The Invisible Run-Off

Today, the Alphaville section of the Financial Times published The invisible run-off, in which I discuss a new source of “quantitative tightening” that almost no one seems to have noticed.  I estimate that $350 billion of private funds will be absorbed when the U.S. Treasury refinances its securities that are now in special accounts for state and local government bonds.  The Treasuries are currently held in escrows to secure municipal bonds that have been “advance refunded.”  An advance refunding is a complex refinancing technique for bonds that are months or years away from their first scheduled call date.

The Tax Cuts and Jobs Act prohibits advance refundings going forward because they increase the supply of tax-exempt bonds (at least until the old bonds are called), thereby shaving the revenue to the Treasury.

According to the Joint Committee on Taxation, the end of advance refundings will save the federal government $17 billion over the next ten years:

 

 

Of course, that’s not much in comparison to the overall projected effect of tax reform:

 

 

Over the next few years, perhaps $350 billion in escrow Treasuries will mature.  These will have to be refinanced without the help of new advance refundings. The run-off from escrows is not as large as the Fed’s expected balance sheet reduction (as much an obsession to the markets as a sizzling steak  to a dog), but the escrow wind-down could match about a third of the Fed’s roughly $1 trillion planned disposal of Treasuries.  The loss of escrow funding to the Treasury, and the additional supply to the market, could be prove significant.

Addendum:

The key to the $350 billion estimate for escrow securities was the S&P Municipal Bond Prerefunded/ETM Index.  The index includes about $190 billion in bonds that have been escrowed to a call date (“ETC”) or to escrowed to maturity (“ETM”).  I scaled up the prerefunded bonds by taking the ratio of the whole S&P municipal bond universe ($2.2 trillion) to the full reported size of the municipal market ($3.8 trillion).

I was interested to see that the average coupon of the prerefunded bonds in the index is 4.9%.  This seems to confirm the prevalence of 5% coupons in recent years.  These high coupons (their yield is now 1.6%) were among the most attractive candidates for refunding.

The escrow Treasuries generally have much lower coupons than the refunded bonds they support, so more than $1 in Treasuries are needed to cover the interest payments on each $1 of refunded bonds.   This relationship implies that $350 billion could be a conservative estimate for Treasuries in advance refunding escrows.  On the other hand, some of the escrows are so short that they are considered to be “current refundings” instead of advance refundings.  Current refundings are still allowed, but their short shelf life has probably limited their impact on the index.  To the extent that some bonds in the index correspond to current refundings, the $350 billion estimate could be on the high side.  Another distortion would be if the prerefunded share of the S&P index universe does not match that of the whole market.

 

Addendum added January 21, 2018

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My Letter to the Wall Street Journal

The Wall Street Journal just published a letter of mine, Debt Bomb has Shorter Fuse Than Many Citizens Think (credit to them for the snappy title, and to my wife Corrina for invaluable editing).  I respond to the Journal’s recent editorial Obama’s Debt Interest Bomb.

The editorial warned of a growing burden of interest payments on the national debt, due to rising interest rates and the anticipated drawdown of the Fed’s portfolio of Treasury securities.  In my letter, I point out that the problem is exacerbated by two factors.  First, the short maturity structure of the Treasury’s debt offers little protection against higher interest rates.

The second factor is the uneven composition of the securities held by the Fed.  The Fed neutralizes the interest payments it receives by returning them back to the Treasury.  Because the Fed tends to hold the Treasury’s higher-rate securities, the Treasury will sorely miss the Fed’s subsidy when it’s gone.

 

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Quarter the Cross: An Elegant Construction

Last month, I presented an infinite pattern of nested crosses as a response to the  #QuarterTheCross challenge on Twitter.  The idea is to find interesting ways to shade one-quarter of the area of the cross built from five squares.nested_crossNow David Butler, a math lecturer at the University of Adelaide, has found an elegant way to construct this pattern with the classic tools of compass and straightedge (I used some simple MATLAB code).

As the crosses get smaller, each new one must shrink by \sqrt{3}.

I asked David to explain his construction.

The segment marked “1” is \dfrac{1}{3} of the “radius” from a corner of the outer cross to the center, so the construction generates an inner cross with the required radius, \dfrac{\sqrt{3}}{3}=\dfrac{1}{\sqrt{3}} as long as the original radius.

A nice feature of this construction is that the compass is only used near the beginning.  After that, the construction always provides a scaffold for the next inner cross.

 

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Quarter the Cross

Yesterday, I noticed that some of the math teachers I follow on Twitter were challenging their students, and themselves, with the #quarterthecross problem.  The problem is simply to find interesting regions of a five-square cross that take up exactly one-quarter of its area.  This looks like a great way to get kids to explore fractions and geometry.

nested_cross

A solution that occurred to me would be to use an infinity of nested crosses.  If the area of the cross shrinks at each step by one-third, then the combined area of the colored regions converges to one-quarter of the large cross.  This works because the alternating geometric series

\dfrac{1}{ 3} - \dfrac{1}{ 3^{2}}+\dfrac{1}{ 3^{3}}- \dfrac{1}{ 3^{4}}+\dfrac{1}{ 3^{5}}...

converges to \dfrac{1}{4}.  Note that if the area shrinks by one-third, the width of the cross must scale down by the square root of 3.  So every two steps the width shrinks by one-third, placing a little cross precisely inside the middle square of a larger cross.

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My FT Alphaville Commentary on Managing U.S. Treasury Debt

My commentary Go Long, Mr Mnuchin has just been posted at FT Alphaville of the Financial Times.

I address whether the U.S. Treasury debt should be lengthened and whether it should sell 50-year or 100-year bonds.  I think that “ultra-long” bonds are a good idea but that there won’t be enough demand for them to significantly reduce the Treasury’s interest rate risk.  This should be accomplished by reshaping the whole distribution of maturities, which is currently very front-loaded.  I also argue that the Treasury should update its measures of interest rate risk, and keep a close eye on how the Fed manages its Treasury portfolio.

Please check out the post and let me know what you think!

I am grateful to my wife Corrina for her essential suggestions and thoughtful editing through countless revisions. 

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NAMA in NOLA

I am excited to go to New Orleans this week to speak at the annual conference of the National Association of Municipal Advisors (NAMA). I will be on a panel about bond structuring with Lori Raineri of Governmental Financial Strategies Inc., Dave Abel of William Blair, and Shelley Aronson of First River Advisory. We will discuss some of the important structuring questions that face municipal advisors, such as how to analyze  the tradeoffs involved with callable premium bonds.

Click here to see our slides.  They include a conceptual bond glossary that I prepared.

I look forward to a great conference (with maybe a little jazz on the side).

 

 

Updated 10/3/2016 with link to presentation slides.

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Taming Premium Bonds

Premiums 15-Year
The Bond Buyer published my commentary Taming  Premium Bonds earlier today.  Although callable premium bonds are very popular in the municipal market, I argue that they hurt issuers and the market.  Market rules dictate that the proceeds to the issuer compensate only for high coupons to the call date.  The compensation for high coupons past the call date is buried inside the call option, making a refunding almost inevitable.  These bonds also make the market more opaque.  As a solution, I propose that the call premiums be set to breakeven levels so that the price-to-call matches the price-to-maturity.  Please see the article for the details.

Update: This not a new idea.  I applied it as a financial advisor many years ago, and it is also the basis for one of the puzzles on this blog.

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