Kenneth D. Garbade
On January 31, 2012, the Treasury Borrowing Advisory Committee advised the Secretary of the Treasury that it unanimously supported the issuance of floating-rate notes by the U.S. Treasury. Sovereign issuers are not known as hotbeds of financial innovation, and the introduction of a new sovereign debt instrument is a significant event. This post provides some perspective on the possible issuance of floating-rate notes by reviewing the history of earlier innovations in Treasury debt instruments, including Treasury bills, STRIPS, and TIPS. It concludes that the Treasury has been an infrequent, but nevertheless astute, innovator.
Treasury Debt Management before and during World War I
In the decades before World War I, the Treasury financed deficits primarily with coupon-bearing bonds. For short-term cash management purposes, it was additionally authorized to issue coupon-bearing certificates of indebtedness that matured in a year or less. For example, the War Revenue Act of June 13, 1898, authorized the Secretary of the Treasury to finance the costs of the Spanish-American War by issuing 1) up to $400 million of twenty-year bonds and
2) one-year certificates, subject to the limitation that no more than $100 million of certificates could be outstanding at any point in time.
World War I saw an immense increase in Treasury indebtedness, from about
$1 billion shortly before the war to about $25 billion in mid-1919. The war was financed in part with certificates sold on a continuous basis to banks and others, but more importantly with long-term bonds sold to individual and institutional investors in widely advertised war loan drives.
The Introduction and Evolution of Treasury Bills
During the 1920s, personal and corporate income taxes were due in quarterly installments the year after income was earned; there was no provision for withholding. Early in the decade, Secretary of the Treasury Andrew Mellon developed a program of regular quarterly sales of coupon-bearing debt on tax payment dates, with new issues scheduled to mature on future tax dates. The program was designed to facilitate the redemption of maturing debt as well as the refinancing of debt that could not be paid down at maturity. Various combinations of one-year certificates, coupon-bearing notes between one and five years to maturity, and bonds with more than five years to maturity were offered on a fixed-price subscription basis to a broad range of institutional and individual investors across the country.
Mellon’s program regularized postwar debt management operations, but the absence of intraquarter financings meant that the Treasury had to borrow at the start of each three-month interval whatever funds it might need during the interval. The Treasury could, and did, deposit (in commercial banks) money that it did not immediately need, but the interest that it earned was less than what it paid on its debt.
To lower its funding costs, the Treasury introduced Treasury bills in 1929
(see my 2008 Economic Policy Review article for details). The original idea was that the Treasury would auction bills in small amounts from time to time between quarterly financing dates to raise funds “as needed.” The bills would be scheduled to mature on or shortly after one of the next two tax payment dates and would either be paid down with tax receipts or refinanced with the regularly offered certificates, notes, or bonds. As expected, bills proved enormously successful and an important addition to the Treasury’s arsenal of debt instruments.
Treasury officials extended the use of bills in 1931 when they funded loans to veterans of World War I with sales of thirteen-week bills and subsequently refinanced those bills as they matured with new thirteen-week bills. This was the first use of bills to fund Treasury indebtedness on a continuing basis (rather than simply to the next tax payment date) and the first instance of “regular and predictable” offerings of Treasury debt (for more details, see my 2007 Economic Policy Review article). The Treasury further expanded the use of bills to include twenty-six-week bills (in 1958), one-year bills (in 1959), and four-week bills
(in 2001). The Treasury reintroduced cash management bills in 1975 to bridge short-term funding gaps on an as-needed basis.
When interest rates rose to unprecedented levels in the late 1970s, the duration of long-term bonds plummeted. (The duration of a bond is the weighted average time to payment of the bond’s principal and interest, where the time to a particular payment is weighted by the present value of the payment.) Shrinking duration complicated portfolio management for long-term fixed-income investors like life insurance companies because those investors couldn’t acquire securities with durations nearly as long as the duration of their liabilities.
Single-payment custodial receipts, such as the CATS (Certificates of Accrual on Treasury Securities) first issued by Salomon Brothers in the summer of 1982, were one response to the problem of shrinking duration. A broker-dealer firm would buy coupon-bearing bonds, put them in a trust, and sell custodial receipts for the individual interest and principal payments. The duration of each single-payment receipt was equal to the time remaining to payment. However, custodial receipts were proprietary products of the respective broker-dealer firms and traded in markets that were less liquid and less competitive than markets for conventional Treasury securities.
Treasury officials appreciated that separating the payments on a bond into individual claims enhanced the demand for long-term Treasury debt and lowered the cost of bond finance, and they realized that demand could be enhanced further if the Treasury itself provided a publicly available alternative to proprietary custodial receipts. In early 1985, Secretary of the Treasury Donald Regan announced the STRIPS (Separate Trading of Registered Interest and Principal of Securities) program. The new program allowed any depository institution holding a designated Treasury note or bond to exchange the security for a portfolio of separately transferable claims on the underlying interest and principal payments. The single-payment claims were direct obligations of the United States, maintained in the Federal Reserve book-entry system, and transferable through Fedwire. STRIPS quickly proved to be a winning innovation for both investors and the Treasury.
Treasury Inflation-Protected Securities (TIPS) are perhaps the most striking Treasury debt instrument innovation in the twentieth century. TIPS, introduced in 1997, gave investors an opportunity to acquire a security whose payments were fixed in real, rather than nominal, terms. The Treasury benefited because it could issue TIPS at interest rates that did not include a premium for the risk borne by holders of dollar-denominated debt that inflation might rise unexpectedly and that the real value of future interest and principal payments might decline.
Investors place a high value on Treasury debt securities for a variety of reasons, but one of the most important is liquidity: the ability to buy or sell large amounts quickly at or very near “round-lot” prices. Treasury officials have been careful to craft terms for new instruments to maximize liquidity, and they have been alert to opportunities to revise terms to further promote liquidity. For example, after the first few Treasury bill auctions in 1929 and 1930, investors complained that capital gains taxes on bills limited the fungibility of bills maturing on a common date, greatly complicated bookkeeping expenses, and impaired liquidity. Congress acted promptly to cure the problem by eliminating capital gains taxes on Treasury bills.
Similarly, two years after providing for the conversion of notes and bonds into STRIPS, Treasury officials introduced a facility for converting STRIPS back into notes and bonds. Arbitrage thereafter prevented the market value of STRIPS from falling significantly below the market value of the notes or bonds from which they were derived, thus importing the liquidity of conventional notes and bonds into the STRIPS market.
TIPS are the only example of a new Treasury debt instrument that suffered from appreciable illiquidity. In part, this was a consequence of the fact that TIPS were particularly attractive to a variety of buy-and-hold investors, like pension funds, that do not need to trade frequently. Additionally, because TIPS provide income streams different from those provided by conventional fixed-income securities, their value relative to that of conventional securities is not readily identifiable and TIPS prices are not closely tied to prices of nominal notes and bonds by cross-market arbitrage. Some of the benefit of issuing TIPS was offset, in the early years of the program, by larger yield premiums associated with reduced secondary-market liquidity. The liquidity of the TIPS market has, however, improved over time as TIPS have grown to be a more important vehicle for Treasury debt finance (TIPS are discussed further in articles by Sack and Elsasser and Dudley et al.).
This brief review of innovations in Treasury debt securities in the twentieth century suggests that the Treasury has been an infrequent, but nevertheless astute, innovator. It has introduced new securities to address significant problems faced by itself or by investors, and it has benefited from commensurately reduced funding costs. Additionally, it has been sensitive to innovate securities with terms that promote liquidity, to revise terms on the basis of experience to further enhance liquidity, and to ensure issuance volumes large enough to sustain liquid secondary markets.
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.