Debt Management
Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges Gao ID: GAO-09-932 September 29, 2009The 2008 financial market crisis and the economic recession led to a rapid and substantial increase in federal debt. This report, part of a line of work on debt management, was conducted under the Comptroller General's authority. It describes current debt management challenges and examines the role of a program that could benefit Treasury--Treasury Inflation Protected Securities (TIPS). GAO analyzed market data and interviewed experts as well as the two largest holders of Treasury securities in each of six sectors.
In January 1997, Treasury introduced an inflation-indexed security--TIPS. Treasury's stated objectives were to both raise the national savings rate and to reduce the federal government's cost of borrowing. TIPS offer inflation protection to investors who are willing to pay a premium for this protection in the form of a lower interest rate. In a functioning TIPS market, the difference between the interest rate on nominal Treasury securities and the interest rate on TIPS is expected to be approximately equal to the expected inflation rate. Federal government actions in response to both the financial market crisis and the economic recession have added significantly to Treasury's borrowing needs. Since the onset of the recession in December 2007, Treasury has borrowed more than $2.3 trillion, largely by issuing short-term nominal debt, which significantly changed the composition of Treasury's debt portfolio. The challenges presented by increasing debt and the change in its composition take place in the context of the medium and longer term fiscal outlook and will not recede with the return of financial market stability and economic growth. The Congressional Budget Office (CBO) projects that, absent changes in current policy, debt held by the public will double in 5 years (from 2008 to 2013) and almost triple in 11 years (from 2008 to 2019)--reaching 82 percent of GDP. In order to meet these challenges Treasury needs to diversify its funding sources and lengthen the term-to-maturity of its debt portfolio. TIPS can contribute to this effort. Treasury's TIPS program has had varying degrees of liquidity (the ease with which investors can trade the security) since its inception. The major institutional investors that GAO interviewed perceived Treasury's commitment to the TIPS program as having wavered in recent years, decreasing the liquidity of TIPS in the market. Investors demand a premium for holding less-liquid TIPS, which increases Treasury's borrowing costs. TIPS offer benefits to Treasury and measuring the cost against which to weigh these benefits requires both forward-looking and after-the-fact analysis. A more robust TIPS program could benefit Treasury by diversifying and expanding its funding sources and reducing the cost of nominal securities. Governments are well suited to bear inflation risk because periods of inflation are often associated with increased revenues. TIPS auctions also help provide a measure of market inflation expectations. On July 1, 2009, GAO briefed Treasury's Office of Debt Management on the findings from our analysis and interviews with major institutional investors. Treasury later posed questions about ways to improve the TIPS program to the Primary Dealers and the Treasury Borrowing Advisory Committee (TBAC). At the August 2009 TBAC meeting, members discussed TIPS. Following the meeting, Treasury's Deputy Assistant Secretary for Federal Finance reaffirmed Treasury's commitment to TIPS and announced plans to gradually increase issuance of TIPS.
RecommendationsOur recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director: Team: Phone:GAO-09-932, Debt Management: Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges
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Should Play a Heightened Role in Addressing Debt Management Challenges'
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Report to the Secretary of the Treasury:
United States Government Accountability Office:
GAO:
September 2009:
Debt Management:
Treasury Inflation Protected Securities Should Play a Heightened Role
in Addressing Debt Management Challenges:
GAO-09-932:
GAO Highlights:
Highlights of GAO-09-932, a report to the Secretary of the Treasury.
Why GAO Did This Study:
The 2008 financial market crisis and the economic recession led to a
rapid and substantial increase in federal debt. This report, part of a
line of work on debt management, was conducted under the Comptroller
General‘s authority. It describes current debt management challenges
and examines the role of a program that could benefit Treasury”Treasury
Inflation Protected Securities (TIPS). GAO analyzed market data and
interviewed experts as well as the two largest holders of Treasury
securities in each of six sectors.
What GAO Found:
In January 1997, Treasury introduced an inflation-indexed security”
TIPS. Treasury‘s stated objectives were to both raise the national
savings rate and to reduce the federal government‘s cost of borrowing.
TIPS offer inflation protection to investors who are willing to pay a
premium for this protection in the form of a lower interest rate. In a
functioning TIPS market, the difference between the interest rate on
nominal Treasury securities and the interest rate on TIPS is expected
to be approximately equal to the expected inflation rate.
Federal government actions in response to both the financial market
crisis and the economic recession have added significantly to Treasury‘
s borrowing needs. Since the onset of the recession in December 2007,
Treasury has borrowed more than $2.3 trillion, largely by issuing short-
term nominal debt, which significantly changed the composition of
Treasury‘s debt portfolio. The challenges presented by increasing debt
and the change in its composition take place in the context of the
medium and longer term fiscal outlook and will not recede with the
return of financial market stability and economic growth. The
Congressional Budget Office (CBO) projects that, absent changes in
current policy, debt held by the public will double in 5 years (from
2008 to 2013) and almost triple in 11 years (from 2008 to 2019)”
reaching 82 percent of GDP. In order to meet these challenges Treasury
needs to diversify its funding sources and lengthen the term-to-
maturity of its debt portfolio. TIPS can contribute to this effort.
Treasury‘s TIPS program has had varying degrees of liquidity (the ease
with which investors can trade the security) since its inception. The
major institutional investors that GAO interviewed perceived Treasury‘s
commitment to the TIPS program as having wavered in recent years,
decreasing the liquidity of TIPS in the market. Investors demand a
premium for holding less-liquid TIPS, which increases Treasury‘s
borrowing costs.
TIPS offer benefits to Treasury and measuring the cost against which to
weigh these benefits requires both forward-looking and after-the-fact
analysis. A more robust TIPS program could benefit Treasury by
diversifying and expanding its funding sources and reducing the cost of
nominal securities. Governments are well suited to bear inflation risk
because periods of inflation are often associated with increased
revenues. TIPS auctions also help provide a measure of market inflation
expectations.
On July 1, 2009, GAO briefed Treasury‘s Office of Debt Management on
the findings from our analysis and interviews with major institutional
investors. Treasury later posed questions about ways to improve the
TIPS program to the Primary Dealers and the Treasury Borrowing Advisory
Committee (TBAC). At the August 2009 TBAC meeting, members discussed
TIPS. Following the meeting, Treasury‘s Deputy Assistant Secretary for
Federal Finance reaffirmed Treasury‘s commitment to TIPS and announced
plans to gradually increase issuance of TIPS.
What GAO Recommends:
GAO recommends that, in the context of projected sustained increases in
federal debt, the Secretary of the Treasury take steps to increase TIPS
liquidity and reduce their cost to Treasury: increase issuance, issue
longer-dated maturities, and conduct more frequent auctions. Also, the
Secretary should continually review the appropriate composition of the
TIPS program and consider: the impact of Treasury‘s public statements
and TIPS issuance on TIPS liquidity, how different analytical
perspectives are valuable for evaluating cost, how TIPS can diversify
Treasury‘s investor base, and how TIPS impact the cost of nominal
securities.
Treasury took note of our findings, conclusions, and recommendations
and said they were consistent with their commitment to increasing TIPS
issuance.
View [hyperlink, http://www.gao.gov/products/GAO-09-932] or key
components. For more information, contact Susan J. Irving at (202) 512-
6806 or irvings@gao.gov.
[End of section]
Contents:
Letter:
Background:
Scope and Methodology:
Size and Composition of Treasury's Debt Profile Has Changed
Substantially:
Treasury's TIPS Program Has Had Varying Degrees of Liquidity Since
Inception and Major Institutional Investors Have Expressed Concern
about Treasury's Commitment to the Program:
TIPS Program Offers Benefits to Treasury, and Measuring Its Cost
Requires both Forward-Looking and After-the-Fact Analysis:
Concluding Observations:
Recommendations:
Agency Comments:
Appendix I: Treasury Inflation Protected Securities:
Overview:
Principal:
Interest Payments:
Taxation:
Auction Schedule:
Purchasing TIPS:
Appendix II: The Cost of Treasury Inflation Protected Securities
Compared to Nominal Securities:
Disentangling the Drivers of Recent Shifts in the Nominal-TIPS Yield
Differential (Breakeven Inflation Rate):
Appendix III: GAO Contact and Staff Acknowledgments:
Figures:
Figure 1: Changes in Outstanding Marketable Treasury Securities from
December 31, 2007, to June 30, 2009 (Total Outstanding as of June 30,
2009--$6.6 trillion):
Figure 2: Marketable Securities by Year of Maturity, as of June 30,
2009 (Total Outstanding--$6.6 trillion):
Figure 3: Net Interest Costs and 10-Year Treasury Rates:
Figure 4: Debt Held by the Public and Percentage of GDP, 2001 through
2019:
Figure 5: Debt Held by the Public as a Share of GDP under Two Different
Fiscal Policy Simulations:
Figure 6: Treasury's Statements of Support for TIPS, Gross TIPS
Issuance, and the TIPS Program's Relative Costs:
Figure 7: Bid-to-Cover Ratios for Selected Treasury Securities, July
2003 to July 2009:
Figure 8: Inflation-Protected Mutual Funds and Assets under Management,
December 2002 to May 2009:
List of Abbreviations:
CBO: Congressional Budget Office:
CPI-U: Consumer Price Index for All Urban Consumers:
GDP: gross domestic product:
ODM: Office of Debt Management:
OMB: Office of Management and Budget:
SIFMA: Securities Industry and Financial Markets Association:
TARP: Troubled Asset Relief Program:
TBAC: Treasury Borrowing Advisory Committee:
TIPS: Treasury Inflation Protected Securities:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
September 29, 2009:
The Honorable Timothy F. Geithner:
Secretary of the Treasury:
Dear Mr. Secretary:
Between December 2007 and the end of June 2009, the Department of the
Treasury borrowed more than $2.3 trillion to finance federal government
actions related to both the financial market crisis and the economic
recession in addition to regular government financing needs. This rapid
and substantial increase in federal debt takes place in the context of
the medium-and long-term fiscal outlook that will present Treasury with
continued financing challenges long after the return of financial
stability and economic growth. GAO has begun a line of work related to
Treasury's management of its growing debt portfolio. As part of this
ongoing work, we will continue to provide updates and make
recommendations as appropriate.
In this first report, conducted under the Comptroller General's
authority, we describe Treasury's borrowing challenges and analyze one
Treasury program that has the potential to provide benefits to both
Treasury and investors--Treasury Inflation Protected Securities (TIPS).
We address the following questions:
* What are the debt management challenges associated with planning for
future borrowing needs given the long-term fiscal outlook and
Treasury's increased borrowing due to economic and financial sector
stress?
* What role, if any, should TIPS play in Treasury's borrowing program?
Background:
Congress has assigned to Treasury the responsibility of borrowing the
funds necessary to finance the gap between cash-in and cash-out,
subject to a statutory limit. Treasury's primary debt management goal
is to finance the government's borrowing needs at the lowest cost over
time. Issuing debt predictably through regularly scheduled auctions
lowers borrowing costs because investors and dealers value liquidity
and certainty of supply. Treasury responds to increases in borrowing
needs in a traditional manner, by first increasing the issuance size of
existing securities; then, increasing the frequency of issuances; and
finally, introducing new securities to its auction calendar as
necessary.
Treasury normally auctions nominal marketable securities that range in
maturity from 4 weeks to 30 years and sells them at auction on a pre-
announced schedule. Treasury also issues cash management bills that are
not part of the regular schedule to meet immediate cash needs. Treasury
securities are widely viewed as the premium risk-free asset and are
actively used by investors, traders, and foreign central banks for
hedging, liquidity, and reserve purposes. The outstanding mix of U.S.
Treasury securities can have a significant influence on the federal
government's interest payments. Longer term securities typically carry
higher interest rates (which translate to increased cost to the
government), primarily due to concerns about future inflation. However,
these longer term securities offer the government the certainty of
fixing the interest payments over a longer period and reduce the amount
of debt that Treasury needs to refinance in the short term. In
contrast, shorter term securities generally carry lower interest rates
but add volatility to the government's interest costs and require
Treasury to conduct more frequent auctions to refinance maturing debt.
During the 1980s and 1990s, a number of countries introduced inflation-
indexed securities to their debt offerings, including the United
Kingdom, France, and the United States.[Footnote 1] In January 1997,
Treasury introduced its own inflation-indexed securities, TIPS, as part
of its debt program. At the time, Treasury's stated objectives for
introducing TIPS were both to raise the national savings rate and to
reduce the federal government's cost of borrowing. TIPS offer inflation
protection to investors who are willing to pay a premium for this
protection in the form of a lower interest rate. In a functioning TIPS
market, the difference between the interest rate on nominal Treasury
securities and the interest rate on TIPS should approximately equal the
expected inflation rate. Treasury currently issues 5-, 10-, and 20-year
TIPS. In the past, Treasury issued 30-year TIPS, but discontinued them
in 2001. See appendix I for additional details on the structure of
TIPS.
Scope and Methodology:
To identify the debt management challenges associated with Treasury's
increased borrowing, we analyzed the scale, timing, term to maturity,
and composition of Treasury's borrowing since the start of the economic
recession, using data and information obtained from the Department of
the Treasury and the Federal Reserve. We also interviewed market
experts, Treasury, and Federal Reserve staff and officials.
To examine what role TIPS should play in Treasury's debt portfolio and
the potential for the TIPS program to help address Treasury's debt
management challenges, we conducted literature reviews on the costs and
benefits of inflation-indexed securities and examined research by
Federal Reserve economists, market experts, academic sources, and the
Department of the Treasury, including an internal review of the TIPS
program done by the Office of Debt Management (ODM). We also conducted
12 structured interviews in June 2009 with the two largest holders of
Treasury securities in each of the following sectors: mutual funds;
commercial banks; life insurance companies; property and casualty
insurance companies; state and local pension funds; and private pension
funds. The major institutional investors we interviewed held at least
$351 billion in Treasury securities. Of their Treasury holdings, $99.4
billion were TIPS, which was 19 percent of total outstanding TIPS as of
March 31, 2009. These interviews covered the institution's holdings of
Treasury securities, demand for TIPS, changes that could be made to the
TIPS program, perceived risks to investors in Treasury markets, and
Treasury's sources for information on demand for Treasury securities.
On July 1, 2009, we briefed Treasury's ODM on the findings from the
structured interviews, which are discussed and expanded upon in this
report.[Footnote 2]
Where possible and appropriate, we corroborated the results of our data
analyses and interviews with other sources. On the basis of our
assessment we believe that the data are reliable for the purposes of
our review. We conducted our review from June 2009 through August 2009
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that
the evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.
Size and Composition of Treasury's Debt Profile Has Changed
Substantially:
Treasury faces two near-term challenges in managing the growing
government debt: the rise in total outstanding debt and the shortening
of the average maturity of the debt profile.[Footnote 3] Treasury's
total outstanding debt increased by $2.3 trillion (25 percent increase
in federal debt) since the onset of the economic recession in December
2007.[Footnote 4] In actions Treasury described as in accordance with
normal operating procedures, Treasury increased short-term borrowing to
address its massive and immediate borrowing needs. As a result, the
average maturity of Treasury's debt decreased as the percentage of
marketable debt maturing within 1 year increased from 35.6 percent to
41.1 percent between September 2007 and June 2009. At the end of June
2009, Treasury's outstanding marketable securities stood at $6.6
trillion, an increase of almost $2.1 trillion from December
2007.[Footnote 5] The largest increase in outstanding marketable
Treasury securities was in short-term debt. Treasury bill and cash
management bill issuance increased by a combined $1 trillion between
December 2007 and June 2009.[Footnote 6] The amount of Treasury notes
issued also increased significantly over this period, adding $929.3
billion to the amount of notes outstanding. Almost half of the increase
was comprised of shorter-term notes (with 2-year and 5-year
maturities). The monthly issuance of 2-year notes alone has almost
doubled in the last 2 years. Figure 1 shows the relative size of the
increases in different categories of securities. The smallest increase
was in TIPS which increased by $60.6 billion.
Figure 1: Changes in Outstanding Marketable Treasury Securities from
December 31, 2007, to June 30, 2009 (Total Outstanding as of June 30,
2009--$6.6 trillion) (Dollars in billions):
[Refer to PDF for image: stacked vertical bar graph]
Borrowing, by Marketable Treasury Securities: Treasury notes;
Outstanding marketable Treasury securities as of Dec. 31, 2007:
$2,488.5;
Increase in marketable Treasury securities from Dec. 31, 2007 to June
30, 2009: $929.3;
Total: $3,417.8.
Borrowing, by Marketable Treasury Securities: Treasury bills;
Outstanding marketable Treasury securities as of Dec. 31, 2007:
$1,003.9;
Increase in marketable Treasury securities from Dec. 31, 2007 to June
30, 2009: $562.6;
Total: $1.566.5.
Borrowing, by Marketable Treasury Securities: Treasury bonds;
Outstanding marketable Treasury securities as of Dec. 31, 2007: $558.5;
Increase in marketable Treasury securities from Dec. 31, 2007 to June
30, 2009: $85.1;
Total: $643.6.
Borrowing, by Marketable Treasury Securities: Treasury Inflation
Protected Securities;
Outstanding marketable Treasury securities as of Dec. 31, 2007: $471.7;
Increase in marketable Treasury securities from Dec. 31, 2007 to June
30, 2009: $60.6;
Total: $532.3.
Borrowing, by Marketable Treasury Securities: Cash management bills;
Outstanding marketable Treasury securities as of Dec. 31, 2007: $0;
Increase in marketable Treasury securities from Dec. 31, 2007 to June
30, 2009: $440;
Total: $440.
Source: GAO analysis of Treasury monthly statement of public debt data.
Note: Does not include $11.9 billion in marketable securities
outstanding for the Federal Financing Bank. Treasury bills and cash
management bills are short-term securities that mature in 1 year or
less from their issue date. Treasury notes mature in more than 1 year,
but not more than 10 years from their issue date. Treasury bonds mature
in more than 10 years from their issue date. Treasury bills, notes, and
bonds are nominal securities, meaning they are not adjusted for
inflation. TIPS are adjusted for inflation and have maturities of 5,
10, or 20 years.
[End of figure]
Treasury has raised significant amounts of cash since the onset of the
economic recession in December 2007 largely by adhering to its regular
and predictable debt issuance schedule, which is meant to ensure the
lowest borrowing costs over time. However, Treasury has also turned to
issuing cash management bills, which are announced shortly before
auction to fulfill Treasury's immediate cash needs. After the financial
market crisis hit in fall of 2008, Treasury raised an unprecedented
$1.1 trillion in under 18 weeks largely by issuing cash management
bills. Treasury was able to finance such an amount due in part to
outsized demand among global investors for a safe and liquid financial
instrument in the midst of the contraction in global economic activity.
Figure 2: Marketable Securities by Year of Maturity, as of June 30,
2009 (Total Outstanding--$6.6 trillion) (Dollars in billions):
[Refer to PDF for image: vertical bar graph]
Year of maturity: 2009–2010: $3,041;
Percentage of total outstanding securities that mature during time
frame: 46%.
Year of maturity: 2011–2015: $2,083;
Percentage of total outstanding securities that mature during time
frame: 32%.
Year of maturity: 2016–2020: $864;
Percentage of total outstanding securities that mature during time
frame: 13%.
Year of maturity: 2021–2030: $424;
Percentage of total outstanding securities that mature during time
frame: 6%.
Year of maturity: 2031–2039: $188;
Percentage of total outstanding securities that mature during time
frame: 3%.
Source: GAO analysis of Treasury monthly statement of public debt data.
Note: Does not include $11.9 billion in marketable securities
outstanding for the Federal Financing Bank, $43 million in matured
notes, and $45 million in matured bonds.
[End of figure]
As shown in figure 2, 78 percent (or about $5.1 trillion) of the
outstanding marketable Treasuries mature by 2015 and will need to be
rolled over (or refinanced)--potentially at higher interest rates.
Because short-term rates have been reduced sharply by the decision of
the Federal Reserve to set its federal funds target near zero,
Treasury's borrowing costs decreased even though debt levels increased.
(See figure 3.) However, projections from both the Congressional Budget
Office (CBO) and Office of Management and Budget (OMB) assume higher
interest rates and higher interest payments. CBO's analysis of the
President's Budgetary Proposals for Fiscal Year 2010 assumed that
interest rates on 91-day Treasury bills would increase from 0.3 percent
in 2009 to 4.7 percent in 2015 and that interest on 10-year Treasury
notes would increase from 2.9 percent to 5.4 percent over the same
period. CBO's analysis of the President's Budgetary Proposals for
Fiscal Year 2010 shows--absent changes in policy--interest payments on
federal debt more than tripling--to almost $800 billion--by 2019.
[Footnote 7] (See figure 3.)
Figure 3: Net Interest Costs and 10-Year Treasury Rates (Dollars in
billions):
[Refer to PDF for image: vertical bar and line graph]
Fiscal year: 2000;
Actual net interest outlays: $223;
10-year Treasury nominal interest rate: 6.03%.
Fiscal year: 2001;
Actual net interest outlays: $206;
10-year Treasury nominal interest rate: 5.02%.
Fiscal year: 2002;
Actual net interest outlays: $171;
10-year Treasury nominal interest rate: 4.61%.
Fiscal year: 2003;
Actual net interest outlays: $153;
10-year Treasury nominal interest rate: 4.01%.
Fiscal year: 2004;
Actual net interest outlays: $160;
10-year Treasury nominal interest rate: 4.27%.
Fiscal year: 2005;
Actual net interest outlays: $184;
10-year Treasury nominal interest rate: 4.29%.
Fiscal year: 2006;
Actual net interest outlays: $227;
10-year Treasury nominal interest rate: 4.8%.
Fiscal year: 2007;
Actual net interest outlays: $237;
10-year Treasury nominal interest rate: 4.63%.
Fiscal year: 2008;
Actual net interest outlays: $253;
10-year Treasury nominal interest rate: 3.66%.
Fiscal year: 2009;
Estimated net interest outlays: $170;
10-year Treasury nominal interest rate: 2.9%.
Fiscal year: 2010;
Estimated net interest outlays: $173;
10-year Treasury nominal interest rate: 3.4%.
Fiscal year: 2011;
Estimated net interest outlays: $216;
10-year Treasury nominal interest rate: 4%.
Fiscal year: 2012;
Estimated net interest outlays: $283;
10-year Treasury nominal interest rate: 4.6%.
Fiscal year: 2013;
Estimated net interest outlays: $367;
10-year Treasury nominal interest rate: 5%.
Fiscal year: 2014;
Estimated net interest outlays: $459;
10-year Treasury nominal interest rate: 5.3%.
Fiscal year: 2015;
Estimated net interest outlays: $533;
10-year Treasury nominal interest rate: 5.4%.
Fiscal year: 2016;
Estimated net interest outlays: $597;
10-year Treasury nominal interest rate: 5.5%.
Fiscal year: 2017;
Estimated net interest outlays: $656;
10-year Treasury nominal interest rate: 5.6%.
Fiscal year: 2018;
Estimated net interest outlays: $728;
10-year Treasury nominal interest rate: 5.6%.
Fiscal year: 2019;
Estimated net interest outlays: $799;
10-year Treasury nominal interest rate: 5.6%.
Sources: Congressional Budget Office data from their analysis of the
President‘s budget proposal of actual and estimated net interest costs
and estimated interest rates and Federal Reserve data of actual
interest rates.
Note: Net interest outlays is a cash measure that is defined as
interest payments on gross debt less interest received on loans and
advances, and is affected by the volume of net debt on issue and by
interest rates.
[End of figure]
Treasury's Director of ODM and the ODM staff whom we interviewed view
the current maturity profile as reasonable given economic conditions
and the massive increase in borrowing that was necessary in a
compressed time period. They underscored the importance of making any
changes to the current debt portfolio in a gradual manner to ensure
that there will be enough demand at a reasonable price and told us that
they plan to gradually transition the portfolio into longer term debt.
[Footnote 8] They also told us that, given the need to be flexible
operationally, Treasury's debt management horizon is shorter than the
horizon used by CBO and OMB in budget projections and that they are
confident about their ability to finance the projected budget deficits
for 2010 and 2011.
Fiscal Outlook Will Present Continued Debt Management Challenges:
As noted, the federal government's policy response to the financial
market crisis and the economic recession created a significant increase
in both debt and debt management challenges. These will not recede when
stability returns to financial markets and economic growth resumes. CBO
projects that, absent changes in current policy, the debt held by the
public will double in 5 years (from 2008 to 2013) and almost triple in
11 years (from 2008 to 2019). (See figure 4.) CBO projects that debt
held by the public will increase from 41 percent of gross domestic
product (GDP) in fiscal year 2008 to 71 percent by the end of fiscal
year 2013.
Figure 4: Debt Held by the Public and Percentage of GDP, 2001 through
2019 (Dollars in trillions):
[Refer to PDF for image: vertical bar and line graph]
Fiscal year: 2001;
Actual debt held by the public: $3.3;
Debt held by the public (as a percentage of gross domestic product):
33%.
Fiscal year: 2002;
Actual debt held by the public: $3.5;
Debt held by the public (as a percentage of gross domestic product):
34%.
Fiscal year: 2003;
Actual debt held by the public: $3.9;
Debt held by the public (as a percentage of gross domestic product):
36%.
Fiscal year: 2004;
Actual debt held by the public: $4.3;
Debt held by the public (as a percentage of gross domestic product):
37%.
Fiscal year: 2005;
Actual debt held by the public: $4.6;
Debt held by the public (as a percentage of gross domestic product):
38%.
Fiscal year: 2006;
Actual debt held by the public: $4.8;
Debt held by the public (as a percentage of gross domestic product):
37%.
Fiscal year: 2007;
Actual debt held by the public: $5;
Debt held by the public (as a percentage of gross domestic product):
37%.
Fiscal year: 2008;
Actual debt held by the public: $5.8;
Debt held by the public (as a percentage of gross domestic product):
41%.
Fiscal year: 2009;
Projected debt held by the public: $8;
Debt held by the public (as a percentage of gross domestic product):
57%;
Fiscal year: 2010;
Projected debt held by the public: $9.4;
Debt held by the public (as a percentage of gross domestic product):
65%.
Fiscal year: 2011;
Projected debt held by the public: $10.3;
Debt held by the public (as a percentage of gross domestic product):
69%;
Fiscal year: 2012;
Projected debt held by the public: $11.1;
Debt held by the public (as a percentage of gross domestic product):
70%.
Fiscal year: 2013;
Projected debt held by the public: $11.8;
Debt held by the public (as a percentage of gross domestic product):
71%.
Fiscal year: 2014;
Projected debt held by the public: $12.6;
Debt held by the public (as a percentage of gross domestic product):
73%.
Fiscal year: 2015;
Projected debt held by the public: $13.5;
Debt held by the public (as a percentage of gross domestic product):
75%.
Fiscal year: 2016;
Projected debt held by the public: $14.4;
Debt held by the public (as a percentage of gross domestic product):
77%.
Fiscal year: 2017;
Projected debt held by the public: $15.4;
Debt held by the public (as a percentage of gross domestic product):
79%.
Fiscal year: 2018;
Projected debt held by the public: $15.9;
Debt held by the public (as a percentage of gross domestic product):
79%.
Fiscal year: 2019;
Projected debt held by the public: $17.1;
Debt held by the public (as a percentage of gross domestic product):
82%.
Source: Congressional Budget Office data from their analysis of the
President‘s budget proposal.
[End of figure]
The actions that Treasury has taken to increase borrowing in response
to the economic recession and financial market crisis take place within
the context of the already serious longer term fiscal condition of the
federal government. While the administration and Congress have been
understandably focused on addressing problems with financial markets
and responding to the economic recession, the government will need to
apply the same level of intensity to the nation's long-term fiscal
challenge. Both our long-term simulations and CBO's show growing
deficits and debt, underscoring that the long-term fiscal outlook is
unsustainable. Under our alternative simulation, by 2025 debt held by
the public would exceed the historical high of 109 percent of GDP,
reached in the aftermath of World War II.[Footnote 9] (See figure 5.)
Figure 5: Debt Held by the Public as a Share of GDP under Two Different
Fiscal Policy Simulations:
[Refer to PDF for image: multiple line graph]
Historical high: 109% in 1946.
Year: 2005;
Baseline extended: 37.5;
Alternative: 37.5.
Year: 2006;
Baseline extended: 37.1;
Alternative: 37.1.
Year: 2007;
Baseline extended: 36.9;
Alternative: 36.9.
Year: 2008;
Baseline extended: 40.8;
Alternative: 40.8.
Year: 2009;
Baseline extended: 54.8;
Alternative: 54.9.
Year: 2010;
Baseline extended: 60.1;
Alternative: 60.6.
Year: 2011;
Baseline extended: 62;
Alternative: 64.1.
Year: 2012;
Baseline extended: 61.6;
Alternative: 66.3.
Year: 2013;
Baseline extended: 60.7;
Alternative: 68.4.
Year: 2014;
Baseline extended: 60.1;
Alternative: 71.1.
Year: 2015;
Baseline extended: 59.5;
Alternative: 74.
Year: 2016;
Baseline extended: 59;
Alternative: 77.3.
Year: 2017;
Baseline extended: 58.5;
Alternative: 80.6.
Year: 2018;
Baseline extended: 56.1;
Alternative: 82.3.
Year: 2019;
Baseline extended: 56.1;
Alternative: 86.6.
Year: 2020;
Baseline extended: 56.2;
Alternative: 91.2.
Year: 2021;
Baseline extended: 56.5;
Alternative: 96.
Year: 2022;
Baseline extended: 57.1;
Alternative: 101.2.
Year: 2023;
Baseline extended: 58;
Alternative: 106.7.
Year: 2024;
Baseline extended: 59.2;
Alternative: 112.5.
Year: 2025;
Baseline extended: 60.8;
Alternative: 118.8.
Year: 2026;
Baseline extended: 62.6;
Alternative: 125.3.
Year: 2027;
Baseline extended: 64.7;
Alternative: 132.3.
Year: 2028;
Baseline extended: 67.2;
Alternative: 139.7.
Year: 2029;
Baseline extended: 70.1.
Alternative: 147.5.
Year: 2030;
Baseline extended: 73.1;
Alternative: 155.6.
Year: 2031;
Baseline extended: 76.6;
Alternative: 164.2.
Year: 2032;
Baseline extended: 80.4;
Alternative: 173.2.
Year: 2033;
Baseline extended: 84.4;
Alternative: 182.5.
Year: 2034;
Baseline extended: 88.7;
Alternative: 192.1.
Year: 2035;
Baseline extended: 93.2;
Alternative: 202.
Year: 2036;
Baseline extended: 98;
Alternative: 212.4.
Year: 2037;
Baseline extended: 103.2;
Alternative: 223.1.
Year: 2038;
Baseline extended: 108.5;
Alternative: 234.1.
Year: 2039;
Baseline extended: 114.1;
Alternative: 245.4.
Year: 2040;
Baseline extended: 119.9;
Alternative: 257.1.
Year: 2041;
Baseline extended: 125.9;
Alternative: 269.1.
Year: 2042;
Baseline extended: 132.2;
Alternative: 281.4.
Year: 2043;
Baseline extended: 138.6;
Alternative: 294.1.
Year: 2044;
Baseline extended: 145.3;
Alternative: 306.9.
Year: 2045;
Baseline extended: 152.2;
Alternative: 320.2.
Year: 2046;
Baseline extended: 159.3;
Alternative: 333.8.
Year: 2047;
Baseline extended: 166.6;
Alternative: 347.7.
Year: 2048;
Baseline extended: 174.2;
Alternative: 362.
Year: 2049;
Baseline extended: 182.1;
Alternative: 376.8.
Year: 2050;
Baseline extended: 190.2;
Alternative: 391.9.
Source: GAO‘s March 2009 analysis based on the Trustees‘ assumptions
for Social Security and Medicare. (See GAO,The Nation‘s Long-Term
Fiscal Outlook March 2009 Update, GAO-09-405SP (Washington, D.C.: April
30, 2009).
[End of figure]
The deterioration in the short-term and long-term budget outlooks,
combined with expenditures associated with the Troubled Asset Relief
Program (TARP) and Recovery Act spending, will likely continue to
stress the existing auction schedule. Treasury has already begun to
respond by adjusting the auction schedule so that they can conduct more
auctions of increasingly larger amounts, while simultaneously
minimizing borrowing costs over the long term.
According to the major institutional investors that we interviewed, the
best days of the week for Treasury to conduct auctions are Tuesday,
Wednesday, and Thursday. However, Treasury is facing an increasingly
crowded borrowing schedule, often with multiple auctions in a single
day. For example, during the week of July 27, 2009, Treasury held eight
auctions, issuing close to $272 billion in securities in one week and
holding multiple auctions on two of those days. In addition, Treasury
has been forced to hold and plan auctions on days that it has tried to
avoid in the past, such as days of major Federal Reserve announcements.
Holding auctions on these days increases uncertainty for auction
participants.
Market experts believe that the large amount of the debt that must be
rolled over in the next few years is cause for concern and agree with
Treasury that it needs to increase the average maturity of its debt
portfolio and diversify its funding sources. Large and growing
borrowing needs put a premium on better understanding current and
future demand for Treasury securities. Two securities that Treasury can
currently use to reduce the amount of securities that are rolling over
in the next 10 years are 30-year nominal bonds and 20-year TIPS.
[Footnote 10] Treasury has already increased the frequency of the
issuance of 30-year bonds; first it reopened the 30-year bond in
February 2009 and then added a second reopening in May 2009,
effectively issuing the 30-year bond on a monthly basis. Treasury
should continue to consider options to lengthen its maturity profile to
mitigate the risks mentioned above. Longer-dated TIPS offer one option.
The 30-year TIPS was discontinued along with the 30-year nominal bond
in October 2001, but only the 30-year nominal bond was reintroduced.
The 20-year TIPS, is currently issued only twice a year, but its record
as a low-cost funding source has been mixed in part due to a lack of
liquidity as explained in the next section.
Treasury's TIPS Program Has Had Varying Degrees of Liquidity Since
Inception and Major Institutional Investors Have Expressed Concern
about Treasury's Commitment to the Program:
Treasury's TIPS program has had varying degrees of liquidity since its
inception in 1997. Liquidity is a measure of the ease with which
investors can trade a security. Liquidity is important to Treasury
because liquid securities can be auctioned at lower rates, and thus
cost Treasury less money.
The difference between the breakeven inflation rate--the interest rate
on a nominal security minus the interest rate on a comparable-maturity
TIPS--and a measure of expected inflation can be used to evaluate the
ex-ante cost of nominal securities relative to TIPS.[Footnote 11] When
this difference is positive, nominal securities cost more than TIPS;
when it is negative, TIPS cost more than nominal securities; and when
the difference is zero, the cost is approximately equivalent. Two
primary factors affect this difference. The first is the illiquidity
premium associated with TIPS, which raises the interest rate on TIPS
relative to nominal securities. The second is the inflation risk
premium, which is the insurance value that investors attach to TIPS'
protection against inflation. The inflation risk premium reduces the
interest rate on TIPS relative to the rate on nominal securities. To
the degree that the inflation risk premium and illiquidity premium are
roughly equal, nominal Treasury securities and TIPS of the same
maturity would cost about the same, on an ex-ante (or before the fact)
basis. For a more detailed discussion on calculating the cost of TIPS
compared to nominal securities see appendix II.
In 1997, when the TIPS program was launched, the initial auctions were
well-received by investors, with robust bid-to-cover ratios.[Footnote
12] As seen in figure 6, the average 10-year breakeven rate minus
expected inflation in 1997 was the largest seen to date on the 10-year
TIPS. Thereafter, from 1998 until about 2004, TIPS liquidity remained
relatively poor and the gross amount issued by Treasury decreased from
1998 to 2000.
Figure 6: Treasury's Statements of Support for TIPS, Gross TIPS
Issuance, and the TIPS Program's Relative Costs (Dollars in billions):
[Refer to PDF for image: vertical bar and line graph]
Year: 1997;
Year-to-date TIPS issuance: $33;
Average 10-year breakeven rate minus expected inflation: 0.35v
Year: 1998;
Year-to-date TIPS issuance: $34;
Average 10-year breakeven rate minus expected inflation: -1.27%.
Year: 1999;
Year-to-date TIPS issuance: $31;
Average 10-year breakeven rate minus expected inflation: -1.00%.
Year: 2000;
Year-to-date TIPS issuance: $16;
Average 10-year breakeven rate minus expected inflation: -0.23%.
Year: 2001;
Year-to-date TIPS issuance: $16;
Average 10-year breakeven rate minus expected inflation: -0.78%.
Year: 2002 (Treasury speeches and expansion of TIPS[A]);
Year-to-date TIPS issuance: $23;
Average 10-year breakeven rate minus expected inflation: -0.92%.
Year: 2003 (Treasury speeches and expansion of TIPS[B]);
Year-to-date TIPS issuance: $26;
Average 10-year breakeven rate minus expected inflation: -0.68%.
Year: 2004 (Treasury speeches and expansion of TIPS[C]);
Year-to-date TIPS issuance: $63;
Average 10-year breakeven rate minus expected inflation: -0.08%.
Year: 2005;
Year-to-date TIPS issuance: $69;
Average 10-year breakeven rate minus expected inflation: 0.23%.
Year: 2006;
Year-to-date TIPS issuance: $77;
Average 10-year breakeven rate minus expected inflation: 0.002%.
Year: 2007;
Year-to-date TIPS issuance: $65;
Average 10-year breakeven rate minus expected inflation: 0.003%.
Year: 2008;
Year-to-date TIPS issuance: $62;
Average 10-year breakeven rate minus expected inflation: -0.49%.
Year: May, 2009;
Year-to-date TIPS issuance: $31;
Average 10-year breakeven rate minus expected inflation: -1.52%.
Source: GAO analysis of Treasury data on TIPS issuances and Federal
Reserve Bank of Philadelphia's Survey of Professional Forecasters
Inflation Expectations.
[A] Treasury official announcement on expansion of TIPS on May 1, 2002.
Treasury speech bolstering TIPS program on June 3, 2002, October 17,
2002, November 8, 2002, and December 5, 2002.
[B] Treasury official announcement on expansion of TIPS on April 30,
2003. Treasury speech bolstering TIPS program on May 20, 2003 and June
26, 2003.
[C] Treasury official announcement on expansion of TIPS on May 4, 2004.
Treasury speech bolstering TIPS program on April 22, 2004, June 16,
2004, and July 8, 2004.
[End of figure]
Starting in 2002, Treasury sought input from market participants on how
to improve the TIPS program and made a number of changes to the
program. Specifically, Treasury increased the amount issued at auction
and increased the frequency and range of TIPS offerings. In addition,
Treasury made a number of speeches and official statements to reaffirm
its commitment to the program and to indicate its dedication to
improving TIPS liquidity. Some of the major institutional investors we
interviewed observed that these efforts improved investor confidence in
the program and ultimately improved the liquidity of TIPS. As seen in
figure 6, from 2004 to 2007, the difference between the average 10-year
breakeven rate and inflation expectations was positive or near zero,
meaning the TIPS illiquidity premium was approximately equal to the
inflation risk premium of nominal securities and indicating that TIPS
liquidity improved over that period.
More recently, from 2006 to 2008, Treasury reduced the gross amount of
TIPS issuance by 19 percent. The major institutional investors that we
interviewed also perceived that during this time, Treasury's commitment
to the TIPS program began to wane, communicating uncertainty about the
program's future. These investors believed that the uncertainty
surrounding TIPS hurt TIPS liquidity in the secondary market.
In the period following the 2008 financial market crisis, TIPS
liquidity further deteriorated as demand for the more liquid nominal
Treasury securities soared. The illiquidity premium, or the extra
compensation that Treasury has to pay investors to hold TIPS, may have
increased during the financial crisis due to the increased difficulty
of selling holdings of TIPS in the secondary market during that time.
Major institutional investors whom we interviewed reported uncertainty
about Treasury's commitment to the TIPS program and suggested increased
issuance and positive signaling to improve the liquidity of TIPS,
thereby reducing the cost of the program to Treasury.
Major Institutional Investors Report Uncertainty about Treasury's
Commitment to TIPS and Suggest Increased Issuance and Positive
Signaling to Improve the Liquidity of TIPS:
Interviews with major institutional investors revealed uncertainty
about Treasury's commitment to TIPS. The investors pointed to the 19
percent decline in TIPS gross issuance amounts, along with Treasury's
tepid signaling on TIPS, as fueling speculation about the future of the
program.[Footnote 13] (See figure 6.) As of June 2009, TIPS made up
about 8 percent of total outstanding marketable Treasury securities,
compared to 10 percent in September 2007 and 2008.
As we reported to Treasury, on July 1, 2009, there was agreement among
the major institutional investors whom we interviewed that Treasury
could improve liquidity in the TIPS market by signaling to the market
its commitment to the program and by increasing issuance. Investors
suggested that Treasury repeat efforts to promote the TIPS program as
they did from 2002 to 2004. Investors told us that increasing the
issuance amount at auction or increasing the frequency of auctions
would have a similar signaling effect and the additional supply would
also improve liquidity in the secondary market. Most of the investors
replied that they planned to purchase TIPS in the next year; interest
in the 10-year TIPS was mentioned most frequently. Some investors
stated that their organizations would be more likely to participate in
the TIPS market if the supply of securities was greater and auctions
were conducted more frequently. Some investors reported wanting to make
larger TIPS purchases than was possible in the secondary market and
also that the long wait between TIPS auctions sometimes did not align
with their investment needs. Currently, there is a 6-month wait between
auctions for 5-year and 20-year TIPS and a 3-month wait between
auctions for 10-year TIPS.
At our briefing, Treasury's Director of ODM and ODM staff told us that
if it were to expand the TIPS program, Treasury would face increased
exposure to auction risk due to the current concentration of bidders at
auction and the resulting possibility that there may not be enough
bidders to cover the auctioned amount. But Treasury already has
policies in place to ensure that potentially under subscribed auctions
are sufficiently covered. In addition to these policies, investors we
interviewed told us that a more formalized line of communication
between Treasury and end-users could enable Treasury to better gauge
market demand. We are in the process of surveying investors on what
actions Treasury could take to increase participation in TIPS auctions
and improve communication with end-users of Treasury securities.
One indicator used to measure demand at a Treasury auction is the bid-
to-cover ratio, which compares the dollars bid to the dollars accepted
at a Treasury auction. If the ratio is high, it indicates strong demand
for a particular Treasury security at auction. There is historical
evidence that auctions in the TIPS market have bid-to-cover ratios only
slightly lower than the more robust market for nominal securities. As
shown in figure 7, for most of the period prior to 2009, TIPS auctions
had slightly lower bid-to-cover ratios than comparable nominal
securities. But more recently, differences between TIPS and nominal bid-
to-cover ratios have decreased. From January to July of 2009, the
average bid-to-cover ratio for 5-, 10-, and 30-year nominal auctions
has been 2.30. The average bid-to-cover ratio of 5-, 10-, and 20-year
TIPS auctions has been 2.31 during the same period.
Figure 7: Bid-to-Cover Ratios for Selected Treasury Securities, July
2003 to July 2009:
[Refer to PDF for image: combination line and plotted point graph]
Bid-to-Cover Ratio shown for:
30-year bond:
5-year note:
10-year note:
5-year TIPS:
10-year TIPS:
20-year TIPS:
Full subscription threshold:
3-month TIPS moving average:
3-month nominal moving average:
Source: GAO analysis of Treasury auction data on 5-year, 10-year, and
30-year nominal Treasury securities and 5-year, 10-year,20-year, and 30-
year TIPS.
[End of figure]
Treasury's current policies to ensure sufficient coverage of auctions
were instituted after a 10-year nominal Treasury note auction had a
relatively low bid-to-cover ratio of 1.2 in May 2003. The more recent,
stronger bid-to-cover ratios indicate that the market would support
increased TIPS issuance. A more liquid TIPS market would benefit
Treasury. At the same time, the cost to Treasury of the TIPS program
going forward remains a subject of debate.
TIPS Program Offers Benefits to Treasury, and Measuring Its Cost
Requires both Forward-Looking and After-the-Fact Analysis:
TIPS offer a variety of benefits to both Treasury and investors. TIPS
provide Treasury the opportunity to diversify its investor base because
TIPS are by design a very different product than nominal securities. In
addition, TIPS may reduce the cost of nominal securities. The cost
against which to weigh the benefits of TIPS, however, is unclear. While
there is agreement on the higher initial cost of the TIPS program, less
consensus exists on the total cost of the TIPS program to date.
TIPS Program Could Benefit Treasury by Diversifying Its Funding Sources
and Investor Base:
TIPS could benefit Treasury by diversifying its funding sources and
investor base. Market experts and researchers, including the Securities
Industry and Financial Markets Association (SIFMA), asserted that TIPS
could provide Treasury with access to new investors whose needs could
complement those of investors in nominal securities.[Footnote 14] In a
2004 letter to Treasury, the Bond Market Association, now part of
SIFMA, stated that "the Association continues to believe that the
Treasury's TIPS program is likely to ultimately help reduce Treasury's
overall cost of funding by attracting a new pool of investors and
facilitate better liability management."
There is direct evidence that TIPS could help Treasury access different
groups of investors.[Footnote 15] According to research by a New York
Federal Reserve expert on Treasury markets, between July 30, 2001, and
December 28, 2005, investment funds (which included mutual funds and
hedge funds) accounted for 30.2 percent of TIPS sold at auction, but
only 11.5 percent of nominal notes and bonds.[Footnote 16] Whereas,
between July 30, 2001, and December 28, 2005, the largest group of
Treasury holders, foreign and international investors, accounted for
8.2 percent of TIPS sold at auction and 21.1 percent of nominal notes
and bonds. Another example of the diversification that TIPS could
provide is that pension funds tend to purchase a higher share of TIPS
securities than nominal Treasury securities at auctions.
While TIPS auctions have been highly concentrated, with just a few
regular participants, TIPS may exhibit less ownership concentration
than nominal securities. As of December 2008, the largest TIPS fund
(Vanguard Inflation-Protected Securities Fund) reported $16.6 billion
in TIPS holdings, accounting for 3.1 percent of the $530 billion in
TIPS outstanding on that date. In contrast, Treasury International
Capital data shows that the largest foreign holder of U.S. Treasury
securities (China) reported $727 billion, accounting for 12.5 percent
of the $5.8 trillion in total marketable Treasury securities on the
same date.[Footnote 17]
One indicator of TIPS' potential to diversify funding sources for
Treasury is the growth of inflation-protected mutual funds. Both the
number and the amount of assets under management in inflation-protected
funds have increased since 2002. As seen in figure 8, the number of
inflation-protected funds doubled from 20 at the end of December 2002
to 40 at the end of May 2009. The amounts of inflation-protected funds
under management increased from $11.8 billion to $54.4 billion during
the same period. The mutual fund managers that we interviewed expressed
their investors' continued interest in the TIPS program going forward
and plan to continue to purchase TIPS securities over the next year.
According to data from one large mutual fund company, between 2003 and
2008 the large majority of inflows into its TIPS fund came from non-
Treasury funds.
Figure 8: Inflation-Protected Mutual Funds and Assets under Management,
December 2002 to May 2009 (Dollars in billions):
[Refer to PDF for image: vertical bar and line graph]
Date: 12/02;
Total net assets: $11.8;
Number of inflation protected Mutual Funds: 20.
Date: 12/03;
Total net assets: $18.1;
Number of inflation protected Mutual Funds: 24.
Date: 12/04;
Total net assets: $28.3;
Number of inflation protected Mutual Funds: 34.
Date: 12/05;
Total net assets: $36;
Number of inflation protected Mutual Funds: 41.
Date: 12/06;
Total net assets: $35;
Number of inflation protected Mutual Funds: 41.
Date: 12/07;
Total net assets: $40.6;
Number of inflation protected Mutual Funds: 42.
Date: 12/08;
Total net assets: $46.5;
Number of inflation protected Mutual Funds: 41.
Date: 5/09;
Total net assets: $54.4;
Number of inflation protected Mutual Funds: 40.
Source: GAO analysis of Investment Company Institute data.
[End of figure]
According to market experts, another potential benefit of the TIPS
program to Treasury is its potential to reduce government borrowing
costs. If Treasury has to increase the supply of nominal securities
substantially to fund larger deficits, it may need to raise yields in
order to attract enough buyers due to the saturation of the nominal
Treasury market. Therefore, issuing TIPS may make sense as a
substantial shift in the composition of Treasury issuance into TIPS
from nominal Treasuries could lead to lower interest rates paid on the
remaining nominal Treasury issuance. This argument has been cited as a
benefit by a number of market experts, but additional research is
required. Treasury's access to auction data puts ODM staff in a unique
position to conduct a comprehensive and ongoing analysis of the impact
that TIPS have on the cost of nominal securities. In commenting on this
report, Treasury told us that ODM staff have reviewed such data. They
note that TIPS have remained less liquid than nominal securities and
are considering approaches to improve the inflation-indexed market.
Treasury securities have the potential to provide a number of social,
fiscal, and monetary benefits. All Treasury securities provide
investors with virtually zero credit risk. Only TIPS, however, provide
zero inflation risk, making them one of the most effective ways for
risk-averse households to meet their savings needs. In contrast, one of
the downsides of nominal Treasury securities is that in the event of
unexpected inflation, the real return to investors will be less than
expected. Investors in nominal Treasury securities assume the risk of
inflation eroding their expected return, but inflation-protected
investments, such as TIPS, shift the inflation risk to the issuer.
Economists have noted that governments are better able to bear
inflation risk because periods of inflation are often associated with
increased revenues. Economists have also noted that TIPS could make the
Federal government more accountable for the inflationary consequences
of its actions in the form of higher payments on TIPS, if inflation
increases. The results of TIPS auctions also provide useful information
to policymakers on inflation expectations. In this respect, TIPS
auctions help provide a measure of market inflation expectations, which
can be taken into account when making monetary policy decisions.
[Footnote 18]
Forward-Looking Analysis of TIPS Program's Costs Adds an Important
Perspective to Evaluating the Role of TIPS as Part of Treasury's Debt
Portfolio:
[Text box:
Ex-ante vs. Ex-post Analysis:
Ex-ante is Latin for beforehand. In models with uncertainty, ex-ante
values are expected values that are calculated before the uncertainty
is resolved.
Ex-post is Latin for after the fact. In models with uncertainty, ex-
post values are the realized or actual values that are calculated after
the uncertainty has been resolved.
In the context of nominal interest-bearing government securities,
investors are assumed to demand compensation for expected inflation. Ex-
ante expectations about inflation are assumed to be formed rationally,
meaning that expectations will be identical to optimal forecasts using
all available information. Ex-post, realized inflation rates may differ
from ex-ante expected values, but these differences should not be
systematically positive or negative.
For a sufficiently lengthy time horizon the cost of TIPS relative to
nominal Treasury securities should be the same when calculated on both
an ex-ante and ex-post basis, all else equal. For shorter time
horizons, the difference between expected and realized inflation values
may appear to be persistent; thus, the ex-ante approach may be
preferred to assess the cost of TIPS relative to nominal Treasury
securities over the short term. End of text box]
Market experts have measured costs of TIPS in two primary ways. The
first approach evaluates TIPS on an ex-post (after the fact) basis.
That is, the cost of TIPS and nominal securities are compared based on
what inflation actually was during a given time period.[Footnote 19]
Economists conducting ex-post analyses have concluded that the TIPS
program has been less cost-effective for Treasury than nominal
securities. A 2008 study by a Federal Reserve economist estimated that
the total cost of the TIPS program through October 2007 was between
$4.5 billion and $7.5 billion.[Footnote 20] Based on TIPS issued
through July 2009, Treasury's ODM estimated the total cost of TIPS at
$10 billion to date. This more recent study includes the anomalous
period characterized by the financial market crisis and the related
flight to quality which made nominal securities relatively inexpensive
for Treasury. Economists generally agree that part of the relatively
higher cost of the TIPS program can be attributed to its start-up
costs. According to market experts and the major institutional
investors that we interviewed, other factors that may have contributed
to the relatively higher cost to Treasury of the TIPS program to date
are investors' perceptions of Treasury's lack of commitment to the
program and the relatively low inflation experienced throughout the
life of the program. Since the TIPS program was introduced, the annual
Consumer Price Index for All Urban Consumers (CPI-U) percent change
never exceeded 3.8 percent, which is low by historical standards. The
CPI-U averaged 7.08 percent and 5.55 percent during the 1970s and
1980s, respectively.
In contrast, other economists who have studied the issue argue that
from an ex-ante (before the fact) basis, TIPS are not more costly to
issue than nominal securities and that the relative cost of the TIPS
program to date in part reflects start-up costs that will not be
incurred again.[Footnote 21] One recent study by Treasury's ODM found
that TIPS are not less costly when measured on an ex-ante basis, but
this study includes the anomalous period characterized by the financial
market crisis and the related flight to quality which made nominal
securities relatively inexpensive for Treasury. Another ex-ante study,
noted that if the TIPS program were as liquid as the market for off-
the-run nominal Treasuries, Treasury would have realized total cost
savings from the TIPS program of $22 billion to $32 billion.[Footnote
22] Over the short run, economists recognize that an assessment of TIPS
program's relative costs depends on whether Treasury or the investor is
the beneficiary from differences in expected and actual inflation. The
time horizon of the analysis affects the results since, over the long
run, the average amount by which actual inflation exceeds expected
inflation will roughly equal the average amount when the opposite is
true.[Footnote 23] Therefore, some market experts argue that TIPS
should be evaluated on an ex-ante basis, for example, by finding the
difference between the breakeven inflation rate (the nominal-TIPS yield
differential) and a survey-based measure of inflation expectations at
the time of the TIPS auction. This difference is independent of
inflation surprises and provides a measure of the net savings or loss
incurred by Treasury.
Concluding Observations:
Faced with the economic recession and the ensuing 2008 financial market
crisis, Treasury is to be commended for its success in raising
unprecedented amounts of cash in a very short amount of time. Absent
policy changes, the medium-and long-term fiscal outlook mean that
Treasury will need to raise increasing amounts of cash, and build
borrowing flexibility by increasing the term to maturity of its debt
portfolio, while retaining its focus on reducing its overall borrowing
cost. While questions remain about how to evaluate the cost of the TIPS
program, TIPS have the potential to provide Treasury with a number of
benefits and help Treasury achieve its debt management objectives.
On July 1, 2009, we briefed Treasury's ODM on the findings from our
analysis and interviews with major institutional investors. Treasury
later posed questions about ways to improve the TIPS program to the
Primary Dealers and TBAC. At the August 2009 TBAC meeting, members
discussed TIPS. Following the meeting, Treasury's Deputy Assistant
Secretary for Federal Finance reaffirmed Treasury's commitment to TIPS
and announced plans to gradually increase issuance of TIPS.
Recommendations:
The Secretary of the Treasury should take the following actions to
improve TIPS liquidity in the context of projected sustained increases
in federal debt:
* increase TIPS issuance,
* issue TIPS with longer-dated maturities, and:
* conduct more frequent TIPS auctions.
The Secretary should continually review the appropriate composition of
the TIPS program, and consider:
* the impact of Treasury's public statements and TIPS issuances on TIPS
liquidity,
* how both ex-ante (before the fact) and ex-post (after the fact)
analyses are valuable for evaluating the cost of TIPS, recognizing the
anomalous nature of market data from periods such as the 2008 financial
market crisis,
* the ways in which the TIPS program can diversify Treasury's investor
base and funding sources, and:
* the degree to which TIPS impact the cost of nominal securities.
Agency Comments:
We requested comments on a draft of this report from the Secretary of
the Treasury and received comments on behalf of the Treasury from its
Deputy Assistant Secretary of Federal Finance. Treasury took note of
our findings, conclusions, and recommendations, and said they were
consistent with their commitment to increasing TIPS issuance in the
context of projected sustained increases in federal debt. Treasury
reiterated that they are committed to issuing TIPS in a regular and
predictable manner across the yield curve, and noted that they are an
important part of their overall debt management strategy. Treasury also
noted that it is always reviewing the appropriate composition of the
TIPS program.
We are sending copies of this report to the Secretary of the Treasury
and other interested parties. We will also make copies available at no
charge on the GAO Web site at [hyperlink, http://www.gao.gov]. If you
or your staff have any questions about this report, please contact
Susan J. Irving at (202) 512-6806 or irvings@gao.gov. Contact points
for our Offices of Congressional Relations and Public Affairs may be
found on the last page of this report. GAO staff who made major
contributions to this report are listed in appendix III.
Sincerely yours,
Signed by:
Susan J. Irving:
Director, Federal Budget Analysis Strategic Issues:
[End of section]
Appendix I: Treasury Inflation Protected Securities:
Overview:
Treasury Inflation Protected Securities (TIPS) are marketable
securities for which the principal is adjusted by changes in the
Consumer Price Index for All Urban Consumers (CPI-U).[Footnote 24] With
inflation (a rise in the index), the principal increases. With
deflation (a drop in the index), the principal decreases for the
purpose of calculating interest payments, but the principal to be
repaid at maturity is at least par value (or the principal amount at
date of original issuance). Although the inflation-adjusted principal
is paid by the Department of the Treasury when the security matures,
interest payments are made every 6 months. TIPS are the only Treasury
security that secures the investor a return on the investment that is
guaranteed in purchasing power terms rather than in dollar terms.
Principal:
At maturity, Treasury pays investors the greater of the inflation-
adjusted principal amount or the par value. That is, investors are
protected against both increases in inflation and the loss of the
original principal. During the lifetime of a TIPS, the principal could
decline with deflation below the original par value, so the coupon
payment could fall below their originally stated dollar amounts, but at
maturity the principal will be redeemed at no less than the original
face amount.
Interest Payments:
Interest is paid every 6 months at a fixed rate, which was determined
at auction when the security was first sold. However, because the rate
is applied to the adjusted principal, interest payments may vary from
one period to another. Interest payments are based on the inflation-
adjusted principal on the date of the interest payment.[Footnote 25] In
a period of inflation, the principal is adjusted upward so the interest
payment increases. In the event of deflation, the principal is adjusted
downward, and the interest payment decreases.[Footnote 26]
Below is an illustrative example of how to calculate the inflation
adjustments to the principal and the semi-annual interest payments
(note that CPI-U numbers and rates are purely hypothetical).
[Text box:
How to Calculate an Inflation-Indexed Security Interest and Principal:
An inflation-indexed security with par value of $1,000,000 was
purchased on April 15, 2003, with a coupon rate of 3.5 percent. The
first semi-annual interest payment date for this inflation indexed
security is October 15, 2003. The reference CPI-U number for the issue
date was 120. The reference CPI-U number for the first interest payment
was 135.
The inflation adjusted principal on October 15, 2003 was:
$1,000,000 x 135/120 = $1,125,000;
The interest payment was:
$1,125,000 x 0.035/2 = $19,687.50.
[End of text box]
Taxation:
Both interest payments and the inflation adjustments applied to the
principal of TIPS are subject to federal tax. The accrued increase in
principal caused by the inflation adjustment is taxable in the year in
which it is accrued, which is the standard structure for all other
Treasury securities. However, with TIPS the increase in principal is an
unrealized gain because the principal is not received until the bond
matures. This is not an issue if TIPS are held in a tax-deferred
account.
Auction Schedule:
Treasury currently auctions 5-, 10-, and 20-year TIPS. Treasury used to
also issue 30-year TIPS, but discontinued doing so in 2001. Treasury
currently auctions TIPS on a quarterly basis. The 5-year TIPS is issued
in April and reopened in October.[Footnote 27] The 10-year TIPS is
issued in January and July, with reopenings in April and October, and
the 20-year TIPS is issued in January and reopened in July.
Purchasing TIPS:
TIPS are sold in increments of $100, with a required minimum purchase
of $100. Treasury issues TIPS in electronic form. At auction, an
investor can place competitive or noncompetitive bids for TIPS.
However, noncompetitive bids are limited in a single auction to $5
million while competitive bids are limited to 35 percent of the initial
offering amount.[Footnote 28] Investors can hold TIPS until they mature
or sell them in the secondary market before they mature.
[End of section]
Appendix II: The Cost of Treasury Inflation Protected Securities
Compared to Nominal Securities:
For a sufficiently lengthy time horizon the cost of Treasury Inflation
Protected Securities (TIPS) relative to nominal Treasury securities
should be the same when calculated on both an ex-ante (before the fact)
and ex-post (after the fact) basis, all else equal.
The following arithmetic illustrates the approximate equivalence
between ex-ante and ex-post evaluations of the cost of TIPS relative to
nominal securities.[Footnote 29]
[Text box:
Ex-Post Calculation of the Nominal-TIPS Cost Difference:
Nominal yield = real yield + expected inflation + inflation risk
premium;
TIPS yield = real yield + illiquidity premium;
Ex-post evaluation of the cost difference between nominals and TIPS
adds actual inflation to the TIPS yield, so ex-post:
TIPS yield = real yield + illiquidity premium + actual inflation;
Ex-post, therefore, the nominal-TIPS cost difference is:
real yield + expected inflation + inflation risk premium - real yield -
illiquidity premium - actual inflation;
In the long run, expected inflation should equal actual inflation on
average, so the ex-post nominal-TIPS cost difference reduces to:
inflation risk premium - illiquidity premium.
[End of text box]
Ex-ante calculation of the cost difference between nominals and TIPS
subtracts a survey-based measure of expected inflation from the nominal-
TIPS cost difference.
[Text box:
Ex-Ante Calculation of the Nominal-TIPS Cost Difference:
Real yield + expected inflation + inflation risk premium - surveyed
inflation expectation - real yield - illiquidity premium;
If the survey accurately captures expected inflation, then expected
inflation equals surveyed expected inflation and this ex-ante
difference reduces to:
Inflation risk premium - illiquidity premium.
[End of text box]
Again, over the long run, if expected inflation = surveyed expected
inflation = actual inflation, ex-ante and ex-post calculations of the
cost of TIPS relative to nominals should be approximately the same.
However, the possibility of persistent inflation surprises in one
direction over a few years suggests using the ex-ante approach over
shorter horizons.
Disentangling the Drivers of Recent Shifts in the Nominal-TIPS Yield
Differential (Breakeven Inflation Rate):
The cost of TIPS compared to nominal securities increased substantially
in fall 2008 when the subprime crisis intensified.[Footnote 30] During
the latter part of 2008, TIPS yields rose while nominal yields declined
resulting in near historic lows in the breakeven inflation rate,
approaching zero by the end of 2008. During 2009, breakeven rates
generally rose from their late-2008 lows and reached the 2 percent
range in early August.
[Text box:
Disentangling the Drivers of Recent Shifts in the Nominal-TIPS Yield
Differential (Breakeven Inflation Rate):
The sharp decline in breakeven inflation rates in late 2008 can be
attributed to a combination of liquidity and technical market factors.
Strong flight-to-liquidity flows during the market upheaval boosted the
demand for nominal Treasury securities. Because TIPS markets are less
liquid than nominal Treasury markets, this reduced the breakeven
inflation rate.
In addition, technical market factors closely linked to liquidity
effects appear to have contributed to the decline in breakeven
inflation rates. Lehman Brothers owned TIPS as part of repo trades or
posted TIPS as counterparty collateral. Because of Lehman‘s bankruptcy,
the court and its counterparty needed to sell these TIPS, which created
a flood of TIPS on the market. There appeared to be few buyers and
distressed market makers were unwilling to take positions in these
TIPS. As a result, the TIPS yields rose sharply.
Inflation expectations and the inflation risk premium, two other
important determinants of the nominal-TIPS yield differential, appear
to have had negligible roles in the recent shifts in the yield
differential. The median survey value of 10-year inflation forecasts
compiled by the Federal Reserve Bank of Philadelphia‘s Survey of
Professional Forecasters displayed little variation over the last 2
years, which implies that long-term inflation expectations remained
stable. Estimates also suggest that the inflation risk premium has
remained relatively small and fairly stable.
Some financial economists view the experience with TIPS yields after
the Lehman bankruptcy as a highly abnormal market situation where
liquidity issues suddenly created severe financial anomalies. They
suggest that this was an unrepresentative episode and that observations
from this period could be ignored.
See John Campbell, Robert Shiller, and Luis Viceira, ’Understanding
Inflation-Indexed Bond Markets,“ Working Paper Presented Brookings
Institute (March 2009); and Ingo Fender, Corrinne Ho, and Peter
Hordähl, ’Overview: investors ponder depth and duration of global
downturn,“ BIS Quarterly Review (March 2009).
[End of text box]
[End of section]
Appendix III: GAO Contact and Staff Acknowledgment:
GAO Contact:
Susan J. Irving, (202) 512-6806 or irvings@gao.gov.
Staff Acknowledgments:
In addition to the contact named above, Jose Oyola (Assistant
Director), Tara Carter (Analyst-in-Charge), Mark Kehoe, Erik
Kjeldgaard, Richard Krashevski, Margaret McKenna and Jason Vassilicos
made contributions to the report. Julie Matta, Rick Cambosos, Stuart
Kaufman, and Greg Wilmoth also provided key assistance.
[End of section]
Footnotes:
[1] As of the end of 2008, inflation-indexed securities made up 24
percent of the United Kingdom's total outstanding debt portfolio, 15
percent of France's outstanding debt portfolio, and 10 percent of the
United States' outstanding debt portfolio.
[2] ODM is responsible for providing the Assistant Secretary for
Financial Markets with advice and analysis on matters related to the
Treasury's debt management policy, the issuance of Treasury and
federally related securities, and financial markets.
[3] Federal debt held by the public is the value of all federal
securities sold to the public that are still outstanding. See GAO,
Federal Debt: Answers to Frequently Asked Questions: An Update,
[hyperlink, http://www.gao.gov/products/GAO-04-485SP] (Washington,
D.C.: August 12, 2004).
[4] Treasury issues two major types of debt securities to the public:
marketable and nonmarketable securities. Marketable securities, which
consist of Treasury bills, notes, and bonds and can be resold by
whoever owns them while nonmarketable securities, such as savings
securities and special securities for state and local governments,
cannot be resold.
[5] Treasury data states that almost half of the $6.6 trillion in
marketable securities is held by foreign investors, as of May 2009.
[6] Treasury's increase in issuance of cash management bills is largely
due to establishment of the Supplementary Financing Program (SFP). The
SFP was created to provide cash for Federal Reserve lending and
liquidity draining initiatives in response to the financial market
crisis. According to GAO's audit of the Bureau of the Public Debt for
Fiscal Years 2008 and 2007, $300 billion in cash management bills were
issued in September 2008 under the Supplementary Financing Program
initiated by Treasury. See GAO, Financial Audit: Bureau of the Public
Debt's Fiscal Years 2008 and 2007 Schedules of Federal Debt,
[hyperlink, http://www.gao.gov/products/GAO-09-44] (Washington, D.C.:
November 7, 2008).
[7] See Congressional Budget Office, An Analysis of the President's
Budgetary Proposals for Fiscal Year 2010 (Washington, D.C.: June 2009).
[8] As of August 2009, the average maturity of issuance on the current
auction calendar now exceeds the average maturity of marketable debt
outstanding.
[9] See GAO, The Nation's Long-Term Fiscal Outlook March 2009 Update,
[hyperlink, http://www.gao.gov/products/GAO-09-405SP] (Washington,
D.C.: April 30, 2009) and CBO, The Long-Term Budget Outlook
(Washington, D.C.: June 2009).
[10] At the August 2009 Treasury Borrowing Advisory Committee (TBAC)
meeting, Treasury asked TBAC members to consider whether 30-year TIPS
should replace 20-year TIPS. 30-year TIPS would also serve to reduce
the amount of securities that Treasury needs to roll over in the next
10 years.
[11] We use the real-time estimate of expected inflation from the
Survey of Professional Forecasters maintained by the Federal Reserve
Bank of Philadelphia.
[12] The bid-to-cover ratio is the ratio between the amounts tendered
over the amounts accepted at auction.
[13] Gross issuance is the total amount issued in a year (whether it is
obtaining new money or refinancing maturing debt). As we have shown, it
has decreased since 2006. The net change in total TIPS outstanding from
year to year increased during this time, but at a decreasing rate
(reflecting the decrease in gross issuance). In commenting on this
report, Treasury's Director of ODM and ODM staff said that they view
this as a stabilization of the TIPS program--done to permit a review of
the program after its first decade.
[14] SIFMA is an organization that represents the shared interests of
participants in the global financial markets. SIFMA members include
international securities firms, U.S.-registered broker-dealers and
asset managers. SIFMA members are part of TBAC, which meets quarterly
with Treasury and presents their observations to Treasury on the
overall strength of the U.S. economy as well as providing
recommendations on a variety of technical debt management issues.
[15] As investors can purchase TIPS in either the secondary market or
at auction, diversification of Treasury's end-user investor base might
not be directly related to auction concentration.
[16] Michael Fleming, "Who Buys Treasury Securities at Auction?"
Current Issues in Economics and Finance, vol. 13, no. 1 (2007).
[17] Treasury International Capital data is available at [hyperliink,
http://www.treasury.gov/tic].
[18] William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer,
"The Case for TIPS: An Examination of the Costs and Benefits," FRBNY
Economic Policy Review (July 2009).
[19] For the total cost of the TIPS program, ex-post analysis computes
the cost of TIPS going forward if future inflation follows an assumed
path.
[20] Jennifer Roush, "The 'Growing Pains' of TIPS Issuance," Finance
and Economic Discussion Series (2008).
[21] Jennifer Roush, "The 'Growing Pains' of TIPS Issuance," Finance
and Economic Discussion Series (2008); William C. Dudley, Jennifer
Roush, and Michelle Steinberg Ezer, "The Case for TIPS: An Examination
of the Costs and Benefits," FRBNY Economic Policy Review (July 2009);
and Pu Shen, "Developing a Liquid Market for Inflation-Indexed
Government Securities: Lessons from Earlier Experiences," Economic
Review (First Quarter 2009).
[22] Off-the-run securities are securities that are no longer on-the-
run (or the most recently auctioned security of a given maturity).
[23] William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer,
"The Case for TIPS: An Examination of the Costs and Benefits," FRBNY
Economic Policy Review (July 2009); and Dean Croushore, "An Evaluation
of Inflation Forecasts From Surveys Using Real-Time Data," Federal
Reserve Bank of Philadelphia Working Papers (December 2008).
[24] The index for the inflation rate is the Bureau of Labor
Statistic's nonseasonally adjusted U.S. City Average All Items Consumer
Price Index for All Urban Consumers (CPI-U). TIPS are indexed to a
lagged value of the CPI by 3 months, rather than the contemporaneous
value.
[25] The amount of each interest payment is determined by multiplying
the adjusted principal by one-half the interest rate.
[26] Even though the principal is adjusted downward for the purpose of
the calculation of interest payments, the original principal amount on
the date of issuance is returned to the investor at maturity.
[27] In a reopening, Treasury sells an additional amount of a
previously issued security. The reopened security has the same maturity
date and interest rate as the original security. However, as compared
to the original security, the reopened security has a different issue
date and can have a different purchase price.
[28] A competitive bid is a bid to U.S. Treasury to buy Treasury
securities at a particular yield. A noncompetitive bid is a method of
purchasing Treasury securities at auction, without having to submit a
price or a yield. Unlike competitive bids, noncompetitive bids are
always accepted.
[29] While the cost difference between nominal Treasury securities and
TIPS is primarily driven by illiquidity and inflation risk premiums,
the relative cost also reflects such technical market factors as the
taxation difference between TIPS and nominal issuances, the convexity
of difference between real and nominal yields, and the price of TIPS
embedded deflation floor.
[30] Ingo Fender, Corrinne Ho, and Peter Hordähl, "Overview: investors
ponder depth and duration of global downturn," BIS Quarterly Review
(March 2009).
[End of section]
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