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Bond Junkies Face Withdrawal as U.S. Turns Spendthrift

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The U.S. Treasury owes $5.776 trillion to investors large and small, worldwide.

Yet Uncle Sam’s announcement last week that it will seek to buy back a mere 0.5% of the securities that comprise that debt helped trigger pandemonium in financial markets.

Some investors rushed to buy 30-year Treasury bonds--the longest-term of long-term U.S. debt--on the assumption that the world may soon face a scarcity of such securities.

That may seem quite surreal to anyone who remembers that not long ago, the federal government was running annual deficits of $200-billion-plus, and that the mountain of bonds sold to cover those deficits was viewed as a serious threat to the stability of the Republic.

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Suddenly, a ubiquitous security whose yield is the global benchmark for long-term rates was being treated like a Beanie Baby whose assembly-line run stopped at a few dozen.

The frenzy to buy the bond drove its yield to 6.14% by Thursday from 6.52% a week earlier, even as the Federal Reserve was seeking to push all interest rates higher with another quarter-point boost in its key short-term rate.

It’s usually a good thing when someone else is willing to pay a lot for something you have. But in the giant market for Treasury debt--securities whose yields have for decades provided the major reference point for pricing many other forms of debt worldwide--all pandemonium is dangerous, regardless of the reason.

What became apparent last week is that many bond investors and traders are facing a new world for which they are as yet unprepared: a world in which the federal government is awash in cash and wants to get out of debt, after helping to create a global financial system that is substantially based on the idea that that debt remains large and readily tradable.

The U.S. government’s nearly 40-year-long borrowing binge, while criticized all along the way as a mortgaging of America’s future, a terrible burden to leave the next generation, etc., etc., did the world a favor in more ways than one.

Not only did it give global investors a massive supply of virtually risk-free securities from which to choose--risk-free in the sense that the Treasury could always be counted on to pay the interest owed on its debt--it also facilitated the “securitization” of many other markets.

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True, the government soaked up funds that could have been used elsewhere in the world economy, at least in theory. But as borrowing in general has exploded over the last few decades at the government, corporate and consumer level, Treasury securities became the fulcrum on which many other debt markets were balanced.

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Say a company wanted to issue bonds to raise money for expansion. What yield should investors demand on those bonds? For starters, those investors would look at what Treasury securities of comparable term paid. No sense accepting a lower yield from a business that could fail if you could get a better yield risk-free from Uncle Sam.

Ditto for mortgage-backed bonds, the development of which has made the mortgage market far more fluid and given homebuyers an array of mortgage choices.

Just as important for the rest of the bond market was that you could always count on new Treasury debt coming to market on a regular schedule. For decades, “Treasury borrowing was very predictable, with a series of regular auctions planned well in advance. The market was very orderly, and supply was very stable,” noted Dana Johnson, head of research at Banc One Capital Markets.

Why was that important? Those same investors and Wall Street dealers who buy corporate and mortgage-backed bonds often need a way to fund, or to hedge, their purchases, either in the short term or the long term. They do so by buying or selling Treasury securities, because the supply of Treasuries is huge, and they can always be bought or sold at some price by virtue of their risk-free status.

If you need to raise money fast, you sell Treasuries. If you want to make a quick bet that market interest rates are going up (devaluing fixed-rate bonds), you “short” Treasuries--that is, you sell borrowed bonds, betting you can replace them later at cheaper prices.

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What happened last week in the bond market, in fact, was a rush of buying by big investors who had shorted 30-year Treasury bonds, betting that yields on those bonds would continue to rise as the Fed boosted rates in general.

When the Treasury confirmed at midweek that it plans not only to cut back on regular auctions of bonds this year, but also that it will offer this year to buy from investors about $30 billion in bonds outstanding, the light bulb went on above many bond traders’ heads: “Oh God--they’re serious about this debt-reduction thing!”

Hence buyers poured into the 30-year T-bond, particularly on Thursday. To raise cash, some had to dump other bonds, such as corporate issues, driving those yields up.

By Friday the panic had subsided, at least for the time being: News of strong U.S. job growth in January pushed all rates higher again, on the expectation that the Fed will continue to tighten credit. The T-bond yield ended Friday at 6.25%.

Yet the Treasury market is still seriously out of joint. Normally, longer-term yields are higher than shorter-term yields. Now, a two-year Treasury note pays 6.63%, or 0.38-point more than a 30-year bond, in large part because investors fear a growing scarcity of longer-term issues--not just this year, but for years to come, if predicted Treasury surpluses do indeed materialize and much of that money goes to pay down debt.

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Could they really pay it all off, as some politicians suggest? The $5.776-trillion debt figure is in fact misleading. Almost 44% of that is in nonmarketable debt, mostly held by Social Security funds.

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The total amount of Treasury securities in investors’ hands at year-end 1999 was $3.28 trillion, down from $3.36 trillion a year earlier. It still sounds monstrous--but then, so do the predicted budget surpluses for this decade.

Long term, there should of course be significant economic benefits from reducing U.S. debt. “It’s a wonderful development,” argues David Lereah, economist at the Mortgage Bankers Assn. in Washington. Money that would have gone into Treasuries now will have to find a home in other bonds. The end result should be a bidding-down of other yields, such as for mortgage-backed bonds (and therefore for home buyers’ mortgages).

But for now, as investors and bond dealers cope with the slow loss of the risk-free securities on which many investing and trading strategies have long been based, Wall Street may well pine for the fiscally irresponsible government of old.

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What Uncle Owes

Here are totals of U.S. Treasury debt outstanding, by category. Treasury bills are securities maturing in one year or less; notes have maturities between one year and 10 years; bonds are securities maturing in more than 10 years. Also shown is the total of “non-marketable” Treasury debt--which is mostly held in Social Security trust accounts.

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Amount outstanding (in billions) Avg. rate Category 12-31-98 12-31-99 on debt Treasury bills $691.0 $737.1 5.20% Treasury notes 1,960.7 1,784.5 6.03 Treasury bonds 621.2 643.7 8.54 Other debt 82.6 115.7 5.50 Total marketable debt 3,355.5 3,280.9 6.36 Non-marketable debt 2,249.9 2,485.1 6.65 Non-interest-bearing debt 8.8 10.0 -- Total public debt $5,614.2 $5,776.1 NA

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NA -- not available

Source: U.S. Treasury

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