Washington’s bond sellers should take a lesson from corporate treasurers
By Joseph S. Fichera
& Charles M. Jones
Views From Beyond the Barron’s Staff
February 26, 1996
While Washington rhetoric focuses on the amount of government debt, another important failure is overlooked. The government lags behind large corporations in minimizing its long-term debt costs. Treasury routinely gambles on its success in keeping interest rates low by raising money mostly from short-term investors. In doing so, it virtually ignores the long-term market and bond structures that can give stability and flexibility to its budgets. Billions of taxpayer dollars are at stake.
Corporate treasurers, who run their corporations to survive the long term, focus on “liability management.” This includes minimizing the long-term cost of debt, not just its immediate cost. Unfortunately, in Washington “liability management” usually refers only to a political problem with the media. It ought to mean using the most current techniques to reduce the cost of the national debt.
A case in point: Treasury sells only “straight debt.” It does not sell callable debt, much less other, more innovative securities. Callable debt can be redeemed, with cash or the proceeds of new debt, before its maturity. Home owners with mortgages have callable debt. They understand the benefit of being able to pay it off and refinance when interest rates drop. To have this ability, the debt must be initially sold with the understanding that the issuer may, before the debt matures, call it and refinance.
Yet when the Treasury issued $12.7 billion of 30-year debt in February 1985 at 11 1/4%, it did so with no call option. Ten years later, taxpayers continued to pay that exorbitant rate, although 30 year interest rates had fallen to 7 1/2%. With a standard 10-year call option and refinancing, taxpayers could have saved $450 million a year for the remaining 20 years until maturity.
Corporations are not as naive in their long-term financings. From 1980 to 1995, according to Securities Data Corp., corporations issued $146 billion of callable long-term bonds, compared with $98 billion of noncallable securities.
The U.S. government is virtually alone in its total reliance on noncallable debt. Most federally sponsored enterprises, like the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp. and the Tennessee Valley Authority, use callable debt extensively. Nearly all long-term debt of U.S. state and local governments is callable. Foreign countries use callable debt.
The Treasury used to issue callable long-term debt. From 1940 to 1984, almost $100 billion of
callable debt was issued. However, the agency structured the securities in a very strange way, with the call option exercisable only during the last five years of the bond. This is the exact reverse of corporate securities. There, bonds can be called after the first five or 10 years so the corporation can get 20-25 years of locked-in savings. Not surprisingly, the peculiar-looking Treasury issues were not wildly popular. The extremely shortened period for savings, five years, so far into the future made the option virtually worthless, to the government and made the structure confusing to investors. In 1985, the Treasury reverted to selling long-term debt without call options.
Callable debt is costlier than straight debt Investors require issuers to pay them, through higher initial rates, for bearing the risk that they might be given their investment back sooner than expected, and in an environment of lower interest rates. Generally, call options add a premium of 0.2%-0.5% to the interest rate. In making the aforementioned 1985 debt callable, the government might have had to pay an additional $50 million a year interest for the first 10 years to have the right to refinance when rates were lower.
So, is it worth the additional cost to sell callable debt?
If the market is working perfectly, debt buyers will demand a fair price for the call option. There are plenty of Wall Streeters out there who can (and do) fire up their “black boxes” every day with sophisticated option-pricing models to determine whether these options are worth the price. The Treasury Department could do this, as well. If interest rates drop, it could refinance and recapture the premium and maybe many times that amount if interest rates rise, it could leave the debt outstanding and be thankful that it doesn’t have to enter the market and finance at a higher cost.
Some believe the capital markets would balk at such a change. Markets, however, care most about volume and stability. They are equipped to price and trade any security the government may issue. Investors buy callable securities because they are being paid to take the risk that the benefits will accrue to the issuer.
Others argue that, by issuing noncallable debt, the government actually saves millions in interest expense. While it is true noncallable interest rates are lower, this is a short-sighted argument. The real cost of not selling callable debt is the sacrifice of future flexibility and potential budget savings many times the cost. While there is a risk that the additional interest expense will have been unnecessary, it is a clearly defined downside that can be evaluated by sophisticated analytical techniques. It also can be seen as today’s price for a concern about future generations and their budgets.
But there is an even better reason for the government to issue callable debt. To see why, we must look at Uncle Sam’s incentives to manage the economy. Seventy-five percent of the U.S. government’s debt matures in five years or less. By financing this way, the government exposes itself to the fluctuations in market rates on a huge portion of its annual budget. It is also a huge gamble. (Much of the “savings” in the seven-year balanced-budget negotiations come from assuming the house wins the bet.) But economists generally approve of this gamble, because having such a large percentage of short-term debt prevents the government from benefiting by generating inflation, and paying its fixed obligations with less valuable dollars. If the government fails in its efforts to keep inflation down, it is punished severely.
But what about the 25% that is financed long-term? There, the government benefits from generating inflation.
Callable debt fixes this problem of conflicting incentive and gives the government the right focus. With callable debt, the government would want to reduce interest rates by reducing inflation because it would want to refinance and save substantially. The government’s incentives are finally aligned.
Others argue that this could also be accomplished with bonds indexed to inflation. This security would keep the government from profiting by inflation, punishing it severely if it fails. However, using callable debt adds the carrot of refinancing savings, encouraging the government to actually reduce inflation.
The Treasury Department needs to focus on minimizing the costs on its long-term debt. Real interest rates are still much higher than historical averages, and call options are cheap. Selling callable debt now would also be a strong signal to the market that the government is committed to further reducing inflation and interest rates. Such a move should be independent of budget battles over the amount of debt and spending priorities. Treasury should return to callable debt, but do it right this time.