Debt-Limit Deadlock Leaves Bond Investors Wondering What's Next

  • U.S. bill disruption has largest sovereign debt market on edge
  • Timing for increased Treasury borrowing depends on Congress

It’s that time again.

When Treasury Secretary Jacob J. Lew set Nov. 3 as the probable date when the government may no longer be able to cover its expenses without Congress boosting the debt limit, the bond market took notice.

The U.S. debt-ceiling deadlock has already caused disruptions in the Treasury bills market, leading to a shortage of supply. Rates surged in recent days as investors backed away from securities viewed at risk for potential payment delays. Analysts are also concerned the regular sales of three-, 10- and 30-year debt, slated for next month, will be disturbed.

While Treasuries remain the largest, most liquid sovereign debt market in the world, this type of turmoil raises plenty of questions for investors whom the U.S. relies upon to own its $12.9 trillion of marketable securities. Interviews bond-market veterans and analysis by the Government Accountability Office provide a framework for how the debt-limit drama may play out this time.

What exactly is the debt limit anyway?

Congress and President Woodrow Wilson created statutory federal debt limits during World War I to give the Treasury more flexibility. It eliminated the need to go to Congress to get approval for each sale of debt. The government spends more than it receives in taxes most years and the debt limit represents the total dollar amount the U.S. is allowed to borrow to pay its bills. 

In 1941, a limit on all debt outstanding was set. It has been increased more than 80 times and stands at $18.1 trillion.

Congress must increase the debt ceiling soon to avoid gambling with U.S.’s full faith and credit, Antonio Weiss, counselor to Treasury secretary said Tuesday at conference at the Federal Reserve Bank of New York.

What happened in the October 2013 debt-ceiling episode?

An 11th-hour political deal reopened the government after a 16-day partial government shutdown sparked as some Republicans wanted to deny funding for the Affordable Care Act and limit federal borrowing.

The protracted processes caused investors to shun hundreds of billions worth of Treasury bills whose payments were due between late October and mid-November and some longer-term Treasuries whose coupon payments came in that time period. Bill rates in that period rose from about 0.01 percent in mid-September to more than 0.50 percent in secondary market trading. Costs to the U.S. taxpayer from higher rates at Treasury auctions are estimated at between roughly $38 million to more than $70 million, according to a July study by the Government Accountability Office.

Rates on bills maturing Nov. 12 reached 0.14 percent Wednesday after trading below zero as recently as Oct. 16.

What about Treasury’s Nov. 4 note and bond sale announcement?

The Treasury could delay auctions, make them conditional on a Congressional agreement, or sell securities to match only the maturing amount, according to Ward McCarthy, chief financial economist in New York at Jefferies Group LLC, one of the 22 primary dealers obligated to bid at the auctions.

That may be unsettling to debt traders in some of these scenarios if the typical pre-auction trading period is abridged, which could also result in higher government borrowing costs. Dealers usually need time to connect with their customers and prepare for bidding for the notes and bonds. The less time they have, the less debt they are likely to offer to buy.

“It would be tough to have refunding auctions that just roll over maturing debt,” said Priya Misra, head of global interest-rate strategy in New York at TD Securities, a primary dealer. “That would create too much uncertainty in the market and the Treasury would likely have to pay-up at the auction. Delaying the refunding is certainly possibly, and it would shorten the when-issued trading period.”

So could a debt-ceiling delay sendU.S. yields lower?

“The most obvious immediate response is that there will be a delay in supply so Treasuries will rally, with yields falling," said McCarthy of Jefferies in a telephone interview. 

"A secondary question is how does the equity market react?" he said. "If it roils the risk markets, that would cause a flow into the safety of the Treasury market.”

Does a delay have the potential lead to higher yields?

In 2002, the announcement of a two-year note auction was delayed by seven business days. Instead of five days to prepare their bids, dealers had less than one. As a result, the bid-to-cover ratio, or the ratio of dollar value of bids at auction to the amount accepted, was the lowest on record for any two-year note auction and cost the Treasury an additional $19 million of interest for each year, according to the estimates cited by the GAO.

The U.S. already pays more than 17 other developed nations to borrow money for 10-years. For example, Benchmark U.S. 10-year notes yield 2.03 percent, while German bunds yield 0.57 percent.

So delays in Treasuries auctions have happened?

Yes. Between 1995 and 2010, the department delayed the announcement of 17 regularly scheduled debt sales and postponed the auction date for 11 auctions, according to another GAO report.

In November 1995, the three- and 10-year note auctions intended to raise money to pay off the debt maturing on November 15, slipped past that date. Treasury issued cash-management bills, a shorter-term kind of debt that usually costs taxpayers more due to higher interest, to fund the gap.

Since 2010 there have been no auction delays due to the debt-limit.

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