Trump's 100-Year Bonds Contain Lots of Risks for Traders
As a former Goldman Sachs bond trader and hedge fund manager, U.S. Treasury Secretary Steven Mnuchin might have felt some pity for volatility-deprived traders of Treasuries. In fact, the market was in a funk until Mnuchin's comments Monday on the rising odds of the government issuing ultra-long maturity bonds smashed longer-dated debt.
Currently, the longest maturity debt issued by the government is 30-year bonds. The Treasury is now asking dealers and others involved in the market what it should consider when structuring a bond with a maturity longer than three decades, such as 50 or 100 years. There is lots of disagreement among analysts regarding the necessity and viability of such Treasury bonds. Many traders are worried they may be too illiquid and would be prone to extreme volatility given their long maturities. After all, it wouldn't take much of an increase in interest rates to inflict outsize losses on holders given the current low levels of rates.
Those fears resonate with traders who are familiar with recent trends in primary dealer positioning. Dealers have been under severe pressure for years to cut their balance sheets and improve their capital ratios. Their participation in auctions is at historic lows, and they are showing no signs of wanting to expand market-making in a product with such narrow profit margins.
In short, traders are concerned that dealers won't have the capacity to sponsor a new bond that carries with it a higher level of volatility and potential for losses. In fact, many dealers have quietly advised the Treasury against extending the government's borrowing reach past 30 years. The extreme risks associated with trading highly volatile 50- to 100-year bonds would not favor the issuance of large sizes. That would further dampen trading volumes and work against the Treasury's goal of extending the average maturity of the government’s debt profile.
Also working against ultra-long bonds is the fact that Federal Reserve officials have started talking about reducing either later this year or in early 2018 the central bank's $4.5 trillion of balance sheet assets by ending the practice of reinvesting proceeds from maturing bonds into new securities. That is expected to have a significant impact on the less liquid longer end of the yield curve. The yield curve steepened after Mnuchin's latest comments, with the spread between 2- and 30-year Treasury yields expanding to 173 basis points from 169 basis points Friday. The fear of ultra-long issuance also drove 30-year yields back above the important 3 percent level.
No doubt there is demand for long-duration bonds among the institutional investors who manage fixed-income portfolios for pension funds and insurance companies. Their liabilities are very long-term in nature so ultra-long bonds often fit the bill. And, there is also plenty of precedent in terms of 50- or 100-year bond issuance from foreign governments and some companies. The securities, though, are often in the hands of institutions that do not trade them, limiting their liquidity. Such “trade by appointment” issues are smaller and their trading history doesn't bode well for the kind of size the Treasury would need to issue to make the shift to ultra-long bonds relevant.
In the past, the lead time for new debt products such as floating-rate notes or inflation-protected bonds has been measured in years. This White House could be working with a much shorter time frame and is seen as less likely to be influenced by resistance from dealers. While an announcement of ultra-long issuance is not seen as likely in the Treasury's quarterly refunding announcement Wednesday, there could be more direct references to the prospect in the near-term, especially as the pressure for higher debt loads to fund infrastructure and tax cuts is increasing. There's a general understanding in the bond market that the Treasury will be issuing more debt across all maturities in the near future regardless of the ultimate decision on ultra-long bonds.
For decades, bond traders were fond of saying that the tops of bond rallies were signaled when Goldman Sachs issued debt for itself. That respect for the firm's market savvy might be a warning to investors now that a former Goldman Sachs bond trader wants the government to sell 50- to 100-year bonds at historically low yields.
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