Cessation of 30-year Treasury bonds raises dealer fears

The decision last week by the US Treasury to stop issuing 30-year bonds caused a significant amount of activity in the markets, as traders sought to adjust to the surprise news. Spreads in 30-year US dollar interest rate swaps widened by 12 basis points shortly after the announcement, with a slight contraction in the shorter-dated, two-, five- and 10-year maturities.

Lynn Reaser, chief economist at Banc of America Capital Management, said the unexpected timing of the Treasury's announcement came as a "shock to the market".The decision caught out many dealers and hedge funds who had gone short the 30-year bonds on the back of the previous year’s rally, said Jack Malvey, chief global fixed-income strategist at Lehman Brothers. The subsequent clamour for long-term bonds sent prices “soaring out of the park”. "There was an explosive rush to cover their positions," said Malvey.

Although 30-year bonds are still expected to be in circulation for the near future, there have been questions raised over what types of instruments can replace them for pricing purposes in the longer-term. Malvey pointed to three possible areas that could solve the benchmark problem.

Firstly, agency-backed securities like those issued by US secondary mortgage institutions Fannie Mae and Freddie Mac hold many of the same risk-return characteristics as treasuries. But Malvey believes that over the longer-term, there are risks that agency securities could lose their AAA-ratings, leaving them an uncertain pricing tool.

Another alternative is the corporate bond market, where peer group benchmarks could be set up, as took place in the 1970s. This would allow a bond issue by, say, WalMart, to be priced in relation to a similar peer like GE, or another similar type of credit.

A third alternative is an increased focus on the swaps curve as a proxy for treasuries, as happens frequently in Europe, where government bonds are issued by national jurisdictions rather than a central European body. The main factor mitigating against this approach in the United States is the relative lack of development of its swaps market. "There is not as much swapping allowed," said Malvey, referring to mutual funds and pension funds that are not permitted to engage in derivatives activity. "Swap spreads are more volatile than nominal spreads and activity tends to be clustered around the five- and 10-year than long-dated," he added.

This fragile nature makes the swaps curve an uncertain benchmark.