Free exchange: Bond shelter
America’s ability to issue debt is helped by a resemblance between Treasuries and money
Mar 10th 2012 | from the print edition
IN A financial landscape full of oddities, the prospect of America being paid interest by its creditors when its national debt is rocketing is one of the oddest. The Treasury recently disclosed it is exploring how to let investors enter negative yields when bidding at debt auctions. Clearly, demand for American government debt is driven by much more than a hunger for returns. Financial-market participants use Treasury bonds and bills as collateral to secure lending, for instance. And for risk-averse investors such as foreign central banks, money-market funds and retirees, America’s debt is uniquely suited to storing savings without much due diligence. In short, its government debt is a lot like money.
This analogy is not perfect, of course. Treasury bonds are less useful for buying things and government debt carries at least the possibility of default. But in terms of liquidity, risk and returns, few things come closer to money. In a recent paper* Arvind Krishnamurthy and Annette Vissing-Jorgensen of Northwestern University quantify the money-like properties of American debt by comparing its supply from 1926 to 2008 with market-based measures of safety and liquidity. They find that when the supply of Treasuries is lower (as measured by the debt-to-GDP ratio), demand goes up, widening the spread between their yields and those on AAA-rated corporate bonds.
The price of safety
That, the authors say, is evidence of the higher value investors place on holding something that is 100% safe (a Treasury bond) rather than almost 100% safe (the AAA-rated corporate bond). At the same time the spread between AAA-rated and lower-rated corporate bonds also widens, a sign that the supply of Treasuries has a broader effect on the price of safer assets. Lower amounts of Treasury debt also lead to a wider spread between Treasury-bill yields and the interest paid on federally insured bank certificates of deposit. Since both are guaranteed by the government, the authors attribute the lower relative yields on T-bills to increased demand for their superior liquidity. Mr Krishnamurthy and Ms Vissing-Jorgensen reckon the value that investors place on the safety and liquidity of Treasuries averaged a hefty 73 basis points in forgone yields over the period they studied.
Lower borrowing costs on government debt are a boon for the taxpayer but not necessarily helpful to other debt issuers. When the supply of Treasuries rises investors get all the safety they need from government-debt issuance. That strips higher-rated corporate borrowers of demand. And constraining the supply of Treasuries brings its own problems. If the federal government does not supply enough money-like assets, investors will go elsewhere in search of safety. Private intermediaries may fill the void with cheap imitations such as asset-backed commercial paper and repurchase, or “repo”, loans (a type of secured short-term funding). Jeremy Stein, a professor at Harvard University and a nominee for governor of the Federal Reserve, says excessive private-money creation can leave the financial system too reliant on these forms of short-term debt and vulnerable to a shock. In a paper co-authored with Robin Greenwood and Samuel Hanson, he argues that more government short-term borrowing can reduce harmful private-money creation.
For policymakers, the role of Treasuries as “money” has several implications. The most obvious is that when investors are willing to pay a higher premium for safety and liquidity, the government can safely carry more debt. David Greenlaw of Morgan Stanley notes that since 2008 the safety premium identified by Mr Krishnamurthy and Ms Vissing-Jorgensen appears to have grown for any given level of debt (see left-hand chart). This could be down to increased demand for safe assets from emerging-market central banks or from banks facing new liquidity rules. Or the culprit may be a shrunken supply of other types of safe assets (see right-hand chart). The commercial-paper and repo markets have slimmed, for example, and the spectre of default haunts several euro-zone sovereign bonds.
With fewer havens to choose from, the surge in Treasury debt since 2008 may have had positive spillovers beyond enabling a generous fiscal stimulus. It has supplied private investors and financial institutions with enough “money” to satisfy their hunger for safety and grease the wheels of the markets. That is analogous to the dollar’s role as reserve currency, which obliges America to issue debt securities in which foreigners can invest those dollars.
Another implication is that America could issue more short-term paper than its debt managers, who worry about rolling over too much paper under adverse conditions, would normally deem prudent. Those worries are not baseless: eventually the thirst for the safest of safe assets will ease and the supply of alternative investments will return. As a compromise the Treasury is mulling the issuance of floating-rate notes, whose interest rate would be reset daily and whose maturity of two years or above would limit rollover risk.
The final implication is for central banks in America, Britain and Japan that have implemented quantitative easing (QE), the purchase of bonds with newly created money. Some of that money has been used to buy up long-term government debt in order to lower long-term interest rates. But in a separate paper Mr Krishnamurthy and Ms Vissing-Jorgensen argue that, by reducing the available supply of sovereign debt, QE raises the premium investors place on the safety and liquidity of government borrowers. That does not help riskier private borrowers, however. It would be more effective to focus QE on assets that are not in such demand, like mortgage-backed securities or corporate debt—the ones, in other words, that behave less like money.
“The Aggregate Demand for Treasury Debt”, by Arvind Krishnamurthy and Annette Vissing-Jorgensen, January 9th, 2012
“The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy”, by Arvind Krishnamurthy and Annette Vissing-Jorgensen, September 9th, 2011
“A Comparative-Advantage Approach to Government Debt Maturity”, by Robin Greenwood (Harvard University and NBER), Samuel G. Hanson (Harvard University), Jeremy C. Stein (Harvard University and NBER), January 2012
“Monetary Policy as Financial Stability Regulation”, by Jeremy C. Stein (Harvard), Forthcoming, Quarterly Journal of Economics
The original article is linked here.