products. Only the thirty-year Treasury offered sufficiently liquidity for use in pricing models throughout the day as a means for establishing valuations. Without this bellwether benchmark, pricing is more difficult.

Fortunately, the market for ten-year Treasuries has remained liquid because the Treasury has focused on repurchasing longer-dated government securities. As a result, the ten-year Treasury has become more widely accepted as a benchmark. It provides a partial solution to the pricing dilemma. While it is unlikely the ten-year Treasury will fall from its new status soon, if forecasts of continued large government surpluses prove accurate, it is certainly possible that even the ten-year bond will eventually lack sufficient liquidity. As a consequence, alternative benchmarks are being discussed.

In February, a survey published by the Bond Market Association indicated that thirteen percent of respondents believed that agency debt would replace Treasuries as a benchmark over the next year. An astounding seventy-nine percent said that agency debt will "supplement" Treasuries, while only eight percent said that there would be no effect on the market from government debt repurchasing.

The agency debt considered most attractive for benchmark status includes securities issued by the Federal National Mortgage Association (Fannie Mae) the Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal Home Loan Bank System. Each of these agencies issues a large amount of debt in a variety of maturities. Most of these securities trade with a high degree of liquidity in secondary markets. Furthermore, the cumulative agency debt outstanding already exceeds that of government debt and is growing rapidly. The agencies themselves aspire to benchmark status for their securities because it would facilitate additional debt issuance in the future.

The problem with agency debt is that it is not riskless. The U.S. government offers no explicit guarantee against default. Investors have presumed there is an implicit guarantee, however, because Congress created the agencies. Indeed, agencies are technically classified as government-sponsored enterprises (GSEs), and they enjoy many regulatory and legal benefits that private debt issuers do not.

There have been recent proposals to eliminate the benefits received by GSEs. This is causing consternation and uncertainty in the market and raises questions about whether agencies can fulfill the need for benchmarks. If legislation is approved to eliminate OSE special privileges, a risk premium could be built into the pricing of agency securities that could result in greater volatility than would otherwise be the case. It is even possible that investors could significantly force up yields on agency debt to reflect more accurately the risk of a collapse in the real estate market. This makes agency debt less desirable as a new benchmark until uncertainty over the status of GSE securities is resolved.

Once the status of GSE debt is settled, an obvious solution to the benchmark issue would be to simply use a composite index for pricing purposes based on agency yields in the same way Treasury yields are used now. The index benchmark would be highly liquid and traded frequently throughout the day. This would allow market-makers to adjust prices for other securities effectively as demand and supply conditions change.

Of course, for the moment there is sufficient liquidity in the ten-year Treasury to satisfy market needs. But until questions about agency debt status are resolved, additional Treasury repurchases will reduce the benchmark efficiency of the ten-year Treasury and potentially induce greater volatility in prices for fixed income securities. How and when agency debt status is resolved and what continued repurchase of ten-year Treasuries will mean are important emerging issues in creating reliable benchmarks in financial markets.

"Mac" Lamm is Chief Investment Strategist of Bankers Trust Private Banking of the Deutsche Bank Group. In 1999, he won NABE's Edmund A. Mennis Contributed Paper Award for the outstanding paper contributed by a NABE member. He holds a Ph.D. degree from Virginia Polytechnic Institute.
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Author:Lamm, R. McFall, Jr.
Publication:Business Economics
Article Type:Brief Article
Geographic Code:1USA
Date:Jul 1, 2000
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