Budget Issues: Treasury's Interest Rate Calculation Changes

Published by the Government Accountability Office on 1999-05-28.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

            United States

XJJGA   O   General Accounting Office
            Washington, D.C. 20548

            Accounting and Information
            Management Division


            May 28, 1999

            The Honorable Bill Archer
            Committee on Ways and Means
            House of Representatives

            Subject: Budget Issues: Treasury's Interest Rate Calculation Changes

            Dear Mr. Chairman:

            The Secretary of the Treasury informed the Congress in a letter dated December 18,
            1998, about Treasury's decision to change the calculation of the interest rates used
            since 1980 to determine the investment returns for a number of government trust
            funds, including Social Security and Medicare. You asked us to determine (1) how
            and why Treasury changed its rules for calculating interest rates in 1980 and 1998, (2)
            the effects of these changes on the unified budget and on the financial status of Social
            Security and Medicare trust funds, and (3) what other trust funds were affected by
            Treasury's decision. This report presents information, which was provided in a
            briefing to your office in April 1999. Also, as part of the audit of the Bureau of the
            Public Debt's fiscal year 1999 Schedule of Federal Debt, we will review whether
            Treasury's methods for calculating interest rates on certain trust funds are being
            applied correctly.


            Treasury sets the interest rate earned on trust fund balances for Social Security and
            Medicare using a statutory formula. The interest rate is to be equal, at the time of
            issue, to the average market yield on outstanding marketable government securities
            not due or redeemable for at least 4 years. Although the formula is set by statute, the
            law does not define the specific method to calculate the yield to be used, except that
            it must be based on market quotations.

            The Federal Reserve Bank of New York provides the market quotations that Treasury
            uses to calculate market yields. The prevalent market practice for calculating yields
            takes into account whether Treasury securities are callable or noncallable-meaning
            whether or not Treasury may redeem the securities prior to their stated maturity date.

                                         GAO/AIMD-99-194R Treasury's Interest Rate Calculation Changes

Market participants compute the yields of non-callable Treasury securities based on
their maturity date.' Computing the yields of callable Treasury securities, on the
other hand, is more complex because of the possibility that Treasury might call these
securities before their maturity date.

Treasury can call the bonds that contained call provisions when they were issued 5
years prior to their stated maturity date ("callable bonds") and thereby pay the bonds'
par value rather than the bond's current market price. The bond's par value is the
amount Treasury agreed to repay by the maturity date. The Treasury has not issued
callable bonds since November 1984. As of September 30, 1998, there were $3.3
trillion outstanding marketable Treasury securities, of which nearly $88 billion were
callable bonds.

Table 1 describes how to select one of two alternative yield values for callable bonds.
If the current market interest rate is higher than the coupon rate on the callable
bonds, the price of a bond is below its par value. In such cases, Treasury would be
unlikely to call the security at par value, so yield is computed based on the time to
maturity of the bond. Treasury called no bonds between 1962 and 1992 because
prevailing market rates were in general greater than coupon rates.

When current market rates are lower than the callable bond's coupon rate, which has
generally been the case in the last 4 years, bond prices are higher than their par value.
In this case, Treasury would likely call the bond at par value before its maturity date;
thus, market participants would calculate yield based on the bond's call date or 5
years before maturity date. Since 1992, the Treasury has called every eligible issue
that has moved into its call period.

Table 1: Rules for Calculating Yield-to-Call or Yield-to-Maturity

                          If market yield is higher than      If market yield is lower
                          coupon rate, then                   than coupon rate, then
 Price of the bonds       Callable bonds trade below par.     Callable bonds trade above
                          Treasury would be unlikely to       Treasury would likely call
                          call the security at par value.     the security at par value.
 Which yield is           Yield-to-maturity.                  Yield-to-call.

'The yield-to-maturity is the rate of discount at which the market price of a Treasury security
equals the present value of the semiannual interest payments and the par value paid upon

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Table 2 illustrates the effect that callability has on bond prices and yields by
comparing the April 15, 1999, market quotation and yield of two securities that
mature on May 2005: one a callable Treasury bond and the other a noncallable
Treasury note. Although the callable bond pays a higher coupon rate (8.25 percent)
than the Treasury note (6.5 percent), the former has a lower price and lower yield.
The Treasury note's bid was 106 19/32, or $106.59 per $100 of face value, while the
Treasury bond's bid was 103 11/32, or $103.34 per $100 of face value 2 The lower bid
of the callable bond reflects the market participants' expectations that Treasury will
call the bond at par value during May 2000, or 5 years earlier than its maturity date.
Thus, the yield on the bond (5.02 percent) is the yield-to-call while the yield on the
note (5.22 percent) is the yield-to-maturity.

Table 2: Treasury Securities, Market Quotations and Yields
                         May 2005 Note           May 2000 - 2005 Bond
 Coupon rate                          6.5%                            8.25%
 Bid                                106.19                           103.11
 Yield                               5.22%                            5.02%
Source: Yields provided by Treasury; coupon rate and bid reported by New York Times,
April 16, 1999.

Treasury Changed Interest Rate Calculations in 1980 and 1998

Treasury made changes in 1980 and 1998 inthe calculation of the interest rates used
to determine the investment returns for a number of government trust funds. Before
1980, Treasury's manual calculations were based on the prevalent market practices
described above. In 1980, when prices of callable bonds were below par, Treasury's
computers were programmed to calculate yields on callable bonds based on yield-to-
maturity only. Treasury lawyers described the 1980 change as a "programming
shortcut that was made in the interest rate environment of the time." According to
Treasury officials, they found no documentation on the 1980 change and nothing to
indicate it was meant as a policy or methodology change.

The second change occurred in 1998, when Treasury officials discovered that the
1980 program for calculating interest rates did not conform to prevalent market
practice. Treasury changed its method of calculating rates back to calculate yield-to-
maturity when market prices are below par and to calculate yield-to-call when market
prices are above par. Although estimates of computer programming and resource
requirements to add the yield-to-call programming option in 1980 were unavailable,

2Bid isthe price offered to buy securities. Prices are in units of 1/32 of 1 percent of par value.
Par value is taken to be $100.

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Treasury officials said that the change when made in 1998 required about 40 staff
hours. Treasury informed the Congress and trust funds' trustees of the 1998 change.

In January 1999, the Treasury Assistant General Counsel for Banking and Finance
was asked for a legal opinion on whether the Secretary of the Treasury has the
authority to change the method of computing interest rates on intragovernmental
borrowings linked to the "average market yield." Because "average market yield" is
not defined by law, the Assistant General Counsel found that the Secretary of the
Treasury has discretion to compute interest rates on either a yield-to-maturity or a
yield-to-call basis. The Assistant General Counsel also found that if the Secretary of
the Treasury decided to change Treasury's policy to compute interest rates on a yield-
to-call basis, the Secretary of the Treasury has no obligation to apply the new policy

We agree with the conclusions of the Assistant General Counsel that the "average
market yield" language of the statute provides the Secretary with discretion in
computing interest rates, that computing interest rates on a yield-to-call basis is
permissible, and that the Secretary may apply such a change prospectively

Effects of Treasury's 1980 Changes on Social Security and Medicare

According to Treasury, its 1980 change increased the rates for the trust funds of
Social Security and Medicare in 1988, 1992, 1996, 1997 and 1998 by one-eighth of one
percentage point over what it would have been had the yield-to-call method been
used. 3 Treasury estimated the revenue difference (i.e., the increased revenue credited
to the trust funds as a result of using yield-to-maturity for callable bonds traded above
par) was $1.4 billion for Social Security and $0.4 billion for Medicare. (See figure 1.)

3The two Social Security trust funds are Old-Age and Survivors Insurance and Disability
Insurance or OASDI; the two Medicare trust funds are Hospital Insurance (Part A) and
Supplementary Medical Insurance (Part B).

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Figure 1: Estimated Revenue Difference in Social Security (OASDI) and Medicare,
          June 1988 Through December 1998, and January 1999 Through June 2013

       $5.0 -$4.3



       $2.0 -            $1.4
       $1.0 -                                     $0.4 $0.7

                             OASDI                Medicare

                  06/1988 -12/1998 .1/1999 - 6/2013

Source: Department of the Treasury.

According to Treasury officials, for outstanding Social Security and Medicare trust
fund holdings as of December 1998, the 1980 change also results in higher future
revenue in 1999 to 2013. The amounts are $4.3 billion for Social Security and $0.7
billion for Medicare. (See figure 1.) For future investments after December 1998,
Treasury believes the 1998 changes may produce a rate of interest one-eighth of one
percent lower than the rates computed based only on yield-to-maturity.

Effect of Treasury's 1980 Change on the Unified Budget

Treasury's 1980 change increased the financial returns for 11 trust funds by one-
eighth of one percentage point in 5 years in the period 1980 through 1998 over what it
would have been had the yield-to-call method been used. The unified budget was not
affected by the increases in 10 of the 11 trust funds because the higher interest
credited was a transfer between federal and trust funds. The only trust fund that
4The $4.3 billion difference shown for Social Security represents less than one-half of one
percent of the total projected interest income for this 14 /2-year period (as estimated by SSA
in March 1999). This $4.3 billion over 14 ½2 years can also be seen in the context of the fact
that Social Security is expected to pay out $394 billion in 1999 alone.
SThe unified budget is a comprehensive report that consolidates receipts and outlays from
both federal and trust funds. Interfund transactions between the two fund groups are
deducted to avoid double counting. Trust funds are any funds designated as such by law. All
other receipt and expenditure funds are classified as federal funds.

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affected the unified budget was the Thrift "G" Fund, the higher interest rate of which
led to an increase in outlays.6 As a result, the deficit increased (or the surplus fell)
about $0.1 billion in the period June 1988 to December 1998.

Other Trust Funds Affected by Changes in Interest Rate Calculations

In addition to Social Security, Medicare and the Thrift "G" funds, Treasury's lawyers
concluded that six other funds were affected because their interest rates are based on
average market yields. These trust funds are Civil Service Retirement, Foreign Service
Retirement and Disability, National Service Life, Serviceman's Group Life, U.S.
Government Life, and Veteran's Reopened. Since the interest credited to these trust
funds involved interfund transfers, none affected the unified budget. The reported
differences, shown in table 3, ranged from $2.0 billion to less than $0.1 billion.

"The "G"Fund, which has been in operation since April 1987, is one of three investment funds
available through the Thrift Savings Plan. This fund consists exclusively of investments in
short-term nonmarketable U.S. Treasury securities specially issued to the Thrift Savings Plan
for federal employees.

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Table 3: Estimated Differences in Other Trust Funds

 Trust fund and investment period      Difference

 Civil Service Retirement
  6/1988 - 12/1998                                   $0.8 billion
  1/1999 - 6/2013                                    $2.0 billion

 Serviceman's Group Life
  6/1988 - 12/1998                        Less than $0.1 billion

 Foreign Service Retirement and
   6/1988 - 6/2013                        Less than $0.1 billion

 National Service Life
  6/1988 - 6/2013                         Less than $0.1 billion

 U.S. Government Life
  6/1988 - 6/2013                         Less than $0.1 billion

 Veteran's Reopened
  6/1988 - 6/2013                          Less than $0.1 billion

Source: Department of the Treasury.

Scope and Methodology

To identify the changes Treasury made in interest rate calculations in 1980 and 1998
and their effects on the unified budget and trust funds, we interviewed Treasury
officials and reviewed Treasury and budget documents. We included their estimates
 and did not examine, test, or recalculate the interest rate calculations generated by
Treasury's computer program nor the amounts credited to the trust funds. To identify
prevalent market practices for calculating bond yields, we reviewed Federal Reserve
documents and the related financial literature. We performed our work between
February and April 1999. We received comments on our briefing slides and provided
a draft of this report for technical review to the Treasury's Office of Market Finance.
We have incorporated its comments as appropriate.

 We are sending copies of this report to The Honorable Charles B. Rangel, Ranking
 Minority Member of the Ways and Means Committee; The Honorable Robert E. Rubin,
 Secretary of the Treasury; The Honorable Jacob J. Lew, Director, Office of
 Management and Budget; other interested members of Congress and other interested
 parties. We will make copies available to others on request. Please call me

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                                                                       was prepared
at (202) 512-9142 if you or your staff have any questions. This report
                                                            Other  major contributors
under the direction of Denise Fantone, Assistant Director.
were Jose Oyola and Chuck Roney (Attorney-Advisor).

Sincerely yours,

Susan J. Irvin
Associate Director, Budget Issues


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