Issuing new "long" bonds benefits numerous constituencies.
When the United States Treasury auctions off 30-year
bonds next month for the first time in half a decade, it will mark a
return to normalcy for the fixed-income markets. The taxpayer in all of
us appears likely to benefit, and savvy investors can, too. "There will
be opportunities created by the issuance," says David Glocke, a
Vanguard principal and portfolio manager.
First, a little history. The category: federal budget surpluses. Remember those? Remember that none other than retiring Federal Reserve Board Chairman Alan Greenspan agreed with projections showing they'd last? "While the magnitudes of future surpluses are uncertain, they are highly likely to remain sizable for some time," the Fed head told the Bond Market Association on April 27, 2001.
Greenspan also told the industry group that day that budget deficits would return. Just not any time soon, he said, and possibly not before the entire public debt could be paid off. Imagine that: Uncle Sam debt free! Yet it was rational exuberance. After all, Washington had been in the black since 1998. And the party historically associated with budgetary restraint had just set up shop at 1600 Pennsylvania Avenue.
Six months after Greenspan's address, in a move that surprised-if not dismayed-Wall Street, Uncle Sam stopped selling the long bond, as the 30-year security is known. Reduced borrowing needs was chief among the reasons cited. "Issuance of long bonds had been cut back significantly the two years prior to that," says Glocke, adding that the cash raised from selling them was used to retire other federal debt. "So the long bond really wasn't a tool that the Treasury needed at the time," Glocke says.
Now the feds are singing a different tune. The view is that a 30-year instrument is part of prudent federal debt management. Even if you are among those who suspect Washington's red ink is the real impetus for the security's resurrection, a notion Treasury officials have scoffed at, all quarters agree that bringing it back is smart.
Managing The World's Largest Debt
By extending maturities in its debt portfolio, the government slows the rate at which the debt rolls over. That helps stabilize the average interest cost, says advisor J. Michael Martin, president and principal of Financial Advantage Inc. in Columbia, Md.
The reintroduction is positive for the capital markets. "It is essential that federal government financings be predictable and routine and supply the needs of the market," says William B. Hummer, senior vice president and chief economist at Wayne Hummer Investments LLC in Chicago. Halting 30-year issuance in 2001 "left a terrible void in the market and created a lot of unhappiness for institutions," Hummer says.
Insurance companies and pension plans in particular need long-term investments to pay for their obligations in the future. Starving the market of 30-year paper has made that tougher to accomplish. So give Treasury credit for reviving the long bond, Hummer says. "But it should have never been abandoned in the first place."
Still, taxpayers profited from the hiatus. By issuing shorter-term securities when interest rates troughed, Uncle Sam paid less to borrow than it would have cost at the long end of the yield curve. In the government's 2003 fiscal year, interest on the public debt was $41.4 billion less than in 2001, a drop of 11.5%, even though we collectively owed nearly $1 trillion more.
"But now is the right time to issue long-term debt," says Marc Seidner, director of active core strategies at Standish Mellon Asset Management. Long-term rates remain attractive, he points out. As of Thanksgiving, they'd risen only modestly from the mid-2003 bottom of approximately 4.20%. Moreover, borrowers currently don't have to pay a premium to lock in rates for extended periods, he says.
From an investor's viewpoint, the government's move to sell securities farther out the yield curve has several implications. One is that some bond-market indexes will see an increase in their duration, the statistic measuring sensitivity to interest rate changes. Because the duration of a 30-year bond is longer than the average duration of such popular indexes as the Lehman Brothers U.S. Aggregate and U.S. Government/Credit, theirs will lengthen by an estimated .09 years when the new issuance is included in index calculations beginning at the end of February, according to the technocrats at Lehman. Index durations will increase further with each subsequent 30-year auction. Investors seeking to remain duration-neutral compared with affected benchmarks will have to add duration to their portfolios.
Trouble In Bond-dom
The new security will give the investment community much needed data on inflationary expectations, says William Fitzgerald, head of municipal investing at Nuveen Investments in Chicago. "Right now, the yield curve is only providing information 25 years out, when the longest-dated Treasury bond matures (February 2031)," he says. (Note: There is an inflation-protected Treasury security, or TIP, maturing in 26 years, in April 2032.)
A similar problem regarding bond pricing will be overcome. Virtually all sectors of the bond market price themselves relative to Treasuries of comparable maturity. But since the 30-year was halted, obviously, the long end of the yield curve has crept in. Some money managers have adopted the February '31, along with other far-dated Treasuries, "as quasi-benchmarks for pricing the long end of the market," says Tony Rodriguez, head of fixed income at First American Funds in Minneapolis.
Others have opted to match maturities more closely but forego the use of a true risk-free rate in their pricing models. Fitzgerald, for example, now looks at the LIBOR swap market to get an idea of what's going on in the 25- to 35-year segment of the yield curve, which is where most of his holdings lie. But swap rates include a premium that investors get for accepting some, albeit small, repayment risk, and that premium changes constantly. Therefore using swap rates as the starting point for valuing, say, AAA-rated munis makes for an inexact science. "Having a new 30-year Treasury will allow us to track changes in the long end of the yield curve better," Fitzgerald says.
The upshot is that once the new Treasury is priced, other fixed-income sectors may undergo repricing as their spreads to it become established. That potentially brings both volatility and opportunity. Take munis, for instance, which some investors view as an alternative to taxable bonds, says Jane McCart, senior vice president and director of high-yield investments at Northern Trust in Chicago. If municipals initially trade too richly against the new 30-year, a lack of demand would cause their prices to fall until their yields become more attractive on a relative basis, she says.
A final consequence of an extended Treasury yield curve is that it will improve portfolio managers' ability to hedge interest-rate risk, Rodriguez says. The Chicago Board of Trade, for its part, is eagerly preparing the requisite products.
Time For Treasuries To Shine?
Will the new bond be a good investment? All eyes will be on it, so the real action could be elsewhere. "The February '31 Treasury may cheapen as investors roll out of it and into the new bond," says Vanguard's Glocke. "That may be the opportunity."
Still, there certainly is reason to believe the new Treasuries could perform well. Institutions suddenly have heightened interest in long-duration investments, says John Brynjolfsson, portfolio manager of PIMCO Real Return Bond Fund. "The recent attention on pension deficits has brought about a significant shift in perspective. Pension managers are recognizing that liabilities are part of the equation" and should influence how they invest, he says.
Washington has reached a similar conclusion. At this writing, lawmakers were pondering legislation that would induce companies to more closely match their pension assets and liabilities. If enacted, according to one estimate, corporate pension plans would need to add to their portfolios $753 billion of Treasuries maturing in 20-plus years in order to match the duration exposure of their liabilities. That's more than three times the currently available supply, wrote Galen Burghardt and William Hoskins in the Outlook '06 issue of Futures Industry magazine.
Yet even without passage of this legislation, demand for the new bonds could be rabid. Treasury is initially expected to sell at most $30 billion annually in twice-yearly auctions-a drop in the bucket compared to institutions' present thirst for long paper, according to experts. When Treasury rolled out a 20-year TIP in October 2004, the issue not only "was fully absorbed by the preexisting demand in the marketplace, to some extent it engendered more demand," Brynjolfsson says. "I think the same will apply in this situation: Adding supply, ironically, will create more demand" and push the long bond's price north.
But overwhelming demand is not a foregone conclusion, he cautions. "Trustees, actuaries and chief investment officers are likely to be cautious about jumping into 30-year bonds, and appropriately so, knowing that the yields are near historic lows," Brynjolfsson says.
Recession is another potentially favorable scenario for the new securities. "At Lipper, we agree with PIMCO's Bill Gross that the U.S. will probably see slower growth or a recession later this year," says Andrew Clark, a Lipper analyst. Such conditions typically lead to falling interest rates. "Then the appetite for long-dated paper grows and prices appreciate," Clark says.
A final word for advisors: Clients will probably hear about the long bond's return in the popular press. Make sure they know it carries interest rate risk despite being backed by the United States government, suggests Warren Olsen, chairman and chief investment officer of First Western Investment Management in Denver. "Whenever there's something new in the market," he says, "it's incumbent upon financial advisors to make sure their client base understands it."