Paris, Monday, July 31, 2000 Investors at a Loss Over Shrinking Debt Supply By John M. Berry Washington Post Service WASHINGTON - Claire Goldman, a 77-year-old retiree in Maryland, first got annoyed with the U.S. Treasury in March 1998 when it announced that it was not going to sell any more of its popular three-year notes. So she began to buy a different, shorter-term security, the one-year Treasury bill. Then, in February, the Treasury cut back sales of that bill from once a month to once every three months. Now it appears very likely to eliminate the bill soon. ''It is going to be very difficult for me,'' said Ms. Goldman, one of the millions of investors around the globe who are being forced to adjust as the world's safest investment - Treasury securities - disappears. The supply of such securities held outside federal government trust funds - although massive at $3.4 trillion - is shrinking as mounting federal budget surpluses reduce the U.S. government's need to borrow money each year. As the Treasury issues fewer notes, bills and bonds, and buys back some others, about $200 billion worth of securities will vanish from the books this year, and most if not all of the remaining supply could be erased over the next 10 years if the surpluses materialize according to government projections. Even the future of an American symbol of thrift, the venerable U.S. savings bond - a form of Treasury security - would be in doubt if there were no debt. Treasury securities have long been a popular investment, primarily because they are seen as carrying zero risk of default. Because they are safe and easy to trade and were until recently in abundant supply, they have been used for a wide range of purposes by all types of investors - becoming the grease that keeps the machinery of world financial markets operating smoothly. The supply shrinkage has already led to hiccups in the machinery and forced small and big investors alike to look for ways to alter investment strategies. Investors who will have to find alternatives include the portfolio managers of corporations, banks, mutual funds, pension plans, state and local governments, foreign countries and even the Federal Reserve System. There is no shortage of private debt, but even the best of it carries more risk of default than Treasury securities, which is a problem for risk-shy investors. As government paper is phased out, various investors will have to find alternatives to use as collateral for loans, securities that can serve as substitutes for backing of esoteric derivative instruments and for hedging positions taken in other securities. Financial markets are coping with new uncertainties because they have long depended on all but the shorter-term Treasuries as benchmarks for setting the interest rates of corporate bonds and other financial instruments. This year will be the third year in a row that federal budget surpluses have caused the government to issue fewer new securities. The Treasury Department has even started buying back from willing sellers older, relatively high-yielding notes and bonds as it retires about $30 billion worth of debt this year. But this new reality seemed to escape most investors and bond traders until just a few months ago, when the Treasury announced it was cutting back both the size and frequency of its auctions of new securities, such as the one-year bill. Suddenly, Treasury prices shot up and yields dropped significantly on the five- and 10-year notes and 30-year bonds. These rates dropped even though the Fed was raising short-term rates. Robert DiClemente, an economist with Salomon Smith Barney in New York, said the ''scarcity value'' of the securities had become more important in determining long-term yields than the Fed actions. After the unexpected drop in Treasury yields, the spread between the ultrasafe government paper and the relatively more risky private securities became much less meaningful. Treasury yields still are used as benchmarks, but they are less important than they were, and that importance will diminish steadily along with the volume of government securities. The markets are casting about for alternatives. Among the options for both individual and institutional investors are AAA-rated corporate bonds and those issued by institutions such as the World Bank. Notes and bonds from ''government-sponsored enterprises,'' such as Fannie Mae, which raises huge amounts of money with which to acquire home mortgages, could fill the bill. Fannie Mae is seeking to have the yields on its securities become a substitute ''benchmark'' against which yields on other securities are based. But Fannie Mae is under something of a cloud because President Bill Clinton's administration is trying to eliminate its access to direct credit at the Treasury, and Congress is holding hearings on that and other issues related to its future status. When the Treasury announces its borrowing plans early next month for the rest of the year, some analysts expect further cuts in new security issues. Along with the 52-week bill, there is also a chance that the 30-year bond, which has been issued regularly since 1977, will be dropped, analysts at Merrill Lynch & Co. told their clients recently. Among the most immediately affected of all Treasury holders is the Fed. As of last week, the central bank held $506 billion worth of Treasury securities as the major asset backing the huge amount of U.S. currency circulating around the world. In recent years, that portfolio has grown an average of 5 percent to 8 percent annually in line with the demand for currency. So long as the amount of Treasury securities was increasing rapidly, as was the case while the government was running large annual budget deficits, the Fed's acquisition of Treasury securities created no problems. But now the central bank is competing with all the other investors for a shrinking pool of securities with the long-term prospect that the Fed will have to make massive changes in what type of assets it holds. Peter Fisher of the New York Federal Reserve Bank, who is in charge of managing the Fed's portfolio, said recently that the central bank needed an active private-sector market for whatever assets it holds to allow it to manage the portfolio properly. ''If private holdings of Treasury debt go to zero, then our holdings would, too,'' he said. The Fed has begun a study to find a long-term solution to this new problem, , Mr. Fisher said, but it will not be completed anytime soon. Years ago, the Fed began to shed its holding of securities issued by Fannie Mae and similar enterprises and under the circumstances appears unlikely to choose such paper to replace Treasury securities. The central bank could choose to change its operating procedures and put money into the system directly by lending it to banks, with the bank loans then serving as the collateral for currency. Or it, too, could choose to buy other types of high-quality private securities. At the end of March, foreigners owned nearly 40 percent of outstanding Treasury securities, with foreign official institutions holding more than $600 billion worth and almost $700 billion worth in private hands. Officials at both the Treasury and the Fed have studied whether the shrinkage of available Treasury securities is likely to reduce the desire of foreigners to invest in the United States, and both concluded there is no reason to think it will. That's an important question for two reasons. First, a drop in the flow of foreign capital would make it more difficult to finance the very large deficit the United States has in trade and other transactions with the rest of the world. Second, a drop in that flow could also knock a large hole in the value of the dollar, which would make imports more costly and possibly increase inflation. [Rest of article at http://www.iht.com/IHT/TODAY/MON/FIN/bonds.2.html ]
