Federal Debt: Debt Management in a Period of Budget Surplus

Published by the Government Accountability Office on 1999-09-29.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before the Committee on Ways and Means, House of

For Release on Delivery
Expected at
10 a.m.
                          FEDERAL DEBT
September 29, 1999

                          Debt Management in a
                          Period of Budget Surplus
                          Statement of Paul L. Posner
                          Director, Budget Issues
                          Accounting and Information Management Division

Mr. Chairman and Members of the Committee:

I appreciate the opportunity to appear before you to discuss managing debt
in a time of surplus. As you requested, my testimony today will be drawn
from a report we are issuing today to Senate Budget Committee Chairman
Pete V. Domenici and you regarding actions taken by the Treasury to
manage the marketable debt held by the public in this new fiscal

The federal budget is about to record the first back-to-back budget
surpluses in more than 40 years. As a result, federal debt held by the public
has declined and, if projected surpluses materialize, it will continue to fall
throughout the next 10 years. The Treasury faces the challenge of managing
the surplus rather than financing a deficit. To support its management
goals, the Treasury has concentrated its borrowing into fewer but larger
debt offerings, and targeted its reductions to offset the trend toward
generally more costly long-term debt.

In August, the Treasury published proposed rules for advanced repurchase
of outstanding debt held by the public−a debt “buy-back.” These
repurchases could require the Treasury to pay a premium since most of the
older securities have interest rates higher than those issued today. Since
the Treasury has the authority for these repurchases, any premiums would
not require an offset under the Budget Enforcement Act, but the payment
of a premium would affect the size of the surplus.

As debt declines, the Treasury will face more difficult trade-offs in
achieving broad and deep markets for its securities and lowest cost
financing for the government. There will be greater pressure on the
Treasury to further concentrate debt in fewer issues to maintain deep and
liquid markets in benchmark securities. Although markets tend to adjust
over time, these changes may not be seamless or without cost.

 Federal Debt: Debt Management in a Period of Budget Surplus (GAO/AIMD-99-270,
September 29, 1999). This report is a follow on to a “primer” on federal debt issued in May
entitled Federal Debt: Answers to Frequently Asked Questions−An Update
(GAO/OCG-99-27, May 28, 1999).

Page 1                                                                  GAO/T-AIMD-99-300
Federal Debt Held by                     As all of you know, fiscal year 1998 brought the first unified budget surplus
                                         since 1969. The fiscal year that ends tomorrow also will show a surplus−
the Public Is Declining                  although we don't know its exact size yet. The Congressional Budget
                                         Office's (CBO) July update showed surpluses continuing throughout the
                                         next 10 years.

                                         In fiscal year 1998, debt held by the public fell by about $51 billion, and the
                                         Treasury has already reduced the amount of debt held by the public by
                                         $68.2 billion in the first 9 months of fiscal year 1999. As figure 1 shows, the
                                         debt held by the public reached a peak of $3.83 trillion in March 1998 and
                                         dropped by $180 billion, to $3.65 trillion, by July 31, 1999.2

Figure 1: Federal Debt Held by the Public, September 1996 Through July 1999

                                         Source: Monthly Treasury Statement, Department of the Treasury.

                                             This total is net of unamortized premiums and discounts on public debt securities.

                                         Page 2                                                                    GAO/T-AIMD-99-300
                       CBO's July projections show debt held by the public falling further from
                       $3.65 trillion in fiscal year 1999 to $0.9 trillion in 2009, assuming current

The Treasury's Debt    The Treasury's stated goals for debt management have remained the same
                       to date regardless of whether the unified budget is in surplus or deficit: to
Management Goals and   have sufficient operating cash to meet the government's obligations, to
Challenges             achieve lowest financing cost, and to promote broad and deep capital
                       markets. Although the goals may be the same, the management challenges
                       are not.

                       Just as deficits lead to increased borrowing, surpluses generally result in
                       the Treasury retiring debt. These two actions are not symmetrical, however.
                       When the debt is increasing, the Treasury is issuing more securities than
                       are maturing and is adding to the amount of debt outstanding. By selecting
                       the instruments with which to borrow, the Treasury can have a greater
                       effect on the maturity profile of the outstanding debt. In contrast, during
                       periods of surplus, the Treasury is retiring more debt than it is issuing.
                       Because the Treasury is not adding to the amount of debt outstanding, the
                       maturity profile is more determined by the maturities of the remaining
                       outstanding debt. As a result, the profile of outstanding marketable debt−
                       both the type of security and when the debt matures−is a significant
                       determinant of how and when the Treasury can reduce debt.

                       The profile of the Treasury's marketable securities consists of bills that
                       mature in a year or less, notes with original maturities of at least 1 year to
                       not over 10 years, and bonds with original maturities of more than 10 years
                       out to 30 years. As figure 2 illustrates, as of July 1999, 57 percent of the
                       outstanding marketable public debt is nominal (not adjusted for inflation)
                       notes, 20 percent is bills, 20 percent is nominal bonds, and the remaining 3
                       percent is inflation-indexed notes and bonds.

                        These budget projections assume compliance with discretionary spending caps on such
                       spending through 2002, that discretionary spending will grow at the rate of inflation
                       thereafter, and that all surpluses are used to reduce debt.

                       Page 3                                                               GAO/T-AIMD-99-300
                      Figure 2: Treasury Bills, Notes, and Bonds as Percentages of Marketable Public
                      Debt Outstanding, July 31, 1999

                      Source: Monthly Statement of the Public Debt of the United States, Department of the Treasury.

The Debt Management   The “April surprise” that occurred in fiscal years 1997 and 1998 created a
                      situation in which the Treasury suddenly and quickly absorbed
Story to Date         unexpectedly high tax revenue, which initially resulted in reductions in
                      short-term debt. Since some bills mature each week, the unexpected cash
                      inflows were used to redeem bills. However, according to a Treasury
                      official, bills were redeemed at such high levels that the liquidity of the bill
                      market was adversely affected and the average life of marketable debt
                      increased modestly−as shown later in figure 4. Although in fiscal year 1998
                      total marketable debt declined 3.2 percent, the amount of outstanding bills
                      fell 9.2 percent. If left unaddressed, the shortage of bills and the
                      lengthening of the average maturity of outstanding debt could have
                      increased the Treasury's cost of borrowing. According to Treasury and
                      Federal Reserve officials, the amount of bills reduced was sufficiently large
                      to cause the market for bills to become less liquid.

                      Page 4                                                                        GAO/T-AIMD-99-300
After this experience, the Treasury took steps to offset these trends and to
better position itself to reduce debt without endangering its management
goals. Instead of reducing the size of all issues equally, the Treasury
concentrated its borrowing in fewer but larger debt offerings, eliminating
the 3-year note and reducing the frequency of the 5-year note from monthly
to quarterly in May 1998. In anticipation of a large influx of April tax
receipts in 1999, the Treasury operated with a lower cash balance, using
cash management bills to ensure adequate cash balances.

Figure 3 compares the allocation of the surpluses for the first 9 months of
fiscal years 1999 and 1998.4 The higher level of operating cash shown for
this period of fiscal year 1998 reflects the fact that this was the first year of
budget surplus. As the year continued, the Treasury both reduced
outstanding debt and moved to change the profile by significantly reducing
bills, reducing some notes, and continuing to issue bonds and inflation-
indexed securities. In fiscal year 1999, however, the Treasury used more of
the cash from the surplus to reduce outstanding debt held by the public by
operating with lower cash balances. Seventy-two percent ($68 billion) of
the fiscal year 1999 unified budget surplus through June 1999 has been used
to reduce debt. In contrast, in a comparable period in fiscal year 1998 only
33 percent ($22 billion) of the surplus was used to reduce debt.

 A budget surplus does not translate dollar-for-dollar into debt reduction because the cash
obtained from surpluses can be used to increase cash balances, to finance federal direct
loan and loan guarantee programs, and for other transactions (largely changes to accrued
interest and checks outstanding). See Federal Debt: Debt Management in a Period of Budget
Surpluses, GAO/AIMD-99-270, for more detail.

Page 5                                                                 GAO/T-AIMD-99-300
Figure 3: Allocation of Unified Budget Surpluses, October to June, Fiscal Years 1999
and 1998

Source: Monthly Treasury Statement, Department of the Treasury.

Page 6                                                            GAO/T-AIMD-99-300
                                         The average maturity of outstanding debt has lengthened from 5 years and
                                         3 months in 1996 to 5 years and 9 months in February 1999. The Treasury's
                                         actions in fiscal year 1999−reducing relatively more notes than bills−have
                                         been aimed at partially offsetting this trend, and in March 1999 the average
                                         maturity of outstanding debt stood at 5 years and 6 months. Nevertheless, if
                                         the Treasury continued to sell new securities on the May 1999 auction
                                         schedule, the average maturity of the outstanding debt would continue to
                                         grow. This would happen because the Treasury would redeem short-term
                                         securities as they mature and longer-term securities would remain
                                         outstanding. Figure 4 shows the trend in average maturity of outstanding
                                         debt from 1990 to 1998.

Figure 4: Average Length of Marketable Debt, 1990-1998

                                         Source: Treasury Bulletin, Department of the Treasury.

                                         Page 7                                                     GAO/T-AIMD-99-300
                            The Treasury announced in August 1999 that it will reduce the frequency of
                            issuance of 30-year bonds from three times a year to twice a year. This will
                            allow the Treasury to continue to concentrate on fewer but larger
                            benchmark issues5 and to partially counter the current lengthening of the
                            average maturity of outstanding debt. Treasury officials also announced
                            that they are considering reducing the frequency of issuance of 1-year bills
                            and 2-year notes. This move would allow the Treasury to increase the
                            liquidity of the remaining benchmark issues. Continuing to issue new debt
                            across the maturity spectrum and especially in certain benchmark
                            securities is key to supporting the Treasury's current goals of obtaining the
                            lowest financing cost and maintaining a broad, deep market for U.S.

Tools to Increase the       As total debt held by the public continues to fall, the Treasury may take
                            other actions to enhance a broad, deep market for Treasury securities and
Treasury's Flexibility in   lowest cost financing while still ensuring adequate cash balances. These
Managing the Debt           actions include re-opening the most recent securities issues (selling more
                            of the most recent issue rather than opening a new issue), repurchasing
                            outstanding debt before it matures, and redeeming callable securities as
                            they become callable.

Re-Open Current Issues      The Treasury can increase the liquidity of outstanding issues by continuing
                            to sell debt from the most recent issue (re-opening) rather than opening
                            new issues. This strategy is useful when the Treasury wants to issue a small
                            amount of a given type of security and it determines that the overall cost of
                            re-opening is lower than it would be for new issues. The Treasury uses re-
                            openings regularly for bills and has used this tool in the past for notes and
                            bonds. Re-opening allows the Treasury to concentrate its new debt into
                            larger, more liquid issues.

                            Two other tools−advance repurchase of securities and redeeming callable
                            bonds−would target one segment of outstanding debt by either inviting or
                            requiring investors, respectively, to redeem securities they currently hold.
                            Reducing the amount of outstanding debt through advance repurchase of
                            noncallable and callable securities allows the Treasury to reduce specific,

                             The most recently issued Treasury securities, known as “benchmark” issues, are used by
                            other financial services to price their products.

                            Page 8                                                                GAO/T-AIMD-99-300
                        less liquid debt issues and to issue new, more liquid (and generally lower
                        cost) benchmark securities across the maturity spectrum and in greater
                        volume than would otherwise be possible.

Advance Repurchase of   Repurchasing debt in advance of its maturity is one way for the Treasury to
Debt                    use the cash obtained from budget surpluses to retire outstanding debt.
                        This would allow the Treasury to maintain a higher volume of new, more
                        liquid benchmark securities. Repurchasing high-interest outstanding debt
                        could also reduce the government's interest costs.

                        On August 4, 1999, the Treasury published proposed rules that would
                        establish a reverse auction−where primary dealers submit offers to sell
                        (rather than buy) a security. Comments on these proposed rules are due on
                        or before October 4, 1999.

                        Repurchasing debt could necessitate the payment of a premium since most
                        of the Treasury's older securities were issued with interest rates higher
                        than those of securities issued today. Any premium paid to buy back debt
                        might be treated as an interest outlay in the budget year when the securities
                        are repurchased.

                        Since the Treasury would repurchase using existing legal authority and no
                        legislation would be required, the Treasury's actions would not constitute a
                        “scorable event” under the Budget Enforcement Act. Therefore, even if the
                        premium were shown as an outlay in the budget year when the repurchase
                        occurred, no offsetting cuts would be required although the amount of the
                        surplus would be affected.

Callable Bonds          In some years, the Treasury has the option to redeem certain securities
                        before their maturity dates without paying a premium. Before December
                        1984, the Treasury issued bonds that can be redeemed at face value at the
                        Treasury's option 5 years in advance of the maturity dates (or on any
                        interest payment date thereafter, after providing 4 months notice). A
                        number of outstanding callable bonds with relatively high interest rates
                        could be redeemed beginning in 2000. There are $87.6 billion in high-
                        interest rate bonds that can be called from May 2000 through November
                        2009. Redeeming bonds would reduce the amount of debt held by the
                        public and may reduce interest costs.

                        Page 9                                                      GAO/T-AIMD-99-300
Future Debt   Budget surpluses offer the prospects of significant benefits for both the
              budget and the economy in the near and longer term. However, surpluses
Challenges    pose challenges to the Treasury's debt management. Declining levels of
              debt prompt the need to make choices over how to allocate debt reduction
              across the full maturity range of securities used.

              The stakes associated with debt reduction strategies are considerable. As
              debt declines, the Treasury faces more difficult trade-offs in achieving
              broad and deep markets for its securities and the lowest cost financing for
              the government. Moreover, a wide variety of government and private sector
              participants both here and abroad have come to rely on Treasury securities
              to meet their investment needs. Both declining amounts of Treasury
              securities as well as shifts in their composition affect the interests of these
              participants. These changes, for instance, may very well affect the use of
              Treasury securities as benchmarks to price other financial transactions.
              Although markets tend to adjust to these shifts over time, changes may not
              be seamless or without cost.

              Projections of continuing and increased unified budget surpluses suggest
              that the challenges to debt management experienced in 1998 and 1999 are a
              harbinger of more difficult decisions yet to come. The CBO July 1999
              baseline projected that debt held by the public would decrease from
              $3,618 billion in fiscal year 1999 to $865 billion in fiscal year 2009, assuming
              compliance with discretionary spending caps through 2002, growth at the
              rate of inflation thereafter, and that all projected surpluses are used to
              reduce debt. To gain an appreciation of the size of the projected reduction,
              consider that the level of debt held by the public projected by CBO for 2009
              is less than the dollar amount of federal securities owned by the Federal
              Reserve and state and local governments combined at the end of fiscal year
              1998. The particular allocation of securities will be determined by a number
              of factors, but the comparison above gives a sense of the size of the
              continuing and more extensive adjustments by both the Treasury and
              market participants.

              As debt held by the public continues to shrink, there will be greater
              pressure on the Treasury to further concentrate debt in fewer issues to
              maintain deep and liquid markets. Moreover, the Treasury will need to
              reassess its issuance of nonmarketable securities such as state and local
              government securities series and savings bonds. In a similar situation,
              Canada has begun a pilot program to consolidate its portfolio by buying
              back outstanding smaller, less liquid issues, allowing a simultaneous

              Page 10                                                       GAO/T-AIMD-99-300
                   auction of new, larger replacement benchmark issues. The U.S. Treasury
                   has taken a number of actions to concentrate its portfolio already and is
                   considering other strategies to enable it to issue new and more liquid issues
                   as overall debt declines, such as buying back outstanding, less liquid debt.

                   Mr. Chairman, this concludes my prepared statement. I will be glad to
                   respond to any questions you or other Members of the Committee may

Contacts and       For information about this testimony, please contact Paul. L. Posner at
                   (202) 512-9573 or by e-mail at posnerp.aimd@gao.gov. Individuals making
Acknowledgments    key contributions to this testimony included Thomas James, Jose Oyola,
                   and Carolyn Litsinger.

(935336)   Leter   Page 11                                                     GAO/T-AIMD-99-300
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