UBS interest rate strategists Mike Schumacher and Boris Rjavinski say issuance of “super premium Treasuries” is “the most attractive stopgap solution to the debt ceiling crisis” in Washington, D.C. that is roiling markets.
“Better than a trillion dollar coin,” even.
In a nutshell, the idea is that the Treasury would issue 10-year or 30-year notes that yield higher rates than those in the market. Investors would have to pay up for the ability to hold these premium securities.
Schumacher and Rjavinski say they discovered the idea in a Time Magazine piece by Christopher Matthews, who in turn cites Bloomberg View columnist Matt Levine.
Levine provides a simple, clear explanation of how super-premium Treasury issuance could help the Treasury Department to get around the debt ceiling:
- The U.S. government takes in $US277 billion in tax revenues each month, and spends $US452 billion each month, for a monthly deficit of around $US175 billion.**
- It also has, on average, call it $US100 billion of Treasury notes coming due each month.***
- Instead of just rolling those Treasuries — paying them off at 100 cents on the dollar by issuing new Treasuries at 100 cents on the dollar — it should pay them off at 100 cents on the dollar by issuing new Treasuries at 275 cents on the dollar and using the extra money to pay its bills. The 10-year yield today is around 2.6 per cent, so you could sell a 10-year with a 23 per cent coupon for 275 cents on the dollar.**** The 30-year is about 3.9 per cent, so a 14 per cent coupon should get you there. Etc. Maths here.
- That’s it. You aren’t adding debt, so you never hit the debt ceiling, but you keep getting more money.
“The overwhelming positive is that Treasury could issue bonds through somewhat normal channels, although with decidedly abnormal coupons and prices,” say Schumacher and Rjavinski. “Another plus is that default would be off the table.”
But how does this allow the Treasury to get around the debt ceiling?
“The debt ceiling applies to the face amount of bonds, not the amount raised, so selling a $US100 bond for $US275 only counts $US100 against the debt ceiling and gets you $US175 in debt-ceiling-free money,” says Levine. “There are rules against issuing premium Treasury bonds, but the rules are just Treasury rules and they can be changed unilaterally by Treasury with no notice and no Congressional approval.”
The UBS strategists run through a hypothetical scenario:
Treasury could announce a series of special auctions. It would maximise relief room under the debt ceiling by focusing on 30-year bonds, but might want to issue some 10s to minimize yield curve distortions and reduce costs.
In our view, these bonds would appeal almost solely to total return buyers. We are not accounting experts by any stretch of the imagination. Still, we think it is reasonable to say that investors such as banks and insurers who operate with accounting constraints would pass on bonds trading at vast premia.
The viability of the auctions would be a function of how cheaply the bonds are priced versus on-the-runs. It is impossible to say whether 20 [basis points] would be a large enough concession. Investors might gain a nice fillip in addition to picking up a liquidity premium.
Treasury could decide to buy back these bonds in a few months, when the politicians presumably have raised the ceiling. Naturally, Treasury could not guarantee a buyback on auction day. Still, imagine for a moment that the buyback did happen, at say +5 [basis points] to on-the-runs. The investor would stand to gain 15 [basis points] of spread tightening. The 20% 30-year bond has a duration near 14 years, so 15 [basis points] equates to a bit more than 200 [basis points] of incremental total return. Not bad. Some observers have suggested that Treasury simply reopen a bond, rather than create a new issue with an extremely high coupon. Treasury issues normally can be reopened for up to one year, subject to restrictions on original issue discount.
One more reminder — we are not accounting experts. The highest-priced Treasury security that was issued within the last year trades a bit below 101, so that does not help. If Treasury figured out a way to reopen an old issue, it could choose among a dozen issues that trade in the 140s. These bonds’ coupons range from 6.75% to 8.75%, and they mature between 2020 and 2026.
How much would issuing super premium Treasuries cost?
“For the 30-year bond, the 20 [basis point] premium combined with a duration around 13.5 years equates to cost of 2.7% of proceeds,” say Schumacher and Rjavinski. “The average monthly budget deficit for fiscal 2014 appears to be around $US60 billion. If Treasury decided to fund it entirely with super premium 30-year bonds, the monthly cost would be about $US1.6 billion. Using 10-years instead of 30-years would reduce the cost to roughly $US0.8 billion.”
“The program would not be free, but a price of $US1-1.5 billion per month seems like a compelling bargain compared to a U.S. default.”