Easy Deficit Cure: Shift U.S. Debt to Shorter Bonds
Like the weather and the Dodgers, everybody talks about the federal budget deficit, but not much is ever done about it.
But here’s one idea that proponents say would not only cut the deficit but also would reduce those sticky long-term interest rates and boost the economy as a bonus: Uncle Sam should stop borrowing money via 30-year bonds.
Instead, the approximately $40 billion a year that the U.S. Treasury now raises through 30-year bonds should be borrowed at shorter terms--say, between one and 10 years, where rates are lower.
The “Ban the Bond” posse apparently includes some of Democratic presidential hopeful Bill Clinton’s closest financial market advisers. The idea, bounced around from time to time in recent years, has also become popular with some of Wall Street’s top money managers and economists.
“I can’t think of anything more beneficial that (Treasury Secretary Nicholas) Brady could do,” says William Gross, managing director of Newport Beach-based Pacific Investment Management Co., one of the nation’s biggest bond investors.
Here’s the scenario: As the longest-term bonds available from any world government, the Treasury’s 30-year issues are the benchmark of truly long-term interest rates. That means when investors try to decide what’s a fair return to demand of corporations, commercial real estate buyers and other important long-term borrowers, they base their decision at least in part on what the federal government pays on its 30-year bonds.
There are always plenty of buyers for 30-year Treasury bonds, including pension funds, speculators and hedgers. So if the government suddenly said that the supply of those bonds would no longer increase, a buying panic could ensue: Anyone with a need or desire to lock up money for that long might be compelled to rush into the market, to grab what they could of 30-year paper.
The surge of demand would in theory cause yields on the bonds to plummet, as sellers could afford to pare down the returns to anxious buyers. That, in turn, would push other long-term rates down, cutting companies’ borrowing costs and providing a psychological lift for the economy.
“I think long-term bond yields would fall by 0.25 points overnight,” says Gross. That would cut the 30-year Treasury yield from 7.36% now to 7.11%.
And by raising money with shorter-term debt, Uncle Sam would also win. The Treasury pays just 5.34% a year on five-year notes, for example, a savings of two full points in annual interest versus 30-year bonds. Considering that interest on the $4-trillion federal debt now exceeds $200 billion a year, any savings is meaningful and needed.
If banning the bond makes so much sense, why doesn’t the Treasury pounce on it? Two reasons:
* It could raise shorter-term rates. If the Treasury borrows more in, say, 10-year notes to make up for what it no longer borrows in 30-year paper, that bigger supply of 10-year notes could overwhelm demand. Interest rates might have to rise on those shorter securities to attract buyers.
That could be particularly harmful to home buyers, because rates on home mortgages are usually set based on 10-year Treasury note yields, says David Lereah, economist at the Mortgage Bankers Assn. in Washington. (The reason is that most homeowners move within 10 years.)
Even so, Ban the Bond proponents note that 83% of all federal borrowing is already done in terms of 10 years or less. Adding a little more shouldn’t make much difference, they say. And it may actually be helpful for the economy if very short-term rates rise a bit while long-term rates fall: Many older Americans with money in short-term CDs would see their spending power rise with even a small increase in short rates.
Indeed, Stephen Axilrod, vice chairman of Nikko Securities in New York and a former Federal Reserve economist, argues for the extreme of shifting all normal 30-year Treasury borrowing into short-term bills of one year or less.
* Treasury “speculation” could backfire. By altering its debt plan significantly based on short-term market trends, the Treasury would essentially become a speculator. Is that a proper role for the world’s biggest borrower? critics ask.
“Treasury has to take the long view--we can’t be seen as playing the market,” argues Jay Powell, Treasury undersecretary for domestic finance. Though the Ban the Bond fans say the 30-year bond yield is too expensive a rate to pay compared with shorter-term yields, Powell notes that “it will only be clear in hindsight” if that’s true: It may well be that locking-in debt today at a cost of 7.36% a year will look like a bargain 10 years from now, should interest rates in general rise.
Nonetheless, the Ban the Bond posse argues that the economy is in a very bad way, and that a major reason for that is still-high long-term interest rates. The benefits of bringing those rates down will more than offset any negative effects from a slight rise in short-term rates, proponents say. “My judgment is that you would have a substantial (positive) effect,” says Axilrod.
Desperate times require desperate actions?
What the U.S. Pays to Borrow Here are current annualized yields on Treasury securities of various maturities: Term Yield 3-month 2.79% 6-month 2.94% 1-year 3.07% 3-year 4.28% 5-year 5.34% 10-year 6.37% 30-year 7.36% Uncle Sam’s Debt Load The federal government faces a situation similar to that of many homeowners: Should it refinance its debt via a longer-term loan, or take advantage of much lower shorter-term interest rates? Here’s a look at how Uncle Sam’s debt to private investors is broken down by maturity: Maturity schedule of federal debt held by private investors
Dollar amount Pct. of Term outstanding total Under 1 year: $787 billion 34.4% 1 to 5 years: 812 billion 35.5% 5 to 10 years: 292 billion 12.8% 10 to 20 years: 86 billion 3.8% 20 to 30 years: 291 billion 12.7%
Percentages don’t add to 100% because of rounding. Source: U.S. Bureau of Public Debt
