FROM THE OFFICE OF PUBLIC AFFAIRS

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Why Treasury Issues TIPS

[Chart 2]

There is one message I have given over the past year. It has been very simple. We are committed to the TIPS market.

My message today is just as simple. Growing the market will be a collaborative effort between all of us: Treasury, the buy-side and the sell-side.

This is still a very young market. Just about six years old. In fact two years ago the future of the TIPS program was in jeopardy. The growth and success of the TIPS market over the past year is exceptional.

Future growth of the market will depend on how well we work together.

But it is not the nominal coupon market.

The first point I want to make is that we view TIPS as a separate liability class just as you should think about TIPS as a separate asset class.

A separate liability class makes sense for us in the same way that a separate asset class makes sense for you.

By developing this different asset class we increase the pool of potential investors. Broadening our investor base diversifies our funding sources. Additionally, by diversifying our borrowing, we reduce exposure to a single adverse shock and both lower and smooth our borrowing costs.

[Chart 3]

I just said that TIPS represent a different liability class, but that does not mean we manage them differently. We issue TIPS the same way we do nominal bonds.

At Treasury, we are committed to issuing large, liquid securities. We increased the number of 10-year note auctions from two to three to our current policy of four/year. We now auction a new security in July and April and reopen it respectively in October and January.

Reopenings can sometimes cost Treasury money because we do not capture the on-the-run premium often associated with new issuance. However, the benefits of large and predictable issuance --and a more stable and liquid secondary market-- outweigh the cost of reopening.

We have become the world’s largest TIPS issuer with more than $150 billion par amount outstanding.

I believe that commitment means growth. We hope to continue to expand the TIPS calendar in the future.

But it is important that we expand the auction calendar without moving too fast and getting too far ahead of the market. We know we must lead, but we don’t want to move too fast and create illiquid market conditions.

[Chart 4]

I am often asked what percentage of our issuance in TIPS. We do not plan to target our issuance as a percentage of gross issuance. We look to increase supply in line with increasing demand, but that will depend on your collective actions and our ability to interpret those actions. As an aside, the advice that many of you freely provide Treasury on market conditions is crucial to our assessment of market growth.

Even though we strive to be regular and predictable, we cannot limit our flexibility as debt managers by committing to specific issuance percentages in the future. Our borrowing needs, driven by outlays and receipts that are enormous by any standard, are unknown - as any of you who have tried to forecast our fiscal position know. Targeted issuance would not have been sustainable.

That being said, TIPS represents approximately more than 25% of our recent 10-year note issuance.

[Chart 5]

Liquidity has markedly improved since Treasury reaffirmed its commitment last year.

Market data and anecdotal evidence is fairly conclusive. More investors are purchasing TIPS.

I want to add that no market compares to the depth and liquidity of the nominal coupon treasury market. The 24-hour liquidity available to traders and investors is remarkable. Daily volume, which averaged around $100 billion in 1998, is now over $500 billion/day.

So, we must be careful how we judge TIPS. TIPS will never trade with the liquidity of nominal Treasuries, but by any other measure, liquidity is good and promises to get better.

[Chart 6]

I am encouraged by signs that many dealers are committing more capital TIPS. A few have actively committed personnel and capital in the past few months. Because Treasury is committed, because their customers are asking for market making, many more dealers are committing trading capital to TIPS.

I do not expect every primary dealer to take a leadership role and help expand the TIPS market the ways many firms here have demonstrated, but I am hopeful we are well on our way to reaching a critical mass of dealers that will be needed to support what I expect to be a very large market.

[Chart 7]

One comment I occasionally hear is that “the market is too small”. Compared to other markets the TIPS market is not small. I understand the frustrations of those who need a larger market and are accustomed to the liquidity of the nominal Treasury market. My response is that the more support you show our current issuance, the faster we will be able to increase auction size and frequency.

But we need sponsorship. I encourage everyone on the buy side to view TIPS as an evolving asset category and manage their expectations. Great strides have been made over the past year, but the market-making infrastructure (often taken for granted in the nominal market) will take time to fully develop. I believe that the increasing awareness that as TIPS are truly a different class-and the product is better understood - markets will deepen.

As the primary seller of TIPS, I am frustrated where I talk to private and public funds that view TIPS as the long-term panacea for their ills, but then trade them with a short-term, opportunistic bias. Growth depends on long-term commitment to this market; arbitraging break-evens and carry versus nominals increases one-way liquidity and does nothing to create long-term sponsorship.

[Charts 8 and 9]

A much higher percentage of auction awards are allocated to investment funds, a further indication that the market has come to believe that we are committed to TIPS.

Diversifying our investor base should lower our costs over time.

[Chart 10]

Returns and risk stand out. Now that TIPS have reached their 5-year threshold for returns and the outstanding volume exceeds that of many other market, I am hopeful that the consultant community will consider recommending TIPS as a strategic asset allocation.

[Chart 11]

I am often asked why not include TIPS in the Lehman Ag. Because of the low or negative correlation to nominal bonds, TIPS should be a separate asset class. Inclusion in the Lehman Ag would provide a short-term benefit to existing TIPS holders, but I am not sure it is the appropriate place for a security with different cash flow characteristics than nominal fixed income securities.

TIPS are a very different asset than nominal bonds and are much less risky because their value will not be eroded by inflation. This allows for meaningful diversification and will help insulate portfolios from both higher inflation and higher inflationary expectations.

[Chart 12]

I think the recent high beta can be explained by very low inflation risk and a general move in real rates. As the fed has diffused any short-term inflation risk, real and nominal yields have moved together.

[Chart 13]

Good summary chart for perspective investors.

[Chart 14]

Structure.

Debt Management

[Chart 15]

Since I joined treasury in the fall of 2001, we have strived to become more transparent about what we do and why. I believe the better you can understand our analysis and decision making, the better you will be able to foresee changes in our issuance calendar.

If we continuously surprised the market, traders and investors alike would have difficulty adjusting their expectations as well as their portfolios. In other words an ad hoc approach to issuance would hurt Treasury in the primary market.

I believe that more transparency on our part will mean better-prepared investors and traders, resulting in a more robust primary market.

Many of the following charts and concepts are new-some are under one-year old. We have attempted to develop a framework for future debt managers --as well as investors-for years to come. It is important for Treasury to quantify as best we can our decision-making and for lack of another word-performance.

I would like to start by talking about our objective-lowest cost financing over time. We strive to meet this objective through regular and predictable issuance of our debt. We are not market timers-that is we do not make a judgment on interest rates.

You all know with a high degree of certainty when our auctions will be. You know that auction frequency or issuance has nothing to do with market conditions or the level of rates. We will not adjust size or frequency as rates or the yield curve change. That is, that we do not issue more long debt when rates are perceived to be low nor do we issue more short term debt when rates are perceived to be high.

But developing a regular and predictable issuance pattern is difficult. It is difficult because we face tremendous uncertainty.

[Chart 15]

In it’s simplest form lowest cost financing means borrowing at the lowest rate without over funding our cash balances. We try to limit the fluctuations in our cash balances for two reasons. First we face a negative funding spread. Second, our balances are collateralized in the private sector. Big swings can cause market dislocations.

Forecasting is very difficult. Every one misses. We strive to do a much better job of forecasting. But as the old saying goes, “if you are going to forecast, you better do it often.”

By way of illustration, total federal tax receipts are $1.8 trillion. The federal budget is over $2 trillion. A small miss on those two numbers -and they are usually correlated over time--will result in a change in the budget deficit of tens of billions of dollars.

[Chart 16]

We know we face uncertainty. It is not our job to project long-term deficits or surpluses. That is the job of OMB and CBO.

What is our job is to make sure our auction calendar can handle a range of reasonable outcomes. Our calendar must be able to handle changes on the margin. We must have flexibility in our calendar. This slide highlights this point quite well.

This chart of financing residuals (+/- one standard deviation) was one we considered before the May refunding when we announced significant increases to our frequency of coupon issuance.

• Lines: central and 1 standard deviation forecasts of deficits
• Bars: residual financing if base case issuance were carried forwards

Financing residuals (one-sided) Forward looking scenario analysis

We believe our calendar was well set up to handle lower deficits. We had and have the ability to reduce auction sizes and pay down issuance. Currently we have over $1trillion in outstanding bills and annualized we issue $300B in 2-yr notes.

But what concerned us was the more pessimistic outlook, higher deficits. Though we believed we could continue to increase auction sizes, we concluded that increased auction frequency would spread out the effects of increased issuance and still give us flexibility if deficits turn out to be smaller than forecasted.

[Chart 17]

Last year we issued over $3 trillion in bills, notes and TIPS.

The fiscal balance is hugely important on the margin and determines the structure of our issuance, but our refinancing dominates our daily debt management decision-making. In other words we rollover our debt, but contrary to many market analysts that interests us but it does not concern us.

I would like to take a moment to talk about rollover risk. The distinction between debt management at Treasury and within the CFO’s office of a corporation are vast, and in my opinion, not necessarily understood by the marketplace. Our risk is not that we cannot rollover our debt; it is in doing so we incur large changes in interest costs. Though we have work to do in this area, we feel a regular and predictable issuance calendar-not one based on rates or market timing-can best mitigate the the risk of volatile interest costs.

[Chart 18]

In a nutshell, our job is to figure out what to auction and when. What security should we sell at what size and in what frequency? The tricky part is to incorporate changes to the calendar in transparent manner within the regular and predictable framework.

We want to issue at the lowest cost over time. The changes must be transparent, we want flexibility and we want to minimize any market dislocation.
This next chart plots our issuance calendar versus different deficit outcomes. The inputs are deficits and borrowing generated from our coupon calendar. The output is bills as a percentage of marketable debt.

The deficits are based off the current (last January) OMB forecast. The inputs are our current issuance calendar. Most analysts are forecasting higher deficits for this year, so the slope of the green line may be too steep. A return to that projection would mean a fast bill pay down.

The red line has no policy implications it is merely a reference point.

[Chart 19]

This chart shows another way of looking at distribution. It highlights how long dated issuance is market timing and significantly reduces flexibility. This is not a chart that shows rollover risk. Rather it demonstrates the costs Treasury faces once it locks itself into longer dated issuance decisions.

[Chart 20]

Soft measure of cost--one observation over 50 yrs. But it implies it is cheaper for treasury to fiancé in the front end of the curve over time. It also shows how hard it is too market time.

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