Viewpoints

March 2011 Ultra-Long Treasury Bonds: Examining the Potential Risks and Benefits

Steve Rodosky
Managing Director Portfolio Manager

Jim Moore, Ph.D.
Managing Director Product Manager

Jared Gross
Senior Vice President Product Manager

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

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Even though the baby boomers are on the doorstep of retirement. and as rates rise. While pension liabilities past the 30-year mark may represent just 10% or less of the total current value of all liabilities. pensions and life insurers have demand for spread products. taxpayer. even if frozen to new benefit accruals. The full benefit to the pension and insurance hedging community probably will not come from 50-year Treasuries alone. 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.Viewpoints March 2011 well as interest rate derivatives. and much of that pool was held by pensions and insurers. 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. It is likely that there would be similar demand for 50-year strips. roughly 24% of all outstanding 15+ year Treasury bonds were stripped. or how duration changes with changes in interest rates or the second derivative of price change. a bond with more convexity will typically sell off less than a less convex bond. but it can matter a great deal for life insurance risk managers and swaps dealers who find convexity dear. Indeed. and supporting deep and liquid capital markets. At the end of December 2010. will not reach its maximum benefit payout stage for 20 years or more from inception.PIMCO. Also. such as an insurance company or defined benefit pension plan. 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. Major changes to the debt issuance calendar are usually signaled well in advance. Most investors who do not deal with long-dated liabilities or levered books do not think a lot about convexity. WWW. maintaining regular and predictable debt issuance. high quality corporate bonds. these longer-dated liabilities generally represent 10-20% of the total duration and 25-35% of convexity for all liabilities. A 50-year reference point would likely spur additional creation of very long. Any change to the debt issuance patterns as significant as the introduction of very long bonds would need to meet all three requirements. a typical pension plan. Q: It is suggested that the natural investor for this type of instrument would be an entity with extremely long duration liabilities. What makes a new. Q: Although this is currently just a proposal. 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. 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. both through the Quarterly Refunding process and in other public venues where Treasury officials are speaking. Why is convexity so valuable? Mainly because as rates fall. stretching out some 50-75 years or more.S.COM 2 . but also from the products that its existence spurs. a more convex bond will rally more than a less convex bond.

Further.K. with the U. Treasury will be naturally reluctant to commence issuance too far out on the curve because of the need to maintain issuance for at least 10 or 20 years so as to link up with the existing 30-year bond to form a continuous yield curve. Treasury will want to select a maturity point that best meets the needs of the presumed long term investor base. the spread has averaged 13 bps for the U.K. market showing wider variation than the French bond spreads. • The need to maintain regular and predictable issuance means that Treasury would be unlikely to introduce an instrument that will only be needed for a short period of time and then withdrawn. and French yield curves. Although one expects yield curves to be upward sloping. Over the period since issuance. and therefore longer maturity debt to be costlier than shorter maturity debt. the issue boils down to whether the new demand will allow Treasury to issue debt at yields that are competitive with the current issuance up to and including the 30-year point. at present. which. are sufficiently bleak as to make the case forcefully. there is some evidence to suggest that at very long maturities the yield curve may be essentially flat or even inverted.COM 3 .PIMCO. and too far out may capture only a few investors. WWW. The primary basis for making this judgment will be the magnitude of the federal government’s long term deficit financing needs.K. including the details of the instrument to be issued and the schedule of issuance. • With respect to the capital markets. Too close to the 30-year and the impact will be marginal. This ultimately would be followed by adding the auction (or other issuance mechanism) as part of a subsequent Quarterly Refunding. gilt market and -2 bps for the French market. Q: The TBAC presentation included evidence from the U. the penultimate step of an introduction would be an announcement at a Quarterly Refunding. suggesting that very long bonds could be issued at yields lower than 30-year bonds. 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: • With respect to the cost of debt financing.Viewpoints March 2011 Once the groundwork has been laid. 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.

10 0. the accounting and regulatory pressures for better asset liability matching were more stringent in the U.Viewpoints March 2011 50-Year – 30-Year Spreads 0.05 0.K. 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.PIMCO.30 Source: Bloomberg Figure 1 Two things are worth pointing out about the U. typically the principal component of the whole bond. market.00 -0. First.K.COM 4 .30 -0.20 -0. the coupon stream winds up residing on dealer balance sheets until another source of demand shows up. the post-2008 U.20 0.25 -0. Q: Given what we know about market demand. yield curve was inverted. the U. acting as a catalyst to LDI and tighter asset/liability matching – again leading to higher demand. The spread averaged -19 bps before November 2008 and -6 bps since. Much of the demand comes from continental insurance companies and Dutch pension plans. Given balance sheet constraints in the dealer WWW.K. the French 50-year OAT. 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.05 % -0.K. which initially came to market at a slight yield premium to the 30-year. Second. 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.10 -0. By December 2005.35 Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Jan-10 Jul-10 Jan-11 UK 50 .15 -0. As the principal strips are created and sold to end users.30 FR 50 . which had the effect of increasing the convexity benefits of extremely long bonds and making them more attractive to investors. than in continental Europe.15 0. Taken together. before November 2008.

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.S. portfolios that invest in such securities are not guaranteed and will fluctuate in value. with concentrations in finance. Prior to joining PIMCO in 2003. Rodosky was vice president of institutional sales with Merrill Lynch. interest-rate. He is the lead portfolio manager for long duration strategies. credit. Dr. investments may be worth more or less than the original cost when redeemed. D. He leads the global liability driven investments product management team and is co-head of the investment solutions group. Jim Moore is a managing director in the Newport Beach office. WWW. Government. He has 17 years of investment experience and holds an undergraduate degree from Williams College.COM 5 . the less liquidity they’d be able to provide (or warehouse) in other sectors. issuer.: two years as an advisor to the executive director on investment policy at the Pension Benefit Guaranty Corporation and three years at the Treasury department. Certain U. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U. strategic risk management and capital structure advisory work for key clients in the Americas and Pacific Rim. Prior to joining PIMCO in 2008. Mr. in turn. Therefore. He is also PIMCO's pension strategist. focusing on debt financing and management and domestic securities market issues. Prior to joining PIMCO in 2001. Moore also taught courses in investments and employee benefit plan design and finance while at the Wharton School of the University of Pennsylvania.Viewpoints March 2011 community.S. The more inventory held on a dealer’s balance sheet. Mr. obligations of U. He received an undergraduate degree from Villanova University.D. he was a senior relationship manager in Lehman Brothers' pension solutions group.PIMCO. This could. He held a similar position at Goldman Sachs. He has 16 years of investment experience and holds undergraduate degrees from Brown University Jared Gross is a senior vice president in the Newport Beach office and a product manager for liability driven investment products. 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.C. He focuses on long duration and other pension investment strategies. The value of most bond funds and fixed income securities are impacted by changes in interest rates. starting with a 40-year or 50-year bond would make the most sense. this creates a serious drag on the capacity of the market to absorb very long issuance. agencies and futures.S. working with large corporate and public pension plans in the U. Investing in the bond market is subject to certain risks including market. he was in the corporate derivative and asset-liability strategy groups at Morgan Stanley and responsible for asset-liability. while a 100-year bond would be less realistic. Government securities are backed by the full faith of the government. insurance and risk management. where he earned his Ph. About the authors: Steve Rodosky is a managing director in the Newport Beach office and a portfolio manager covering Treasury bonds. Past performance is not a guarantee or a reliable indicator of future results. 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. He has 16 years of investment experience and holds a master's degree in financial markets from Illinois Institute of Technology.S. Gross also spent five years in Washington. and inflation risk.

Newport Beach. Information contained herein has been obtained from sources believed to be reliable. or referred to in any other publication. CA 92660. 800-387-4626. WWW. strategy or investment product. PIMCO. without express written permission. ©2011. No part of this material may be reproduced in any form. 840 Newport Center Drive.COM 6 . but not guaranteed. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security.PIMCO.Viewpoints March 2011 This material contains the current opinions of the author and such opinions are subject to change without notice. Pacific Investment Management Company LLC.

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