Monday, May 9, 2016

Bond Swap

The U.S. Treasury debates new-for-old bond swap, reports FT. The Treasury will issue more of the popular 10 year bonds, and then buy them back at some point before they mature.

The idea is to make treasury markets more uniform and liquid. Once bonds get several years old, they tend to sit in proverbial sock drawers, and they're harder to buy and sell (they are "off the run.") To the extent that this illiquidity lowers their value, the Treasury can buy them back cheaper.
“By buying cheap issues and funding the buybacks with issuance of rich on-the-run securities, the Treasury could enhance liquidity in these issues, while decreasing its borrowing costs,”
There is a lot of writing about "safe" and "liquid" asset shortages, so issuing more of a few popular issues and leaving less outstanding otherwise is beneficial to markets.

Comment.  I like the idea, but I think the Treasury should go further. Coincidentally, I just happen to have recently written an article called "A new structure for U.S. Federal Debt" that explains it all in detail.

When you think about it, the treasury ends up in a strange place. Why would you constantly issue 10 year debt, and then buy it all back when it's (say) 8 year debt? What is the question that this structure solves? (Other than the desire of dealer banks to double their earnings on buying and selling treasury securities!)  

My proposal is simpler: Issue perpetuities. These securities pay $1 coupon forever. Buy these back, not on a regular schedule, but when (!) the day of surpluses comes that the government wants to pay down the debt. Then there is one issue, with market depth in the trillions, and the whole on the run vs. off the run phenomenon disappears. I hope the Treasury will someday at least try selling some perpetuities.


  1. What's the difference between "Fixed-Value Floating-Rate Debt" and fed reserves? Why bother having both of them?

    1. Right now, only banks can access reserves at the Fed. The Fed isn't legally allowed to let you have an account there. If "you" is a large corporation with millions in cash, way above FDIC insurance limits, this is an issue. The Fed is getting around this limit in clever ways, but if the Treasury gave us the same thing, then we could respect the traditional limits that the Fed only deals with banks.

  2. Why issue benchmarks and then refinance them as they roll down the curve? This solves, inter alia, the question of what to use as liquid benchmarks for pricing new issues of non-government debt and hedging them on delivery (and afterward).

    You did address this in your debt restructuring proposal but implementing your suggestions for STRIPs and swaps nonetheless requires whole-hog acceptance of the move to perpetual-based issuance. Meanwhile, a ready supply of cost-effective nominal USD rate hedges is highly relevant to the global credit market. That's what the TBAC will be telling Treasury and it looks like they're listening.

  3. Medium-term debt has an important use explained by Markus Brunnermeier: it acts as macroeconomic insurance, and is especially useful to banks for this purpose. He describes it as "stealth recapitalization" - a way for monetary authorities to help out banks during downturns, by lowering policy rates, and raising the value of these bonds.

    Converting all federal debt into money is a great idea, but then you need a way to plug the hole created by the loss of these medium-term bonds. Thus the proposal to reform structure of government debt should also include some offering that completes the market. After this transition, we will have interest rates determined by long-term forces, and will not see them oscillate at business-cycle frequencies due to our current system of stabilization.

  4. Why duplicate the efforts of the Fed which issues zero coupon perpetuals?

  5. "What is the question that this structure solves?"

    It only makes sense if they are trying to exploit some anomaly in the yield curve.

    If there is some problem with liquidity of bonds after they have been outstanding for several years that is a sign of a problem with the structure of the market. There should be so many potential players in the Treasury market that an efficient low cost trading platform should create liquidity in all outstanding US Treasuries across the yield curve.

  6. From the New York Fed: "Primary dealers—banks and broker-dealers that trade in U.S. Treasuries with the New York Fed—are the largest group of buyers at auction."

    Also: "Only the designated primary dealers are required to bid a specified amount in every Treasury auction." (

    So, much of the auctioned debt goes to Broker-Dealers who can use these inventories for fun long/short, butterfly, or whatever, trading purposes before finding them a new home with a buy-and-hold institutional investors.

    THEN these same New York Broker-Dealers are obliged to purchase more US debt in subsequent auctions.

    To keep from blowing up their inventories of debt, Broker-Dealers have to move a held debt off their balance sheets. This also finances their new purchases.

    Before these bonds are sold off to mostly buy-and-hold institutional investors, they are readily available big traders. That availability dries up after the sale. (Why would Calpers want to lend their bonds to be shorted?)

    I think the following story provides a rationale for why on-the-run bonds sell at premiums: They are the available securities that can be used for fun and profit by arbitrageurs and other traders. When they are sold off to make room for newly issued bonds, they lose their usefulness to the traders. Price drops, accordingly.

    I don't know how the Treasury swaps change the dynamic structure of the US bond market described above. If 8-year bonds are not in the for-trading inventory of Broker-Traders, they still won't have an on-the-run type of premium. Maybe the Treasury should get a better understanding of what is causing that premium before they start on some plan to exploit it.

    1. Big point: the sellers of the vintage bonds with 8 years left to maturity are the buy-and-hold institutions with a price inelastic demand curve. They will surely demand a premium price to give up bonds they are happy to keep in their portfolios. After all, they will have to replace their off-the-run 8-year bonds with on-the-run 10-year bonds at the on-the-run premium price.

      Don't see there being any benefit going to the Treasury, when all is said and done.

  7. John,

    "The idea is to make treasury markets more uniform and liquid. Once bonds get several years old, they tend to sit in proverbial sock drawers, and they're harder to buy and sell (they are "off the run.") To the extent that this illiquidity lowers their value, the Treasury can buy them back cheaper."

    Typically when bond traders buy and sell bonds they use the roll down feature found in the Treasury curve. A ten year bond that is eight years old is really a two year bond. As such, the two year bond trades like any other two year bond when it is bought and sold. The U. S. Treasury, however, does not buy back bonds on the roll down. They pay back principle plus accrued interest and that's it.

    It has nothing to do with the liquidity / illiquidity of the bonds themselves. The U. S. government is advantaged in buying back it's own debt just like any other debtor is advantaged in buying back / cancelling his or her own debt.

    Example: I take out a $100,000 two year mortgage at 5% annual (non-compounded). At the end of one year I owe $105,000 and at the end of two years I owe $110,000. My mortgage is sold by the bank I received it from to a pension fund for $107,500 after 6 months. That doesn't change the fact that I can retire my mortgage after 1 year for $105,000.

  8. There is buzz that Japan will issue perpetuals (or consols) offering zero interest

    1. Perhaps the point of interest here is that the consols are being issued by the treasury, and not the monetary authority. But your theories do help us see that the distinction is artificial in many ways. I really like your proposal to simplify the plumbing by having the currency come directly from the treasury.

    2. Currency is typically a liability of the central bank.
      Presumably consols (perpetuals) will be liabilities of the Japanese government.

      The United States, for a time, had two co-circulating currencies - Federal Reserve Notes (lent into existence by the central bank) and United States Notes (fiat currency printed by the Treasury):

      As always, it helps to read the fine print. Written on every Federal Reserve Note is the following:

      "This note is legal tender for all debts, public and private"

      On United States Notes, however, the following phrase appears:

      "This note is legal tender at its face value for all debts public and private except duties on imports and interest on the public debt."

      Even if Japanese consols end up being a currency that co-circulates alongside the Yen, I don't know that both would be free of restriction.

      Bottom line - not all currencies are created equal.


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