The federal government has been showing a surplus for two years, prompting the Treasury to pay down debt and scale back issuance. That’s the good news.

Unfortunately, Uncle Sam’s progress at crawling out from under his mountain of debt is creating some unwelcome turmoil in other bond markets. U.S. Treasurys have been the benchmark securities against which most other classes of debt have been priced for more than 20 years. The drop in the available supply threatens to limit their ability to fill this role.

In fact, as of July 31, marketable Treasury securities outstanding had fallen to $3 trillion from $3.5 trillion two years ago, and the Office of Management and Budget projects that continuing surpluses will cause this debt to be fully redeemed in 2012.

If Treasurys can no longer be used as the benchmark security for the bond markets, that could pose a huge headache for issuers, underwriters and investors.

The possibility caused something of a stir earlier this year when the Treasury Department revealed its plans to buy back outstanding government bonds and use the budget surplus to reduce the overall national debt for the first time in decades. In a scenario straight out of Economics 101, the threat of a shrinking supply of government debt sparked a rally in the long bond.

The rally in long term Treasurys also led to a so-called inverted yield curve that has persisted for months: Bonds with short-term maturities suddenly had higher yields than long-term debt. Only in the past few weeks has the long end of the yield curve begun turning back to more of a normal pattern, but 30-year Treasurys still carry lower yields than one and two-year T- bills.

The inverted yield curve has made it impractical for corporate issuers to price their long-term debt against the 30-year Treasury. Instead, issuers have already found it expedient to price their bonds over agencies or swaps, at least for pre- marketing purposes.

Fed Economist Weighs In

Whether these short-term remedies evolve into long-term solutions is another matter, but the practicality of such solutions has been assessed by an economist at the Federal Reserve Bank of New York.

“Many of the features that make the Treasury an attractive benchmark and reserve asset are likely to be adversely affected by the paydown of federal debt, and recent developments suggest that this may be happening already,” N.Y. Fed Senior Economist Michael J. Fleming wrote in a report to be published in a forthcoming issue of Brookings Papers on Economic Activities.

Some readers might remember that Fleming also visited the question of the paydown of the national debt earlier this year, and his earlier work sparked a rally in securities issued by government sponsored enterprises, or GSEs. Financial publications such as The Wall Street Journal. published accounts of his research.

In his upcoming report, Fleming evaluates the most likely substitute benchmarks such as agency debt, corporate debt and interest rate swaps. The report also briefly addresses the impact an altered market for U.S. Treasurys might have on the Social Security trust fund.

The paydowns achieved so far may appear modest, since only a small fraction of the total outstanding federal debt turns over each year, but there has already been a substantial reduction in new issuance, Fleming notes.

The Agency Alternative

The current pattern of federal budget surpluses began in 1998, and at the time, officials from two GSEs, Fannie Mae and Freddie Mac, were quick to respond, proposing that their debt could be used to fill the vacuum left by the reduction in Treasury debt.

Offerings of Fannie Mae Benchmark Notes and Freddie Mac Reference Notes have ranged from $2 billion to $9 billion, and they’ve had enough liquidity and enough action in the repo market to give them some credibility as an alternative.

In addition, “the relative performance of agency securities with other fixed income securities suggests that they may be good reference and hedging benchmarks,” wrote Fleming.

“Yields on agency securities tend to move closely with those of swaps and corporates over periods of time,” he wrote. “The co-movement suggests a credit component to interest rate risk that is common to agencies, swaps and corporates, but not Treasurys.”

On the other hand, while credit risk has caused agencies to move largely in synch with the rest of the bond market, the fact that they are not risk free like Treasurys is also a disadvantage. Despite the widespread assumption that Fannie Mae and Freddie Mac are somehow protected by the U.S. government, the privileges they enjoy could be erased by Congress.

This threat to the GSE’s current protected status was brought to light in March when Treasury Under Secretary Gary Gensler told Congress he favored eliminating the lines of credit Fannie Mae and Freddie Mac now have at the Treasury. This sparked a sell-off in agency debt.

While Congress isn’t likely to revisit the GSE issue until after the election, the threat remains.

But if agencies lose their appeal as a substitute benchmark, where will the markets turn? One possibility is corporate debt.

Have You Priced off a Ford Lately?

In the days before the massive run up of Federal debt, it was not uncommon for corporate bond issuers to price their debt relative to other large liquid corporate bonds such as those issued by the financing arms of auto companies.

In some ways a return to this practice makes sense.

The supply of agency debt stood at $1.6 trillion as of March 31, the most recent data Fleming had at the time he wrote his report. By contrast, the supply of corporate debt stood at $3.1 trillion on March 31.

Unfortunately, the corporate market is far more fragmented than the agency market, which is dominated by a relative handful of large issues, including Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system. Fannie alone had roughly one- third of the total agency debt.

One of the largest corporate issuers, Ford Motor Credit, by comparison, had $155 billion of outstanding debt as of March 31, or roughly 5% of the market’s total. Not only is the value of bonds from individual issuers a relatively small portion of the overall market, but credit quality can vary widely. Some issuers are naturally going to have high-grade AA or AAA debt, while others are going to be saddled with junk bonds.

The fragmentation of the corporate market lessens liquidity for many issuers.

“Indexes do not necessarily make good reference benchmarks, and they cannot be used for hedging,” wrote Fleming. “Individual issues, on the other hand, often carry significant credit risk such that their performance deviates sharply from that of other issues.”

Ford Motor Co.’s recent experience is instructive.

The automaker announced its Global Landmark Securities (GlobLS) program in June 1999, in an obvious attempt to be the corporate market’s answer to Fannie Mae and Freddie Mac. But, one year later, it was forced to cancel a $3 billion issue due to “Ford fatigue,” said Jennifer Doerr of Standard & Poor’s MMS.

“They overhit their funding targets,” she explained.

As recently as August, the yields on Ford’s debt widened some 25 to 30 basis points just as the firestorm was ignited regarding the faulty Firestone tires on Ford’s Explorer.

Now, with Ford’s hope of making its GlobaLS a benchmark answer to the shrinking supply of Treasurys dashed for now, others with similar ambitions are becoming more cautious. Doerr says that if Ford can’t do it, other corporate issuers are probably less confident of their ability to fill the vacuum left by the U.S. Treasury.

Can You Swap This?

Fleming is relatively optimistic on the practicality of relying upon interest rate swaps, which are typically agreements by financial institutions to exchange a fixed rate stream of interest payments for an adjustable rate.

Fleming notes that the swap market is large enough and liquid enough to serve as a substitute benchmark. Perhaps the single biggest risk associated with swaps is credit risk.

But Fleming wrote that most swap contracts permit a party to unwind its contract should its counterparty lose its investment grade rating. Finally, swap dealers tend to insulate their clients against counterparty default by executing swap agreements out of credit- enhanced subsidiaries.

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