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February 09, 2006

Debt Markets Demystified
by Rob Kirby

This week the U.S. Treasury is set to undertake a very large and onerous quarterly refunding with the re-introduction of the 30 year or "long bond." Treasury debt to be auctioned is as follows:

This represents almost 50 billion worth of issuance and with the deteriorating state of the U.S. government's finances - it seemed like an appropriate time to revisit the debt markets with an overview of how they work and how they're graded.

Root Causes

We all know that governments incur debt - of that there is no question. A good many of us probably even realize that U.S. debt [or deficits] can be broadly summarized as arising from fiscal imbalances [which occur when the government spends more on programs than it raises through tax receipts] or through the Current Account [which aggregates the balance of trade between the U.S. and the rest of the world]. These two distinct drivers of debt have lent to the "coining of the phrase" - the twin deficits - namely, those of the aforementioned fiscal and current accounts. To keep the two straight in your mind it would perhaps be best to view the former as arising from government spending and the latter resulting from an imbalance in international trade.

Often, in the media - folks speak of either the growing rate of indebtedness as a percentage of GDP [Gross Domestic Product or value of all goods and services produced in the U.S. economy in a year] being "too much" or "unsustainable." What I would like to discuss or attempt to explain - is how we know or ascertain that indebtedness is in fact too much, unsustainable or near a breaking point - since anyone who would be old enough to read this excerpt would most assuredly have heard these claims for as long as they remember.

All Debt Must Be Funded

As consumers, when we borrow money - we perhaps take a mortgage on a house or we might use a credit card which allows us to spread our payments for said purchases over time - making monthly payments with interest. When governments wish to spend cash money that they do not have in their "bank account" - they [or the Treasury] may choose to issue or auction bills, notes or bonds; that pay a specified rate of interest [coupons that typically pay interest twice per year or semi-annually] for set period of time [maturity]. Since governments have the ability to tax its citizens and ultimately the ability to print money - they are generally perceived as being the most creditworthy issuer of debt in any jurisdiction. Therefore, stemming from this logic - the rates that the government pays for money, across a variety of maturities [from 3 month Treasury Bills all the way out to 30 year bonds] is the basis for the government yield curve - against which all other debt [individual or corporate] is graded or compared.

How the U.S. government goes about auctioning debt instruments is primarily through weekly issuance of Treasury Bills [maturities out to one year], quarterly issuance of government bonds [maturities ranging from 2 years - 30 years] and periodic issuance of other Treasury notes and Inflation Protected Securities [TIPS] of varying maturities.

The strength, viability or underpinnings of both the U.S. dollar and the U.S. capital markets are dependant on the debt markets - outlined above - operating in an efficient and orderly manner.

Results Speak Louder Than Words

In a broad sense, some of the most watched aspects of bond/note auctions are [in no particular order]; bid to cover ratio, low yield, median yield and high yield.

I would now like to zero in on two of the U.S. government's most recent debt auctions and point out how the published results of each serve as beacons - accessing the health of the debt market by taking its temperature, as expressed by individual auction results:

22 Billion 2 Year Notes Auctioned Jan. 25, 2006:
Bid to cover: 2.11	Meaning there was roughly 45 billion in bids for the roughly 22 billion in debt being auctioned.
Low yield: 4.35	Meaning the most aggressive bid in the auction was 4.35%
Median Yield: 4.405	Meaning half of the notes auctioned were at a yield higher than this and the other half lower.
High Yield: 4.427	Meaning the lowest price at which bids were accepted.

Commentary:

The bid to cover ratio [while not strong] was adequate with there being better than 2 dollars in bids for every dollar of debt being auctioned. While the "tail" [spread between median and high] was relative "tight" - what was alarming was the spread between the low and high [in excess of 7 basis points] - which was "large" for an auction of relatively short term [2 year] debt. Even more indicative of how the new debt was received is what happened immediately following the auction - the yield on 2 year government debt backed up "directly" to 4.53%. This indicates that there was little investment demand for the notes following the auction and the dealer community that bid for this debt [between 4.35 and 4.42%] now own it in their inventory [and they are thus "underwater" on it given that their cost of funding - negative carry - is the fed funds rate of 4.50%. The fact that the dealer community likely still owns a good portion of these bonds at unfavorable prices could raise suspicions that their appetite for additional debt might be impeded at the next debt auction until rates rally or this debt is off loaded.

Conclusion: a poor auction

10 Billion 20 Year TIPS Auctioned Jan. 24, 2006:
Bid to cover: 1.48	Meaning there was 14.7 billion worth of bids for 10 billion worth of debt being auctioned.
Low yield: 1.90	Meaning the most aggressive bid for the auction.
Median yield: 1.955	Meaning half of the notes auctioned were at a yield higher than this and the other half lower.
High yield: 2.039	Meaning the lowest price at which bids were accepted.

Commentary:

Given that this auction was for inflation protected securities [ostensibly more desirable or less risky than long term debt with a fixed coupon], the bid to cover ratio at 1.48% was exceptionally weak. The tail [spread between median and high] was large 8+ basis points and the spread from low to high yield at almost 14 basis points was also very large. These results are highly indicative of yet another auction that had very tepid - at best - investment demand.

Conclusion: a poor auction

A concluding observation I would like to throw out is this:

Recent debt auctions - as outlined above - have reported at best tepid results which are at odds, to say the least, with recent strength the U.S. Dollar has shown on foreign exchange markets.

With this week's roughly 50 billion in 3 year, 10 year and 30 year bonds being auctioned, the global investment community will no doubt be keeping a close watch on the upcoming results.

Rob Kirby
Kirby Analytics

Copyright © 2004 - 2006 Rob Kirby

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