A recent research piece by Barclays Capital Strategist Joseph Abate argues for more Treasury supply in a piece entitled, "The case for more bills." Abate writes, "With the SFP bill program on hold and no slackening in the appetite of money funds and other risk-averse investors, we expect bills to remain well bid for the "foreseeable future". But is there a case for increasing issuance?" He notes, "As the bill universe has shrunk, the bid-to-cover ratio at auctions has nearly doubled since 2002, and yields have plunged to 0%. Heightened risk aversion has increased the demand for bills, compounding the lack of supply. In the current environment, ABCP and repo are imperfect substitutes. Money fund managers are struggling to balance investor demand for non-deposit near riskless investments against the shortage of eligible securities. In addition to the empirical case for more bills, given their demand, there may also be a "macro-prudential" role for increasing bill supply. Boosting the supply of bills would enable money funds to reduce their heavy bank exposure while at the same time decreasing systemic risk."
Abate explains, "As the Treasury has sought to lengthen the average maturity of the debt outstanding, it has cut back on bill issuance. Net issuance of bills fell nearly $300bn in 2011 and as a proportion of total outstanding Treasury debt has contracted to its lowest level in nearly 50 years. The decline bill supply this year was exaggerated by the expiration of the $200bn Supplemental Financing Program.... As increasing the debt ceiling became a political landmine, the program was terminated in March. And even though the Treasury now has the capacity under the debt ceiling to bring the SFP program back, it has decided not to -- at least for the "foreseeable future.... [N]et bill supply may contract further beyond March -- especially if the coupon calendar is left unchanged and the deficit comes in lower than expected."
He tells us, "As bill supply has shrunk, the sector has gotten richer, with secondary market yields pinned near zero for months. The bid-to-cover ratio at bill auctions has nearly doubled since 2002 -- climbing from under 2.5 when bills accounted for a fairly steady 20-25% of aggregate Treasury debt to over 4.6 this year. At recent 3m and 6m bill auctions, the bid-to cover ratio approached 5 -- that, is there was 5x the demand for the securities relative to the amount on offer. Similarly, the Treasury recently asked TBAC members for their opinion on "allowing negative rate bidding in bill auctions." Even allowing that the 10% supply figure is not a forecast, the continued scarcity of bills as the Treasury lengthens the average maturity of the outstanding is likely to keep them expensive and demand at weekly auctions brisk."
Abate continues on the "Money fund dilemma," "A "money-like" asset is any instrument that offers same-day liquidity and absolute security of principal return. And while Treasury bills are the money-like asset most commonly thought of, financial institutions have created instruments that are close substitutes. These include investments in money funds and bank deposits, as well as any asset whose short tenor and collateralization makes it nearly as safe and liquid as bills. Under most circumstances, these near-money instruments are fairly close substitutes for bills, which explains why, for instance, repo, commercial paper, and deposits all trade close to bill yields. The near moneyness of bills has a large effect on their yields. For 1m bills, during 1990-2006, the moneyness reduced their yield an estimated 30bp over what would be implied based on an asset pricing model derived from Treasury coupons."
He adds, "But as risk aversion picked up this summer, investors began to reconsider the near moneyness of their private sector substitutes. Money fund managers have reduced their holdings of commercial paper, deposits and repo from certain banks and regions. Since the end of May, total financial paper outstanding has contracted 21%, or $125bn, and money fund holdings of foreign bank deposits and CP have declined 18%. At the same time, aggregate money fund balances, although down slightly, have been remarkably stable in part because the funds have nearly 50% of their investments in securities with less than 7d left to maturity -- in effect, becoming even more "money-like." The stability in their balances and the shrinking universe of eligible assets has created a big headache for managers who are left picking over the reduced supply of government-guaranteed paper like shoppers after a holiday sale."
Abate writes, "Moreover, ABCP and repo are only imperfect substitutes for meeting this demand because their supply is also shrinking. The amount of AB-CP outstanding is just 29% of its 2007 peak, as balance sheet accounting rule changes and lingering aversion have kept issuance light and heavily skewed toward non-US financials. With so much scrutiny on the geographical distribution of their holdings and the heavy financial company exposure in their portfolios, ramping up AB-CP holdings now is doubtful. Similarly, regulators are pushing banks to term out their funding and reduce their reliance on the repo and short term unsecured wholesale funding markets. Tight limits on intra-day credit and close attention to balance sheet leverage may steadily shrink the size of the tri-party repo market."
He notes, "At the same time, Moody's notes that there has been a sharp decline in issuance caused by the consolidation in the banking sector, as well as a reduction in VRDNs caused by municipalities terming out their debt in the low rate environment and concerns about the banks providing the liquidity support on the structure. As a result, we believe there is a strong empirical case for increasing the supply of bills -- at least temporarily -- to meet the surge in demand caused by the increase in risk aversion."
Abate says, "However, there may also be other reasons for increasing the supply of bills, or at least letting it return to the 20-25% share of total Treasury debt outstanding in 2002-06. The standard argument given for lengthening the maturity profile of the Treasury's debt is to reduce rollover risk -- the risk that the combination of rising interest rates and frequent auctions would sharply increase the Treasury's debt service burden if it relied too heavily on bills (or FRNs, for that matter). But a series of recent articles has noted that there could also be a "macroprudential" role for debt management and the issuance of bills."
He continues, "As noted above, financial institutions can create near-money instruments that in normal times are close substitutes for government paper. However, as Greenwood, Hanson, and Stein (among others) note, these institutions have an incentive to over-issue this paper. The consequences from over-issuance of private sector near-money creates destabilizing asset fire sales in times of financial stress as the issuing institution attempts to meet its short-term claims by rapidly selling off its assets, for instance, by liquidating the collateral underlying repo transactions. Pozsar notes, for instance, that this incentive, together with the very strong appetite from institutional investors for near-money, contributed to the growth of the "shadow banking" sector in the years leading up to the 2008 financial crisis and may have contributed to its depth. It follows that if one goal of policy is to reduce this incentive for banks to over-issue near-money, then increasing the supply of short-duration government debt could crowd some of it out."
Finally, Abate concludes, "Instead, by starving the market of government near-money, the Treasury is unintentionally increasing the incentive banks have to issue substitutes. And even though high level of risk aversion may be preventing over-issuance currently, there is no guarantee that in the future, the gap between the supply and demand for government near-money will not be increasingly met by the private sector. This, in turn, increases systemic risk. As a result, we judge there is a strong case (both empirically and from the perspective of reducing systemic risk) to be made for increasing bill supply."
