A week ago, the US Treasury announced a program to double buybacks of long-term debt. The announcement came on the heels of rising long term US bond yields. After the announcement, yields fell, though the effect was short-lived.
How does the buyback program work?
The buyback program effectively swaps long term debt for short term debt. The treasury issues short term debt and uses the proceeds to retire outstanding long-term debt. This changes the maturity structure of the debt. The average debt maturity goes down.
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How is this supposed to help?
From the government’s perspective, this buyback program accomplishes two goals. First, it reduces yields on long-term bonds. This is good for consumers and businesses that can borrow long term more cheaply. For example, mortgage rates are closely linked to long term yields. Second, it reduces borrowing costs for the government. Currently, the ten-year Treasury yield is 4.7%. The one-year Treasury yield is 4%. Switching from the ten-year to the one-year saves 0.7% in interest costs.
While lowering maturity can reduce borrowing costs, it comes with its own risks. For one, the government has to rollover the debt sooner. If interest rates go up in the short term, borrowing costs may end up increasing. Recently, Fed Chair Kevin Warsh indicated that interest rates would go up if inflation stays at current levels.
For an investor, holding long term debt is riskier. This is why investors typically get a higher return for buying long-term bonds. It is compensation for risk. For the issuer (i.e. government or business), it is preferable to issue long-term bonds. It results in more stable and predictable cash outflows. Issuers pay a premium for this stability.
A key insight here is that investor tolerance for risk matters. If risk tolerance is high, they are more willing to buy long term debt. When the US treasury intervened in the bond market, it did so in response to rising long term yields. Bond yields and prices move in opposite directions. A higher yield means lower prices, likely due to a fall in demand.
Thus, the treasury was responding to a fall in demand for long term debt. It responded by announcing that they would swap long term for short term debt, for which demand is more stable. Many commentators criticized the US Treasury for trying to manipulate bond markets. But it is also possible that they were simply responding to changing market conditions.
Why has the demand for long term debt fallen?
There are two possibilities, one good and one bad. The good possibility is that there are better investment opportunities for long term investors. In this scenario, higher treasury yields imply higher economic growth. The bad possibility is that investors are worried about inflation and the fiscal deficit. When deficit and debt levels increase, inflation tends to follow as governments attempt to monetize the debt. In this scenario, higher treasury yields imply higher inflation.
Can we tell which of these factors is driving the increase in yields?
Unfortunately, we can’t know for sure. But we can make a good guess based on other data. Market and survey-based measures of expected inflation tell us that inflation expectations are moderately higher today compared to the start of the year.
One common measure, the ten-year breakeven rate, is up about 10 basis points this year. In contrast, the actual ten-year yield is up about 50 basis points this year. This points to most of the yield increase not due to higher inflation. Instead, the higher yields point to a growing economy. Note that this is an imperfect measure, so it is still a guess.
The actions of the US Treasury point us in a different direction. The Treasury would be concerned if it thought inflation and the deficit were the cause of higher yields. The Treasury would not be concerned if economic growth was the cause of higher yields. The fact that the Treasury acted and intervened in the bond market indicates that they are concerned.
If average maturity of US debt declines in a significant way, the US fiscal position becomes much riskier. This in turn makes long-term debt riskier for an investor and further reinforces the move towards short-term debt.
This implies that from an investor’s perspective, there is some increase in risk from holding long term US bonds. Investors have not lost faith in the Treasury market. But there is a level of concern that did not exist at the start of the year.
Disclaimer:
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.