March 11 (Bloomberg) -- Treasuries fell, pushing the five- year note's yield up the most since May 2004, as the Federal Reserve's move to relieve the credit crisis prompted investors to dump holdings of government debt.

Notes maturing in five years or less led the decline as the central bank said it will allow its 20 primary dealer firms to pledge agency and private mortgage debt as collateral against as much as $200 billion in Treasuries. Investors and securities firms have hoarded government debt as the mortgage market seized up on concern brokers and buyers face widening losses.

``The Fed is trying to do anything it can to free up markets,'' said Jason Brady, a managing director in Santa Fe, New Mexico, at Thornburg Investment Management, which oversees $4 billion in fixed-income assets. ``People have been in asset- preservation mode. To the extent we shift away from that mode, you sell Treasuries.''

The five-year note's yield climbed 20 basis points, or 0.20 percentage point, to 2.58 percent at 12:59 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 2 3/4 percent security due in February 2013 dropped 29/32, or $9.06 per $1,000 face amount, to 100 27/32.

The yield rose the most since May 7, 2004, when it increased 24 basis points on a report showing the economy created more jobs than forecast during a recession.

``A lot of short rate expectations are embedded in five- year notes,'' said Scott Gewirtz, head of Treasury note and bond trading in New York at Lehman Brothers Holdings Inc., one of the 20 primary dealers that trade daily in the repurchase market with the Fed. ``If you think that the Fed is going to use new ways to deal with the current crisis outside of pure rate cuts, maybe that hits them the hardest.''

Two-Year Note

The two-year rate increased 18 basis points to 1.67 percent today for the biggest gain since Dec. 12. The benchmark 10-year note's yield was up 10 basis points to 3.56 percent.

Two-year notes yielded 189 basis points less than 10-year notes, the narrowest difference this month. The spread increased to 208 basis points on March 6, the widest since June 2004, as traders bought two-year notes on speculation the Fed would make deeper cuts in the benchmark lending rate.

After the Fed's announcement, traders pared bets policy makers will cut the benchmark lending rate by three-quarters of a percentage point on March 18. Interest-rate futures on the Chicago Board of Trade showed a 70 percent chance of a 75 basis point cut, compared with 90 percent odds earlier today and 86 percent odds yesterday. The odds of a 1 percentage point cut fell to zero, from 14 percent yesterday.

Auction Collateral

The auctions of Treasuries announced today, which will begin March 27, may be secured by collateral including AAA rated mortgage securities sold by Fannie Mae, Freddie Mac and banks. The central bank ``will consult with primary dealers on technical design features'' of the new tool.

The $200 billion of Treasuries to be lent covers all the agency and mortgage-backed securities held by primary dealers as of Feb. 27. Dealers held $139.7 billion in agency debt and $60.2 billion in mortgage bonds, according to the Fed.

``The Fed's facility literally is able to handle all of the agency securities and mortgage-backed securities that dealers hold,'' said Tony Crescenzi, chief bond market strategist at broker Miller Tabak & Co. in New York.

Under the new program, called the Term Securities Lending Facility, the Fed will lend Treasuries to primary dealers for 28-day periods through weekly auctions. The Fed also said in a statement in Washington that it's increasing the amount of dollars available to European central banks through swap lines.

`Richness of Treasuries'

``One of the things that's been driving the richness of Treasuries is that Treasury collateral has been trading at a premium,'' said Jason Stipanov, an interest-rate strategist in New York at primary dealer Morgan Stanley. ``This is increasing the supply of Treasury collateral in the system, and the higher supply should generally cheapen Treasuries.''

The difference in yields on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes narrowed about 9 basis points to 218 basis points. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less.

Banks and securities firms have demanded more collateral on loans secured by debt from investment funds including Carlyle Capital Corp., forcing investors to sell assets to meet margin calls, and few buyers have emerged. The spread reached the highest level since 1986 on March 5.

Today's steps are the latest in Chairman Ben S. Bernanke's effort to alleviate increasing strains in financial markets that curtail the availability of credit to homeowners and companies.

Term Auction Facility

The Fed last week said it will make up to $200 billion available to banks through auctions of funds under the Term Auction Facility and expanded repurchase agreements with primary dealers. The Fed has auctioned $160 billion in temporary loans to financial institutions in six TAF operations since December.

The difference between what the government and companies pay for three-month loans, known as the TED spread, fell to 1.42 percentage points, the narrowest in a week. It touched 1.63 percentage points on March 6, the biggest difference since Dec. 27, reflecting banks' reluctance to lend.

Three-month Treasury bill rates rose 12 basis points to 1.45 percent, the biggest increase since Feb. 4. The London interbank offered rate, or Libor, for dollars dropped for a 10th day to 2.87 percent, the lowest since February 2005.

To contact the reporters on this story: Sandra Hernandez in New York at Shernandez4@bloomberg.net; Deborah Finestone in New York at dfinestone@bloomberg.net.

Last Updated: March 11, 2008 13:07 EDT