An interesting take on floating rate notes

There's been some discussion of whether the Treasury should issue floating rate notes.   Some people argue that doing so would expose the government to interest rate risk, but as this blog posting points out, this risk is already present in the current way that the government issues short term debt.  

An interesting piece and worth the read.

Treasury yields surge...

In class we've been talking about the risks involved in investing in Treasuries - specifically - what happens when rates change.  Well guess what?  Treasury rates are surging.   As the linked article points out, this isn't actually bad news.

For a cool chart see here.

The US is downgraded.

Well the big news is that S&P has downgraded US Government debt.  In true form for Standard and Poors, the rating agency made a $2 trillion math error which was quickly pointed out to them by the White House.  Still they proceeded with the downgrade.  Ironically, S&P played a big part in getting us in this sorry mess because of their worthless ratings of mortgage backed securities.

The truth is, as several commentators have pointed out, that the debt should be downgraded, not because the US doesn't have the money to pay its bills but because there has emerged a political willingness to use default as a bargaining chip.  The reason the debt has been downgraded is largely because the tea party crowd refused to increase the debt ceiling (something that was done frequently and without fuss in prior administrations).  Their action has shown the markets that default is now a possibility.  It's hard to know what the costs will be in terms of higher interest rates, but what is clear is that this is not what the US economy needed right now.

Should the US issue 100 year bonds?

There's been some talk in the press about whether the US Treasury should issue 100 year bonds.  The idea is that by issuing long term bonds, the government would be able to lock in the current low interest rates.   The fundamental premise seems a little silly really.  First of all, the idea of locking in long term rates assumes that rates will, on average be higher than they are currently.   If this is so, then why would anyone buy these bonds off a low rate.   Put another way, to make this argument you have to assume that the Treasury has better rate forecasting ability than the market.

Another argument for these bonds is that there is demand for them from various institutional investors.  So why would investors demand long term bonds?   The most obvious reason is that long term bonds tend to have high duration.  This means that their prices are more sensitive to interest rate movements than shorter duration bonds.  Counter-intuitively, these long duration bonds are actually very useful for managing interest rate risk - particularly when used in immunization strategies.

So this all sounds good, but it turns out the the Federal Government already issues a longer duration bond than a 100 year bond.  The duration of a 100 year 4% coupon bond selling off a yield of 4% is actually about 25 years.   However, 30 year STRIPS, which are zero coupon bonds, have a duration of 30 years.  Therefore the duration argument doesn't really seem to make much sense.  The only small advantage to 100 year bonds is that they have higher convexity than the STRIPS.

You can check these numbers using the Bond function on wolfram alpha.

Bottom line, I don't think that 100 year bonds have much of an advantage over currently available bonds.

What about China and the US Government debt?

Twice in the past couple of weeks I have been at some social event (usually involving beer) and have been asked "what about China and all the US debt it keeps buying?"

This article discusses the issue nicely.

I also need to drink beer with less serious people.

HT: Greg Mankiw

NC Pension fund expanding investment opportunity

The NC State Pension fund is going to be allowed to expand its investment options to TIPS and lower rated debt. Provided this is done carefully, the TIPS in particular should provide additional diversification to the portfolio overall.

Shouldn't the premium on a US Gov CDS be zero?

Felix Salmon over at Portfolio.com notes that the CDS (credit default swap) premium on US Government bonds is around 50bp. This means that you can buy "insurance" on your US Gov Bonds for about half a percent a year. The question he poses is why is this not zero?

Its an interesting article and well worth a read.