Safe as a U.S. Treasury Bond

The U.S. government stopped selling 30-year bonds back in 2001, then last summer, with future deficits apparently escalating, talked about bringing them back. But they proved this week it's a sucker bet, as the government arbitrarily decided to call in 30-year bonds sold in 1979. They are apparently damn tired of paying that 9 1/8 percent interest, and if you don't sell them back by May 15, you won't be earning any more interest on them. Sorry, but who knew that promise they made 30 years ago would gets so damn expensive to honor?

Comments

[Jimmy Dean]

So you're complaining that the government is exercising a legal right that it had under a contract? Huh? I thought libs supported freedom to contract.

[Douglas Fletcher]

So buy gold.

[joe]

That's the point, Doug. People will put their investments elsewhere, driving up the cost of government debt, and ultimately the cost to taxpayers. And lord knows we're going to have plenty of government debt to pay for over the next generation.

Jimmy, it was certainly legal for the government to do this. It is also legal for me to dress up my cat like Britney and act out her music videos. That doesn't make it a good idea.

[Jimmy Dean]

The Hit and Run comment was criticizing the an apparant breaking of a promise by the government. It makes no mention of this making it more difficult for the government to obtaining debt financing. The treasury has plenty of financial wizards. I think I will defer to their expertise on what the effect will be on future interest rates.

[Rujith de Silva]

The original post referred to "that promise they made 30 years ago" which "would get[s] so damn expensive to honor," when, in fact, there was no such promise to pay that interest for 30 years. So the post is factually incorrect, and Brian Doherty should correct it. - Rujith.

[R. C. Dean]

The point is, the government exercising these call provisions sends a signal to future long-term bond investors that this is likely to happen again in the future. As a result, these investors will probably not pay as much per $100 par value of these bonds.

The government has been calling long bonds for years. Call options are, and have been, priced into these models. This fear is pretty groundless; to the extent that there may be a marginal tweak to the pricing of bonds, it will be decimal dust. This is sound fiscal management, pure and simple.

No, this post falls into the category of "If Chimpy McHitler does it, it must be bad."

[Alan G.]

I guess the pricing of fixed income instruments is just too tough for a journalist. Who knew?

[Dave]

I came a little late to this party, but I'd like to join in the piling on! How about an update and correction? If not, why not?

[Ed B]

A call option on a bond is all this is. Trillions of $ are traded in the options market and priced into any underlying investment. Investment banks make lots of fees by stripping out the options and selling the pieces and parts.

We should be nice to Brian Dougherty, it is a bit much for him to understand derivatives and their applications.

Its also too much to expect that contracts with the government should be upheld. Now that is an interesting argument, one which requires more thought then a Hit & Run snippet w no research. Rothbard argued that all bond holders should be repudiated.

http://www.mises.org/fullstory.asp?control=1423

Interesting, no?

[AndyHat]

These bonds were issued as 30-year bonds with a 25-year call option. They're at 25 years now, interest rates are lower than the bonds are paying, they get called. That's exactly what any investor who would have been in the market for these bonds would expect. (These are not savings bonds of the sort sold to end consumers; these are the sorts that are sold at auction with a largish minimum purchase ($1000 now; not sure what it was in 1979)). Anyone buying these bonds would have been fully aware of the meaning of a 25-year call option, and would have discounted their bid (raising the effective interest rate) accordingly at the time of the auction.

Calls on these late 70's issues began on May 15, 2000 for bonds issued in 1975, which were paying 8 1/4%. See http://www.publicdebt.treas.gov/sec/seccall.htm for that call notice, plus links to the call notices for each of the subsequent 5 issues (See http://www.publicdebt.treas.gov/of/ofhistor.htm for the list of 1970's issues).

The Treasury Department would look like complete idiots if they didn't call these bonds as their call options come up. They're doing exactly as any reasonable investor would expect.

[linsee]

OK, so I've got some of these stripped treasuries in my IRA. I get the principal back at the maturity date (which offhand I don't remember), somebody else is collecting the interest that they're not going to be paying any more. What happens?

[AndyHat]

Linsee: As you can see in the detailed recall instructions at http://www.publicdebt.treas.gov/sec/seccall5.htm, the principal is payable on the call date. So you'll just need to arrange with your IRA administrator to redeem the bonds and get your principal back to reinvest. If you don't redeem the bonds on the call date, additional interest will simply not be paid.

[Andrew]

The economics is (of course) outpacing this feeble lay-person, but I take it that the Treasury's actions will definitely make borrowing a tad more expensive in future-- this is not in dispute?

Is that a signal that the Treasury expects govt. borrowing needs to decline? I rather think that new governmet spending has nearly peaked, and that we can expect government spending to subside over the next presidential term, relative to the economy; pretty much no matter who gets elected-- a bit more under Bush (admit it!)-- and, on the margin, a bit less under any Democrat, who would have to at least try to a Democrat.

[AndyHat]

No; these calls will have no effect on the cost of future borrowing. The Treasury has not included a call option on bonds issued since 1985, so there's no risk of them being called (besides which, with interest rates as low as they currently are, it's unlikely a bond sold today would ever be called, even if it had the option).

If Treasury were to include a call option on a future issue, yes, that would slightly raise the cost of the bonds which have that option. However, the fact that in this case Treasury called bonds that had a call option is simply business as usual.

If anything, the calls will allow Treasury to issue debt more cheaply in the future; since they're eliminating high-interest debt, replacing it with lower interest debt (eventually), the overall creditworthiness of the US is increased.

[Girish Maiya]

Brian's argument is absurd. In fact, if the government did not call the bond, then they would be wasting taxpayer money by making those large coupon payments instead of refinancing the debt at the lower interest rates available today. Is Brian's contention that the Government should waste our money in this manner, when a perfectly legal and ethical way exists to get cheaper debt? Brian, have you ever refinanced a car or a house? Was that sleazy?

[joe]

Thank you, AndyHat, that fact changes things considerably.

[Jimmy Dean]

So, the only question remaining is why this stupid post is still up

[Andrew]

Thanks Andyhat

S'pose that might reverse my analysis-- the Treasury may be bracing for anticipated heavy borrowing? Good to be mindful of this.

[Tim]

Andrew,

I think that you are needlessly hung up on trying to divine what is motivating the Treasury to exercise their call option. You are just thinking too hard. The fact that they exercised the call tells us *nothing* about their future borrowing plans. They had a very simple choice between two possibilities:

1) continue paying 9.125% on debt, or

2) call the debt, and reissue other notes at much lower rates.

As you can see, this is a *very* simple choice, and the only thing we might conclude about the folks at Treasury is that they are not stupid.

[Keith]

Huh, why the sour tone in the H&R writeup? As a taxpayer, all else being equal, I'm delighted the government is spending less on interest for the same volume of debt. And doesn't the fine print on any bond say the issuer has certain conditions under which they can call in or prepay the bond? I'll read up on the links for any shenanigans, but as long as BPD followed a standing process, this is good news by me. It's a gigantic nationwide mortgage refi. And frankly, I can't cry for income investors who maintain a wealthy-old-people lifestyle out of the flesh (I mean, tax receipts) of the youth.

[Randall Loffelmacher]

Yeah, cheers to Keith.
What's the big deal here? Government lies all of the time. Why not celebrate the fact that we're saving on those interest payments, even if it's a drop in the bucket?

Oh, maybe I just undid my own argument with that last statement.

[Ron Hardin]

Um, it's part of the deal for the bond. Most bonds, I think all corporate ones, have call provisions (they get to call them in at a declining premium to face value at various times). It's a heads-we-win-tails-you-lose provision but also protects the borrower from making a huge bet on high inflation. There were some govt bonds that were not callable but those must be really old by now. The buyer on the other hand is making a bet on low inflation. If you don't like the deal, don't buy the bond; or buy short term Treasuries, where there is essentially no bet on inflation at all.

[Ron Hardin]

Maybe it's the opposite, nowadays govt bonds are not callable but they used to be. Anyway it's part of the deal on the bond.

[joe]

Keith, as a taxpayer, I'm unhappy that all the bonds the government issues in the future are going to have to offer higher interest rates in order to attract buyers.

[Bostonian]

It's wrong to go back on an agreement, even if you are the government.

If I had a bond (or a lot of them), I would take them to court.

[R. C. Dean]

It's wrong to go back on an agreement, even if you are the government.

Are you people really that dense? It was part of the agreement that they could call the bond early! I'd put it in all caps if I thought it would help.

This is a way of saving taxpayer money by paying off expensive debt. But, because it is the Bush administration that is doing it, it must be wrong. Everything Chimpy does is a lie, right?

What a bunch of maroons.

[Keith]

Joe,

That's a change of subject, and does not necessarily apply to the '79 bond. If the BPD's rate on replacement debt does not get to 9% over the next 5 years, there is no result other than a taxpayer win by this.

Bostonian and others,

According to the treasury's web page:
"Some Treasury bonds issued before 1985 are subject to call by the Treasury Department. When it exercises its option to call a bond, Treasury steps in prior to the bond's original maturity date and redeems the bond and stops paying interest on it"

So, I'm waiting to find out how the Treasury has gone back on a deal, since the "deal" on pre-'85 bonds included a government call option.

[mak_nas]

if you really expected the gov't to continue to let lay a 9% 30-year callable bond when they both contractually can and have expressed an interest in refinancing into 10-years with a 4.25% coupon, you were the silly one -- not the gov't.

on the bright side, you had 24 years of (sort of) risk-free debt paying you well above market interest, and you got all your capital back. not bad at all.

[mak_nas]

it bears mentioning that callable bonds are well known to knowledgable investors, and the market prices call risk into any callable debt instrument -- i.e., there is a risk premium that the investors get. so no one gets screwed here, folks.

[joe]

Keith, I'm not talking about the direct effect on bond rates, but about the perception among investors of the reliability of T-Bills. There used to be no virtually no risk premium, because there was no perceived risk. No more.

[Brian Doherty]

Joe is getting at what I was getting at, though it's certainly not true there was NO risk premium involved before (and after all it's just the interest at risk), it's also certainly true that people don't invest in bonds *fully expecting* that they won't be able to earn that interest for the full stated period of the bond. (They do need to be aware it's a possibility of course, and that I'm sure gets factored into most investment decisions) But the more this calling in actually happens, the less likely, other things being equal, that people will demand a higher interest premium to make up for the likelihood they won't be getting the interest for the full extent they thought when they bought it. Was what the government did legal? Sure. Did it seem sleazy enough to me that I wanted to take a few sentences to make fun of it? Sure. By the way, I'm pretty sure George Bush has nothing to do with either the decision to call in the bonds or my decisions to poke at that decision.

[Umbriel]

Callability is a standard element in bond pricing models. I'm unaware of any modifier for an "oh, they'd never do such a thing" factor, and there's nothing any more "dishonorable" about it than there is in refinancing your house.

If there's any news here at all, it's the question of why the government didn't call and refinance these things years ago. Might the investors holding them (insurance companies? Pension funds?) be of some significance? If anyone has been "hurt", it's them.

[Ron Hardin]

Typically there's a premium, eg. $112 per $100 for a certain period, $108 for another period, etc. They'd call them when the premium dropped enough to make it worthwhile, and of course the bond has to be trading near the premium, meaning interest rates are low enough. If you want to see people getting hurt, it's bond buyers after interest rates go up. Which incidentally you can get in on the ground floor of now, if things don't work out.

Keeping the value of the dollar stable is the general good thing. Then none of this comes into play.

[Jim Lesczynski]

"If there's any news here at all, it's the question of why the government didn't call and refinance these things years ago."

The call feature doesn't kick in until 5 years from maturity.

[David R.]

I actually learned something today from this very informative comment section. Too bad Brian Doherty didn't admit that he had, also. Is "sleazy" the right word here?

[Tim]

Brian,

You are wrong. I am sorry, there is just not a nice way to say it. You are wrong. Most people that read Hit and Run don't click through to the comments page, and most people (apparently including yourself) don't understand call provisions. Thus, almost everybody that read your initial post gets the complete wrong idea about what is going on. You have completely misrepresented this story, and that is unethical. You should not moderate your remarks in comments, you should make an update to the original post, for everybody to see.

The bonds may have been a "sucker bet" to some purchasers, but if so, it is only their own fault, as the call provision was open, available information factored into the price. You say the "government arbitrarily decided to call in 30-year bonds sold in 1979." This is a LIE. There is nothing arbitrary about their decision. They had perfectly sound financial reasons for it, and you need to retract that statement.

[Brad S]

Tim - you're right, but you're also missing the point.

Yes, the bonds have call provisions such that what the federal government is doing is perfectly legal.

The point is, the government exercising these call provisions sends a signal to future long-term bond investors that this is likely to happen again in the future. As a result, these investors will probably not pay as much per $100 par value of these bonds. Therefore, long-term interest rates go up. The punchline - the long-term value of the dollar is reduced, also known as INFLATION.

With the government "balance sheet" in the kind of shape it is, and with our federal government running budget deficits every year (not even including the massive future liabilities associated with Medicare and Social Security), this is just one of the first signs that huge inflation is coming. I hope you like paying high prices for goods and services.

[AndyHat]

I just came across this article that explains why the 25-year-call option on these bonds was probably not worth it, as well as why it probably would be a good thing for Treasury to include a shorter term call option on future issues.

[Brian Doherty]

To put a finer point on the above: there may be circumstances in which I decide that a quickly composed, poorly thought out post based on ignorance of a key detail are worth just killing. However, when it generates a comment thread as educational on the issue (and amusingly derogatory) as this, I think it should stand. The blog-plus-comment communication form ideally works as a good example of Popperian conjectures and refutations (and occasionally just works as a means for a bunch of strangers to insult each other and make bad jokes). I think this thread is a fine representative of the former.

[Tim]

Brian,

I did not ask you to spike the post. I only asked you to make an update to it. That would have been very helpful, but it is sort of beside the point now, because this post has slid far enough down the page that it is seen by many fewer eyeballs. In the future, when comments alert you to your error, you might just add to the post:

UPDATE: I was mistaken about the way these financial instruments work, and the government's actions are in fact completely correct. Please see the comments for elaboration on these points.

The point here is that most people don't read the comments. That is why updating the post is helpful.

[Brian Doherty]

Was I aware these bonds had a built-in 25 year call option? No, I was not.

Are risk-managing tools the same as risk-eliminating tools? No, I don't think they are, which means when the risk being managed actually comes true, it does make a difference. If (as I mistakenly believed) this call option was possible at any point, not just after 25 years, it would make this whole discussion a bit less pointless.

However, knowing now (as I did not when I wrote the post) that the call option was only possible at 25 years does make it all rather pointless.
However, take down the post? That would also mean taking down this comment thread, and missing all this fun and education for future generations.

[Will Spencer]

Ignorance of the rules of economics is expected in Democrats, shameful in Republicans, and unforgiveable in Libertarians.

[Brian Doherty]

I agree with Will. Of course, ignorance of the particular rules of a call-in option on a particular bond don't have anything to do with ignorance of the rules of economics. I would say, though, that assuming blithely that risk management tools equal risk eliminating tools---which is what people who insist that calling in bonds early makes *no difference at all* to the decisions of those buying bonds--does gets pretty close. We have expectations about the future, and prices for anything involving things that happen in the future will strive toward adjusting for those expectations. But such adjusting will never be perfect.

[Brown Kevin]

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DATE: 05/20/2004 06:51:11
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