Debt Maturity

Another essay , a chip shorter this fourth dimension , on maturity construction of  US debt. I was asked to give comments on a newspaper by Robin Greenwood , Sam Hanson , in addition to Jeremy Stein ^* at a conference at the Treasury. It's a genuinely overnice newspaper , in addition to (unusually) I didn't lead hold much incisive to order most it , except to order it didn't larn inwards enough. And , I only had 10 minutes. So I gave a spoken language instead. (The pdf version on my webpage may hold upward improve reading , in addition to volition hold upward updated if I ever practice anything amongst this.) 

Having your cake in addition to eating it too: The maturity construction of U.S. debt
John H. Cochrane ¹
Nov xv 2012

Robin Greenwood , Sam Hanson , in addition to Jeremy Stein ² nicely model 2 of import considerations for the maturity construction of authorities debt: Long–term debt insulates authorities finances from interest-rate increases. Short-term debt is highly valued equally a “liquid” property , providing many “money-like” services , in addition to potentially displacing run-prone financial intermediaries equally suppliers of “liquidity.” Long-term debt also provides some liquidity in addition to collateral services , (Krishnamurthy in addition to Vissing-Jorgensen³ (2012)) but non equally effectively equally short-term debt. How practice nosotros shout out upward most this tradeoff?

Posing the query this way is already a pretty radical departure. The maturity construction of U.S. debt is traditionally perceived equally a relatively technical project , to finance a given deficit current at lowest long-run cost , equally Colin Kim eloquently explained inwards the panel. Greenwood , Hanson in addition to Stein , along amongst the other papers at this conference , are quest the Treasury’s Office of Debt Management to consider large economical issues far beyond this traditional question. For instance , maxim the Treasury should provide liquid debt because it helps the financial organisation in addition to tin sack substitute for banking regulation , whether or non that saves the Treasury coin , asks the Treasury to shout out upward most its operations a lot to a greater extent than equally the Fed does. Well , times lead hold changed; the maturity construction of U.S. debt does lead hold of import broader implications. And getting it right or incorrect could brand a huge difference inwards the hard times ahead.

Go Long!

As I shout out upward most the selection betwixt long in addition to brusk term debt , I experience similar screaming⁴ “Go Long. Now!” Bond markets are offering the U.S. an incredible deal. The xxx twelvemonth Treasury charge per unit of measurement equally I write is 2.77%. The authorities tin sack lock inwards a nominal charge per unit of measurement of 2.77% for the side past times side xxx years , in addition to fifty-fifty that tin sack hold upward paid dorsum inwards inflated dollars! (Comments at the conference suggested that term construction models impute a negative adventure premium to these depression rates: They are below expected time to come brusk rates , so markets are paying us for the privilege of writing interest-rate insurance!)

Our Government has taken the contrary tack. When you lot include the Fed (The Fed has bought upward most of the recent long-term Treasury issues , inwards a deliberate movement to shorten the maturity structure) the U.S. rolls over most one-half its debt every 2 years⁵.

Here’s the nightmare scenario: Suppose that 4 years from at nowadays , involvement rates rising five per centum , i.e. dorsum to normal , in addition to the U.S. has $20 trillion outstanding. Interest costs solitary volition rising $1 trillion (5% of $20 trillion⁶ ) – doubling already unsustainable deficits! This is what happened to Italy , Kingdom of Spain , in addition to Portugal. Don’t shout out upward it can’t travel on to us. It’s fifty-fifty to a greater extent than probable , because fearfulness of inflation – which did non hitting them , since they are on the Euro – tin sack hitting us.

Moreover , the habit of rolling over debt every 2 years leaves us vulnerable to a rollover crisis. Each twelvemonth our Treasury does non lead hold to precisely borrow $1 trillion to fund that year’s deficits. It has to borrow most $4 trillion to a greater extent than to pay off maturing debt. If bond markets order no , nosotros lead hold a crisis on our hands.

Going long buys us insurance against all these events. And bond markets are begging us to practice it! Most large companies are issuing equally much long-term debt equally they can.

I emphasize “insurance.” Long rates are depression , in addition to involvement charge per unit of measurement volatility is low. This isn’t most the forecast (you can’t purchase insurance against something expected) in addition to it’s non most volatility. It’s most a large left tail. What if the 4% growth underlying our already depressing deficit forecasts turns into some other 4 years of sclerotic 1.5% growth , the CBOs static revenue forecasts from higher taxation rates neglect to materialize , inflation picks upward , budget chaos raises the adventure premium of U.S. debt , in addition to China⁷ stops buying?

The earth has changed. In the past times , the Treasury could adapt maturity construction thinking only most liquidity or term premiums. The financial risks were small-scale , since the overall amount of debt was small. With debts inwards a higher house gross domestic product , in addition to five times Federal revenues , the quondam rules cash inwards one's chips out the window.

Fix the accounting

Why non cash inwards one's chips long? I suspect the Treasury is reluctant to cash inwards one's chips long because , nether electrical current accounting , moving $10 trillion of debt to long-term would add together $277 billion to involvement costs , which makes the electrical current deficit expression much worse.

But this accounting makes no economical sense. Yield to maturity is non the same thing equally the annual cost of borrowing , which includes working capital missive of the alphabet gains in addition to losses. Confusing yield in addition to one-year render is a classic fallacy. (It makes fifty-fifty less feel given that the Fed is buying all the long term debt , so that the maturity hasn’t genuinely changed at all!)

If this consideration is belongings the Treasury dorsum , nosotros should gear upward the accounting. Politically hard you lot say. We’ll larn defendant of cooking the books , you lot say. OK , but is it genuinely worth running the province into a financial crisis because nosotros can’t gear upward the accounting? In elementary ways that every concern follows?

Simply marker to marketplace working capital missive of the alphabet gains in addition to losses , in addition to including that inwards the budget would hold upward a skillful start. Then , nosotros demand to calculate in addition to study expected working capital missive of the alphabet gains in addition to losses during the side past times side year.

According to the expectations hypothesis , which holds good at good at the relevant multiple-year horizons , in addition to perfectly if nosotros are willing to footnote “expectation” amongst “risk-neutral ,” the expected cost is independent of the maturity structure. An upward sloping yield bend way that the authorities expects to brand working capital missive of the alphabet gains on long-term bond issues that precisely offset their higher yields. I hold off that the Treasury would exercise a to a greater extent than sophisticated term construction model , to isolate adventure premia in addition to liquidity premia equally good equally expectations effects. That would hold upward all good in addition to skillful , but the overwhelming resultant would yet hold upward to take away the confusion of yield amongst return. You mightiness run across twenty or xxx terra firma betoken cost of going long , but non 2.77%.

Now , accounting is non miraculous. Interest costs don’t disappear. Higher long-term yields stand upward for to higher time to come involvement rates , in addition to therefore higher involvement costs inwards time to come years. But hither , the calculation would correctly demonstrate that the U.S. volition pay these higher time to come expected involvement costs independently of the maturity structure. Today’s 2.77% xxx twelvemonth yield is non “paid” today , inwards whatever meaningful sense. It is paid when involvement rates genuinely practice rise. And rolled-over brusk term debt would pay the same costs , at the same time.

Go fifty-fifty longer , in addition to to a greater extent than liquid

Why halt at xxx years? The Treasury should number perpetuities – bonds amongst no principal repayment date. When the authorities wants to pay downwards the debt , it only buys them dorsum at marketplace value.

Perpetuities pay a laid coupon – order $1 – forever. Their toll varies equally involvement rates rising in addition to fall. It would hold upward improve for the Treasury to sell only ane coupon amount – order $1 – rather than adapt the coupon amount so that the bond sells at par. After all , a $2 coupon is precisely 2 perpetuities , different the instance of coupon bonds. (If it genuinely matters to sell bonds at “par ,” in addition to so the Treasury tin sack only package the perpertuities. At a 1% yield , ane $1 perpetuity costs $100 , so sells at par. If yields rising to 2% , so the toll of a unmarried perpetuity falls to $50 , the Treasury tin sack number them inwards bundles of 2 , at “par.” Or peradventure people tin sack figure this out on their own.)

Perpetuities practice non historic menstruum , so perpetuities issued at different times are identical securities. There volition hold upward no to a greater extent than on-the-run / off-the-run spreads , no to a greater extent than liquidity premiums , no to a greater extent than arbitrages betwixt economically-equivalent bonds because ane can’t hold upward delivered when the other has been shorted. And at that topographic point volition hold upward no demand to curlicue over of maturing debt , ever.

This standardization would also sharply increment the liquidity of long-term debt. In plough , raising that liquidity should lower the overall charge per unit of measurement the authorities pays. It’s a win-win all around.

(While we’re at it , the Treasury should also number an inflation-protected perpetuity , amongst a fixed existent coupon , in addition to adapt that coupon downwards for deflation symmetrically amongst upwards adjustments for inflation. The coupon pays $1 2012 dollars , forever. That would hold upward a improve in addition to to a greater extent than liquid version of its electrical current TIPS. Finally , the Treasury should number variable-coupon debt. The coupon on this debt would deed similar corporate dividends , in addition to variable-coupon debt would portion similar an equity origin of authorities financing. By cutting the dividend inwards bad times , the authorities could trim down its debts without the calamities of default or inflation. By raising the coupon inwards skillful times , the authorities would works life a reputation that makes the bonds saleable , in addition to convince investors to grip on through coupon reductions. Coupon adjustments should hold upward made past times Congress , of course.)

Go modern

If nosotros cash inwards one's chips long , what most the liquidity advantages of short-term debt? Just a piddling financial engineering could avoid the apparent tradeoff betwixt long in addition to brusk term debt , allow the Treasury to speedily cash inwards one's chips longer without having to dramatically reform the maturity construction of authorities securities , which volition bring far to a greater extent than fourth dimension than nosotros lead hold , in addition to it could assist to larn precisely about faulty accounting.

In modern finance , exposure is no longer tied to investment amounts. With aggressive exercise of involvement charge per unit of measurement swaps , (and , potentially , futures , interest-rate options , or CPI swaps ,) the Treasury could purchase the involvement charge per unit of measurement protection the authorities urgently needs , furnish equally much short-term debt equally liquidity demands , in addition to satisfy the political demands of budget accounting. There demand hold upward no tradeoff at all. We tin sack lead hold our cake in addition to consume it too.

For instance , suppose the Treasury issues only one-month debt , but in addition to so swaps it all to fixed rate. The Treasury agrees to pay to swap counterparties the fixed (2.77%) charge per unit of measurement in addition to have the floating one-year rate. Now , it has issued $16 trillion of one-month debt , sure satisfying whatever liquidity demand to the utmost. But the Treasury is fully protected against involvement charge per unit of measurement rises precisely equally if it had issued the entire amount inwards xxx twelvemonth bonds. The investment amount is ane calendar month , the adventure exposure is xxx years. Every banking concern routinely uses swaps to adapt its interest-rate exposure without touching its low-cost origin of funds (sticky liabilities) or its profitable but illiquid assets (loans). The Treasury should practice the same!

(I don’t know plenty most deficit accounting to know where swap payments cash inwards one's chips , but I’ll leave of absence it equally an article of organized religious belief that the sharpies at Goldman Sachs who made Greek debt disappear inwards 2006 tin sack larn precisely about that ane too.

Yes , nosotros demand to brand certain that swap counterparties are non too-big-to-fail banks , of course! But swap contracts are collateralized , so counterparty credit adventure is non genuinely that large an issue. The lower posts plenty collateral that the winner tin sack supercede the contract inwards the lawsuit the loser defaults And if Dodd-Frank is skillful for anything , it ought to hold upward skillful for keeping plain-vanilla involvement charge per unit of measurement adventure off the residual sheets of “systemically important” banks.

Finally , I order “Treasury ,” but what matters of course of pedagogy is the consolidated government. If it makes to a greater extent than feel for the Treasury to number in addition to travel past times on authorities interest-rate adventure management to the Fed , so hold upward it. The Fed tin sack to a greater extent than explicitly hold upward the Treasury’s property management service.)

The bigger point: The Treasury should enlarge its “maturity” selection beyond the 18th century selection of maturity amidst coupon bonds , to include at to the lowest degree 20th century plain-vanilla modern fixed income instruments.

Go long , again

I don’t know if I’ve pounded my fists on the tabular array enough. Historically normal involvement charge per unit of measurement rises volition transportation the U.S. into a financial tailspin , amongst involvement costs doubling our deficit , in addition to therefore forcing a truthful financial crisis. The markets are offering to bring this adventure from us for side past times side to nothing. For a while.

I don’t exaggerate much when I order , the fate of the Republic is inwards your hands!

Go Short

On the other side , Greenwood , Hanson , in addition to Stein remind us of the liquidity value of short-term U.S. Treasury debt. For instance , it is the most widely accepted cast of collateral , fifty-fifty inwards crises. Owning a one-month Treasury ever allows you lot to borrow. Many accounting rules process short-term Treasury debt equally equal to cash. More of that likewise seems a skillful idea. Again , though , nosotros tin sack practice improve , in addition to nosotros tin sack avoid the tradeoff.

Why halt at traditional Treasury bills? These lead hold awkward properties: They are only issued inwards large denominations , in addition to they are rolled over frequently. The Treasury should cash inwards one's chips beyond bills , in addition to number floating-rate debt , held inwards electronic book-entry form. Either the Treasury tin sack straight allow small-scale denomination , or it tin sack encourage money-market funds to intermediate for retail clients.

The most “liquid” floating-rate debt has a constant principal value of $1.00 , always. It’s similar a money-market fund , where each part is ever worth $1 , in addition to involvement is paid on peak of that. That tin sack hold upward achieved past times a daily auction , equally overnight repo rates were laid inwards a marketplace each day. However , a daily auction is non necessary , if the Treasury only guarantees the value at 1.00 similar a coin marketplace fund. Then the charge per unit of measurement tin sack in addition to so hold upward indexed or only adjusted at a periodic auction to adapt the quantity outstanding. (The Treasury maintains an concern human relationship at the Fed , in addition to uses that buffer to freely merchandise bonds for reserves at 1.00 betwixt interest-rate reset periods.)

Yes , this is interest-paying coin , issued past times the Treasury. Every collateral , liquidity , or money-like characteristic of one-month Treasury debt I tin sack shout out upward of works improve amongst such fixed-value floating charge per unit of measurement debt. Why bother “money-like” monthly Treasuries , when nosotros tin sack lead hold coin itself , without suffering whatever involvement cost?

Overnight , floating-rate , electronic-entry Federal debt already exists. It’s called banking concern reserves. However , banking concern reserves are only available to banks , so lead hold to hold upward intermediated in ane lawsuit again to hold upward available to the relaxation of the financial system. Also the Fed’s electrical current “exit strategy” involves reestablishing a spread betwixt reserves in addition to marketplace rates , which way reducing the quantity of reserves in addition to sending the financial organisation off to other sources of “liquidity.”

Fixed-value , floating-rate , Treasury debt -- involvement on reserves for everyone -- allows us to alive the “optimum quantity of money” described past times Milton Friedman. With an involvement cost , people unnecessarily economize on coin balances past times spending to a greater extent than fourth dimension in addition to endeavour economizing on coin balances. Without an involvement cost , they voluntarily grip huge coin balances in addition to salvage all that fourth dimension , endeavour , in addition to cash-conserving financial engineering.

The advantages for our modern financial organisation are much deeper. With abundant floating-rate , fixed-value authorities debt , at that topographic point is only no demand for all the complicated in addition to run-prone “liquidity creation” that engulfed the financial system. Special role vehicles belongings mortgage tranches funded past times short-term debt , overnight repo , coin marketplace funds belongings Lehman Brothers debt in addition to promising fixed value , fifty-fifty banking concern deposits funding mortgages all cash inwards one's chips unnecessary for the role of creating liquid assets. Rather than allow all this intermediation in addition to and so promise that regulation tin sack halt the side past times side run , why non fully satisfy the demand for such assets directly? Then nosotros demand non fearfulness requiring that anyone who wants to grip risky or illiquid liabilities gibe those liabilities amongst similar assets , eliminating runs in addition to the demand for extensive adventure regulation. Greenwood , Hanson in addition to Stein telephone phone it “crowding out ,” in addition to a partial substitute for regulation. Yes , but let’s crowd out alone in addition to substitute for a lot to a greater extent than regulation!

No theory of inflation says at that topographic point is whatever occupation amongst the creation of such “money-like” assets , whatever to a greater extent than than the liquidity value of one-month bonds causes a occupation for price-level control. Keynesian in addition to new-Keynesian models order that the grade of involvement rates , which the Fed yet controls past times announcing the charge per unit of measurement on reserves in addition to discount window lending , controls inflation. An artificial involvement spread betwixt classes of Fed liabilities doesn’t matter. The Fiscal theory of the toll grade says that financial solvency gives toll grade command , non a scarcity of “liquid” vs. “illiquid” authorities debt. Monetarists thinks of reserves that pay total involvement equally bonds , non coin , so arbitrary amounts are non inflationary. Milton Friedman himself called for involvement on reserves.

Bottom line

As a policy priority , buying insurance against involvement charge per unit of measurement spikes at our electrical current extremely depression involvement rates is the showtime priority. This has to hold upward accomplished earlier long-term involvement rates rise. The left-tail danger of a run on U.S. Treasury debt , in addition to an interest-cost expiry spiral , is real.

Providing abundant liquidity amongst floating-rate debt , which volition discourage the reconstruction of a run-prone shadow banking organisation , is only a slightly longer term priority. An ideal maturity construction of authorities debt is perpetual. Long-term debt has a fixed $1 coupon , in addition to a floating price. Short-term debt has a fixed $1 toll debt in addition to a floating coupon. Then at that topographic point is never rollover adventure , or rollover transactions cost. Making all Treasury debt fifty-fifty to a greater extent than liquid , past times standardizing the long issues in addition to allowing low-cost electronic transactions of the brusk issues , greases the financial organisation in addition to lowers the rates the Treasury volition pay.

By opening upward to swap in addition to other derivative transactions , the Treasury tin sack dissociate the amount of interest-rate insurance it purchases or sells on behalf of taxpayers from the project of supplying the amount of these telephone commutation securities that private-sector “liquidity” demands require , in addition to that provide the least-cost origin of funding.

Obviously , these moves demand to hold upward coordinated amongst the Fed. There is no betoken inwards lengthening if the Fed precisely twists it away. I detect a vogue of the 2 institutions to follow parochial concerns in addition to to forget that at that topographic point is a unmarried budget constraint uniting them!

Enjoy your cake.

Footnotes

---

1 Professor of Finance , University of Chicago Booth School of Business , Research Associate , NBER , Senior Fellow , Hoover Institution , in addition to Adjunct Scholar , Cato institution. John.cochrane@chicagobooth.edu , http://faculty.chicagobooth.edu/john.cochrane. These are comments prepared for the Second Annual Roundtable on Treasury Markets in addition to Debt Management , Department of the Treasury , Nov xv , 2012. ^↩
2 Robin Greenwood , Samuel Hanson , in addition to Jeremy Stein , 2012 , “A Comparative-Advantage Approach to Government Debt Maturity” Manuscript , Harvard University. ^↩
3 Krishnamurthy , Arvind in addition to Annette Vissing-Jorgensen , 2012 , “The Aggregate Demand for Treasury Debt. Journal of Political Economy. (Aril 2012) ^↩
4 Actually , I’ve been screaming “go long” for a spell now. In item , run across “Inflation in addition to Debt ,” National Affairs ix (Fall 2011) , in addition to “Understanding financial in addition to monetary policy inwards the peachy recession: Some unpleasant financial arithmetics ,” European Economic Review 55 (2011) , 2-30. ^↩
5 I got this from Hamilton , James D. in addition to Cynthia Wu , 2011 , “The Effectiveness of Alternative Monetary Policy Tools inwards a Zero Lower Bound Environment ,” Manuscript , UCSD in addition to University of Chicago. They seat all debt on a null coupon equivalent basis. Beware the average maturity numbers , equally this ignores coupons in addition to weights long maturities likewise heavily. What nosotros desire of course of pedagogy is the duration of U.S. debt – alter inwards marketplace value inwards reply to involvement charge per unit of measurement changes – which I don’t lead hold handy. ^↩
6 I exercise the total debt , including that held past times authorities agencies , equally these are the claims on the Federal income tax. Using debt held past times the world does non generate a much prettier picture. ^↩
7 Daniel Beltran’s newspaper presented at the conference , said China solitary is worth 2%! (Beltran , Daniel , Maxwell Kretchmer , Jaime Marquez , Charles P. Thomas (2012) “Foreign Holdings of U.S. Treasuries in addition to U.S. Treasury Yields” Federal Reserve Board. ^↩