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Home > Library > Stable Times > Volume 5, Issue 1  The quarterly publication of the Stable Value Investment Association First Quarter 2001 • Volume 5 Issue 1 Shrinking Pool of Treasurys Raises Shoals of RiskBy Timothy Middleton There are more questions than answers in the debate over federal budget surpluses. Makers of fiscal policy joust over taxes and spending. At the headquarters for monetary policy, the Federal Reserve wrestles with myriad technical issues, such as how it will temper interest rates and control liquidity if it doesn't have Treasury securities to buy and sell. Budget surpluses raise serious questions for stable-value managers as well. The shrinking supply of Treasurys "is causing people to focus on other investment vehicles, like mortgages and agencies, and to learn to value securities in new ways," says Stuart Spodek, portfolio manager for U.S. interest-rate products at BlackRock Inc. "So new issues have to be confronted. What are the alternative investment products and how do you value them? Does the spread to Treasurys mean anything anymore, and if not how do you look at different products?" What a difference a budget surplus makes. For most of a generation, huge federal deficits created a pool of virtually risk-free securities that grew to nearly $4 trillion. In just three years, however, about $450 billion of that has been erased. It could be all but extinguished in seven years or less. The implications for stable-value managers are myriad. Alternative benchmarks against which performance can be measured will be necessary; they are, indeed, already evolving. Alternative investments must be found – but none are as creditworthy as Uncle Sam himself. "Folks that are not used to taking any credit risk are going to be forced into the credit universe," says James Keller, executive vice president of Pacific Investment Management Co. and lead manager of its Treasury and agency portfolios. And the credit universe itself will inevitably change. "There should be a long-term benefit to our economy and credit markets as the decreasing Treasury Market shifts funds to the High-Grade Credit Sector. Theoretically there should be a group of corporations, or even entire industries, that systematically improve their credit quality in order to capture the premium associated with those credits closest to being risk-free." Stronger corporate balance sheets are good for the nation – but could mean punishing new competitive pressure for the stable-value industry. If Treasurys no longer crowd out riskier bonds, interest rates overall will, all things being equal, decline. Lower yields will put pressure on the industry's already razor- thin margins – and riskier investments could push portfolio risk management to new levels. Bonds and Bills: Not The supply of Treasury bonds, bills and notes, which stood at the end of last year at $3.4 trillion, has already effectively shrunken to around $2.5 trillion. The difference is long-term debt in the portfolios of insurance companies or set aside in defease deals, are not available "to anyone at any price," Keller says. Forecasts vary widely, but most estimates call for the government to pay down Treasury debt at the rate of $250 billion per year. The Congressional Budget Office estimates the Treasury will stop issuing new debt late in 2003 or early in 2004. Already the 3- and 7-year notes have been eliminated, and the 30-year bond and 5-year note issued less frequently. The 1-year bill may also be abandoned. Current estimates will have the entire available debt eliminated around 2007 or 2008. One of the reasons Greenspan has publicly supported tax cuts is that surpluses must be invested somewhere, raising profound policy and political questions. "Private asset accumulation may be forced upon us well short of reaching zero debt," Greenspan told the Senate Budget Committee in January. "Decisions about what type of private assets to acquire and to which federal accounts they should be directed must be made well before the policy is actually implemented, which could occur in as little as five to seven years from now. These choices have important implications for the balance of saving and, hence, investment in our economy. For example, transferring government saving to individual private accounts as a means of avoiding the accumulation of private assets in the government accounts could significantly affect how Social Security will be funded in the future." As the supply of Treasurys has declined, their role in credit markets has been skewed. The yield curve inverted last year as demand for long bonds outstripped their supply. The 10-year bond has replaced the 30-year as the bellwether for long rates, because the latter is so illiquid. In the Lehman Brothers Aggregate Bond Index, a common yardstick for fixed-income managers, the weighting accorded to Treasurys fell to 26% in January from 35% a few years ago. Now What? Some managers are not overly concerned about the effects this will have on their portfolio. The stable value products that find themselves in corporate pension plans, whether defined benefit or defined contribution, are typically GICs or synthetics. GICs "are nothing more than an individually negotiated private-placement bond, and that's not dependent on Treasurys to any meaningful extent," notes Peter Bowles, president of Woodbury, Conn.-based Fiduciary Capital Management. "I would guess our synthetic portfolios probably have upwards of 25% in Treasurys or agencies – but of course the agencies aren't going to go away." One vendor of synthetic GICs, ING Aetna Financial Services, employs portfolios managed by Aeltus Investment Management and insured by Aetna Life Insurance & Annuity Co. The Treasury allocation "is not a very large one," says Tony Camp, manager of stable value products. Instead ING Aetna Financial Services relies on a mix of corporates, mortgage-backed securities and other domestic bonds with an average credit profile around AA. "It's a very conservative investment strategy, in recognition of the kind of customer we're investing for," he says. But others do feel that there will be significant impact. As Treasurys diminish in importance, other securities necessarily assume greater importance. Agencies of the U.S. government are the most immediate substitute. Asset-backed securities, collateralized mortgage obligations, commercial mortgages, corporate bonds and myriad other debt instruments play an increasingly important role. "In some instances, the international arena is available to stable-value managers on an opportunistic basis," notes Michael Wyatt, director of stable value investments for DuPont Capital Management. At BlackRock, synthetic GIC portfolios likewise rely on a mix of mortgages, corporates, asset-backed securities, commercial mortgage-backed securities, agencies and Treasurys. "For the most part, you've seen people underweight the Treasury component," Spodek says. "You've made money by being overweighted in spread products." Over the last couple of years, however, concerns about the diminishing supply of Treasurys have put pressure on this strategy. For valuation purposes, spreads to Treasurys have become a tenuous benchmark. Especially at the long end, Treasury yields have been driven down by strong demand for a shrinking supply. Increasingly, spreads are based on the interest-rate swap market. "Buying spread products isn't what it used to be," Spodek says. As the market searches for a new benchmark to replace Treasurys, agencies are one option but, Spodek notes, "It's not clear necessarily that agencies will become the new standard. While the agencies have done a good job at developing a large liquid marketplace for their debt, there is still political and credit risk associated with their activities." The other alternative is swaps, a liquid global marketplace not dependent on any one individual credit. "Swaps could present a better alternative even than agencies," the BlackRock official says. Bruce Goode, president of Cleveland's Goode Investment Management, has observed the same trend, but with some misgiving. "One of the things that's happened recently is that, instead of using the Treasury curve (in pricing), people are using the swap curve," he says. "My concern is that Treasurys have always been a readily definable benchmark that represent a more straight forward measure of relative value than the swap-spread market." Interest-rate swaps are a derivative – meaning that to benchmark against them is to make the process more abstract and less concrete. This is a not-inconsequential matter: As different financial instruments gain sway in stable-value investing, its risks become more difficult to analyze and manage. "What's likely to happen is people are going to be forced out of the Treasury market and into other products," says PIMCO's Keller. "Funds that invest only in the highest quality tiers will have the biggest adjustment to make. My crystal ball gets cloudy at this point," Keller says, "but the general trend is people are either going to have to take more credit risk, raise their allocations to mortgages (agencies), or use derivatives - like interest swaps." As the market is forced to embrace more credit or prepayment risk, or an increased use of derivatives, "Investors will want to look harder at the capabilities of firms to manage the risks," says Wendy Cupps, PIMCO's director of stable value. "With the increased use of alternatives to Treasurys in portfolios, managers need to have additional modeling skills and back office support to manage both security and portfolio level risks."
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