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Treasury Buy-Back Program

© Naeem Akhtar

As the government surplus swelled in the U.S. in 2000, the Treasury began repurchasing long-dated bonds. The buy-back program had a dramatic impact on the financial sector, significantly reducing liquidity in the market for thirty-year Treasury bonds.

In addition, Treasury repurchases pulled down yields on thirty-year bonds, causing the yield curve to invert. Market participants viewed the inversion as "artificial" because of repurchasing activity and since there was no parallel inversion in corporate and agency debt yields.The liquidity reduction in the thirty-year bond was sufficiently severe that it forced traders to largely abandon the security as a benchmark for pricing other securities. Marketmakers, however, need a continuous flow of transactions for benchmarking purposes. As discontinuities developed in thirty-year bond trading, reliance shifted more heavily to the ten-year Treasury as a benchmark reference.

This was a critical change for financial markets. Since its introduction in the 1970s, the thirty-year government bond had always played a key benchmark role. Besides being used as a basis for pricing numerous other long-dated securities such as corporates, municipals, and sovereign debt, it was used for interpolating prices for off-the-run Treasuries. In addition, it was the basis for pricing options and other derivative products. Only the thirty-year Treasury offered sufficiently liquidity for use in pricing models throughout the day as a means for establishing valuations. Without this bellwether benchmark, pricing is more difficult.

Fortunately, the market for ten-year Treasuries has remained liquid because the Treasury has focused on repurchasing longer-dated government securities. As a result, the ten-year Treasury has become more widely accepted as a benchmark.

A survey indicates that agency debt should replace Treasuries as a benchmark. The problem with agency debt is that it is not riskless. The U.S. government offers no explicit guarantee against default. Investors have presumed there is an implicit guarantee, however, because Congress created the agencies. Indeed, agencies are technically classified as government-sponsored enterprises (GSEs), and they enjoy many regulatory and legal benefits that private debt issuers do not.

Of course, for the moment there is sufficient liquidity in the ten-year Treasury to satisfy market needs. But until questions about agency debt status are resolved, additional Treasury repurchases will reduce the benchmark efficiency of the ten-year Treasury and potentially induce greater volatility in prices for fixed income securities. How and when agency debt status is resolved and what continued repurchase of ten-year Treasuries will mean are important emerging issues in creating reliable benchmarks in financial markets

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