Background

Congress has assigned to Treasury the responsibility of borrowing the  funds necessary to finance the gap between the money that the  government receives, primarily tax revenues, and the money that the  government spends. Government expenditures include regular  withdrawals for programs such as Medicare and Social Security as well as  extraordinary withdrawals for programs such as TARP. Treasury also  makes interest and principal payments for outstanding debt and debt that  is maturing on a continual basis. Treasury’s primary debt management  goal is to finance the government’s borrowing needs at the lowest cost  over time, subject to a statutory limit. To meet this objective, Treasury  issues debt through auctions across a wide range of securities mainly in a  “regular and predictable” pattern based on a preannounced auction  schedule, which it releases on a quarterly basis. Treasury does not “time  the market”—or take advantage of low interest rates—when it issues  securities. Instead, Treasury is able to lower its borrowing costs by relying  on regularly scheduled auctions because investors and dealers value  transparency, stability, and certainty of large liquid supply.
Market participants often characterize Treasury securities as the premium  risk-free asset. Investors, traders, banks, and foreign central banks actively  use them for hedging, liquidity, capital requirements, and reserve  purposes. Treasury securities are also a popular investment for end- investors seeking liquidity and low risk. Treasury’s “regular and  predictable” auctions are for nominal marketable securities that range in  maturity from 4 weeks to 30 years and for TIPS that are issued with 5-, 10-,  and 30-year maturities. TIPS offer a variety of benefits to Treasury, and  inflation protection to investors, who are willing to pay a premium for this  protection in the form of an interest rate on TIPS that may be lower than a  comparable nominal issuance over the life of the instrument.
Treasury responds to increases in borrowing needs in a traditional manner  by: (1) increasing the issuance size of existing securities; (2) increasing the  frequency of issuances; and (3) introducing new securities to its auction  calendar as necessary. Treasury announces upcoming changes during  quarterly refundings so that the market is not surprised. In some instances,  Treasury supplements its “regular and predictable” auction schedule with  flexible securities called cash management bills (CMB). Because of the  nature of CMBs, Treasury does not publish information about CMBs on its  quarterly auction schedule as it does for other securities. Instead, Treasury  announces CMB auctions anywhere from 1 to 4 days ahead of the auction.  Treasury also indicates whether it might issue CMBs over the upcoming  quarter in quarterly refunding statements. The term to maturity—or length  of time the CMB is outstanding—varies according to Treasury’s cash  needs. Treasury generally uses CMBs to finance intramonth funding gaps  due to timing differences of large cash inflows and outflows. Treasury  also uses CMBs to meet sudden and unexpected borrowing needs, such as  those that arose from the government’s responses to the financial market  crisis and economic downturn in 2008 and 2009.
The outstanding mix of Treasury securities can have a significant influence  on the federal government’s interest payments. Longer-term nominal  securities typically carry higher interest rates (which translate to  increased cost to the government), primarily due to investor concerns  about the uncertainty of future inflation. However, longer-term securities  offer the government the certainty of fixed interest payments over a longer  period and reduce the amount of debt that Treasury needs to refinance in  the short term. In contrast, shorter-term securities generally carry lower  interest rates but add uncertainty to the government’s interest costs and  require Treasury to conduct more frequent auctions to refinance maturing  debt, which also poses rollover risk. Among Treasury’s short-term  securities, those that are issued on a “regular and predictable” schedule  generally carry the lowest interest rates.
Two groups, (1) the primary dealers and (2) the Treasury Borrowing  Advisory Committee (TBAC) of the Securities Industry and Financial  Markets Association (SIFMA) provide regular input to Treasury debt  management decisions. The primary dealers are a group of banks and  securities broker/dealers, selected by the Federal Reserve Bank of New  York (FRBNY), that trade in U.S. government securities with the FRBNY  on behalf of the Federal Reserve in order to implement monetary policy.  They are also required by the FRBNY to participate in all Treasury  auctions. On a quarterly basis, Treasury surveys the primary dealers and  also meets with half of them in person. Treasury also meets quarterly with  TBAC, an advisory committee that is governed by federal statute and  comprised of senior level officials who are employed by primary dealers,  institutional investors, and other major participants in the Treasury  market. Treasury also monitors market trends via regular contact with the  Markets Group at FRBNY, subscriptions to all major investment houses’  fixed income research publications, attending fixed income conferences,  and meeting with large foreign investors and reserve managers.

	The Composition of Treasury’s Debt Portfolio Changed Substantially following the 2008 Financial Market Crisis but Has Begun to Transition Back to Pre–Market Crisis Structure

		The Size and Composition of Treasury’s Debt Portfolio Changed Substantially Due in Part to Borrowing for TARP, the SFP, and the Recovery Act

The borrowing associated with the actions that the federal government  took in response to the financial-market crisis and recession including  TARP, the SFP, and the Recovery Act, substantially altered the size and  composition of Treasury’s outstanding debt portfolio. Since the onset of  the recession in December 2007, Treasury’s total outstanding debt has  increased by $3.082 trillion, and marketable debt increased by $2.735  trillion. At the end of December 2009, total outstanding debt was $12.311  trillion, and total outstanding marketable securities stood at $7.272  trillion. According to Treasury, in fiscal year 2009, Treasury held a record  291 auctions in 251 business days and issued nearly $7 trillion in gross  marketable securities, a significant portion of which was used to roll over,  or refinance, existing debt.
The mix of securities Treasury issued in 2008 and 2009 substantially  shortened the average maturity of its debt portfolio and increased the debt  maturing in the next 12 months. As seen in figure 1, when looking at  Treasury’s outstanding marketable securities during the period December  31, 2006, to December 31, 2009, the percentage of securities maturing  within a year peaked in December 2008. Reflecting the same trend, the  average term to maturity of outstanding marketable securities reached its  lowest point of 49 months in December 2008. As we reported in September  2009, these changes were in accordance with what Treasury described to  us as its normal operating procedures. Our September report included  specific details about Treasury’s debt issuance between December 2007  and June 2009.

		Treasury Initially Began to Transition the Composition of Its Debt Portfolio Back to Pre– Market Crisis Structure by Stabilizing Bill Issuance and Increasing Coupon Issuance

The changes to Treasury’s debt portfolio, as discussed above, were not  intended to be permanent, and Treasury has already started to transition  back to pre-financial-market crisis levels of average maturity and  composition of the debt portfolio in a manner that, according to Treasury,  was as rapid and as prudent as possible. During the November 2009 TBAC  press conference, Treasury officials announced that the transition has  begun with a shift of bill issuances to nominal note and bond issuance and  TIPS issuance. This shift will allow Treasury to retain flexibility in meeting  uncertain financing needs in the future. Flexibility is retained by  increasing the borrowing capacity that Treasury has available for shorter- term securities, which are used when unexpected financing needs arise.  During the February 2010 TBAC press conference Treasury indicated a  shift in the transition with the announcement that nominal note and bond  issuance will stabilize in the next year and perhaps even decrease. In  February, Treasury stated that nominal auctions sizes were at levels that  give Treasury the flexibility to address a broad range of potential financing  scenarios. Market participants we spoke with anticipated the stabilization  of note and bond issuance, but cautioned that any decrease in the amount  of nominal note and bond issuance would depend on tax receipts.
Treasury has said that it expects the average term to maturity of  outstanding marketable debt to approach the historical average of 5 years  (or 60 months) by the end of fiscal year 2010 and could perhaps exceed it  in the next 3-5 years. Treasury officials have indicated the changes they  are making to the overall debt portfolio will bring short-term bill levels  closer to historical averages while stabilizing or perhaps even decreasing  nominal note and bond issuance. Treasury has emphasized the importance  of making these changes in a gradual, transparent, and incremental  manner. Some market participants have expressed concern about a  reduction in bill supply. Investors use bills to invest their funds  temporarily in a safe and highly liquid asset. Bills are also used by  institutional investors that are required to buy financial assets maturing in  a year or less. Treasury recognizes the importance of adequate bill supply  and said that it will continue to monitor the bills market for any  disruptions that the decrease in bill supply may cause.

		Treasury’s Issuance of CMBs and the Average Maturity of CMBs Increased Dramatically in 2008 and 2009

Shortly after the start of the financial-market crisis in the fall of 2008,  Treasury borrowed an unprecedented $1.1 trillion in under 18 weeks  largely by issuing CMBs, which are intended for unexpected and  immediate cash needs. Treasury’s use of CMBs was substantial and  continued well after the beginning of the financial-market crisis. The  sustained increase was due in part to the Supplementary Financing  Program (SFP), a temporary program created in September 2008 to  provide cash for use in Federal Reserve initiatives intended to address  heightened liquidity pressures in the financial markets.
In 2008 and 2009, Treasury’s gross issuance of CMBs was $1.432 trillion  and $1.142 trillion respectively (of which $785 billion and $835 billion were  issued for the SFP in 2008 and 2009). This compares to average issuance of  about $254 billion annually from 2005 to 2007. (See fig. 2.) To issue $1.432  trillion worth of CMBs in 2008, Treasury held 47 auctions (of which 21  were issued for the SFP), compared to an average of 18 auctions annually  from 2005 to 2007.
CMBs that were issued in 2008 and 2009 also departed from historical  norms in that their terms to maturity increased significantly. Prior to 2008,  Treasury typically used CMBs to fund intramonth funding gaps and, in  certain instances, to provide Treasury borrowing flexibility when it was  approaching the debt limit. Between 2002 and 2007, CMBs typically had a  term to maturity of less than 2 weeks. During 2005, 2006, and 2007, the  average term to maturity of CMBs was 10 days, 9 days, and 10 days  respectively. In contrast, in 2009, the average term to maturity of CMBs  was 109 days or 15.6 weeks. Removing those CMBs that were used for the  SFP (debt issued for the SFP does not pay for government expenditures),  the average term to maturity of the remaining CMBs was 99 days in 2008  and 198 days in 2009. During its February 2008 quarterly refunding  process, Treasury announced its plans to issue longer-dated CMBs. This  was a change to Treasury’s recent practice of not issuing CMBs with  maturities greater than 21 days and according to Treasury was necessary  in order to spread the extraordinary financing needs away from the front  end of the bill market. Treasury stated that longer-dated maturities would  be issued because of seasonal fluctuations in cash balances, volatility  associated with the timing of tax refunds, and the increased use of  electronic payments versus check payments. On February 13, 2008,  Treasury auctioned a 63-day CMB, which had a longer maturity than any  other CMB issued in the previous 3 fiscal years. Treasury issued additional  CMBs with terms to maturity of greater than 300 days during both fiscal  years 2008 and 2009. Longer-dated CMBs were also, in many instances,  reopenings of existing Treasury bills. Twenty of the 37 non-SFP CMBs  issued in 2008 and 2009 were reopenings of outstanding Treasury bills.  Treasury officials told us that they consulted with market participants and  decided that longer-dated CMBs, for example 9-month bills, were a  prudent, short-term mechanism to raise cash and approximately the length  of time that it would take for coupon issuance to “catch up” and shoulder  a bigger share of Treasury’s financing needs.

		Treasury Paid a Premium for the Sustained Use of CMBs in 2008 and 2009

While CMBs provided Treasury with needed borrowing flexibility  immediately following the start of the financial market crisis in 2008,  Treasury paid a premium for its sustained use of CMBs in 2008 and 2009.  We reported in 2006 that Treasury had paid a premium for its use of CMBs  during the period of 1996 to 2005. During that period, Treasury paid a  higher yield on most CMBs than outstanding Treasury bills of a similar  maturity paid in the secondary market. In the low-interest-rate  environment during 2008 and 2009, all debt, but particularly short-term  debt, was relatively inexpensive for Treasury; however, since the dollar  amount of CMBs issued in 2008 was 5.6 times greater than the amount  issued in 2007, even a small premium could be costly.
Our analysis shows that of the 37 CMBs not issued for the SFP in 2008 and  2009, most had a higher yield when compared with outstanding Treasury  bills of a similar maturity in the secondary market. The difference between  these CMB yields and similar maturing outstanding bills—known as the  yield differential—was positive for the second half of 2008 and all of 2009,  averaging 2.7 basis points higher (or $184 million based on the amount  issued) than outstanding bills of a similar maturity. CMBs play an  important role in Treasury debt management, and it is likely that Treasury  will always need to use CMBs, but Treasury could achieve savings by  limiting the amount of CMBs it issues.
Treasury has already begun its transition out of CMBs that are not linked  to the SFP. As part of that transition, it has extended the average term to  maturity of outstanding marketable securities by stabilizing short-term  debt issuances and transitioning to nominal note and bond issuances. In  February 2010, Treasury officials said that they planned to stabilize  nominal note and bond issuance in the first half of 2010 and perhaps  reduce nominal note and bond issuance in the second half of 2010. As of  September 2009, 28.5 percent of Treasury’s debt portfolio was in bills. If  Treasury does not alter its current pattern of issuance, Treasury projects  this share will decline to 19 percent by September 2010 and to 16 percent  by September 2011. Continuing to transition out of CMBs could reduce  Treasury’s borrowing costs, increase Treasury’s borrowing capacity on the  short end of the yield curve, and extend the average term to maturity of  the debt portfolio.

		The Medium- and Long- Term Fiscal Outlook Will Continue to Present Debt Management Challenges

The actions that Treasury has taken to increase borrowing in response to  the recession and financial-market crisis take place within the context of  the already-serious longer-term fiscal condition of the federal government.  As seen in figure 3, the Congressional Budget Office (CBO) projects that  under the President’s fiscal year 2011 budget proposals, the debt held by  the public will increase from $9.2 trillion in fiscal year 2010 to $20.3 trillion  in 2020. Over this same period, CBO projects that debt held by the public  will increase from 63 percent of gross domestic product (GDP) in fiscal  year 2010 to 90 percent by the end of fiscal year 2020. Our long-term  simulations show growing deficits and debt, underscoring that the long- term fiscal outlook is unsustainable.
According to CBO, interest rates and the size of debt held by the public  will increase in the medium term, leading to higher interest costs for the  government. One way to measure the affordability of debt held by the  public is to compare interest payments with expected revenues. As seen in  figure 4, according to CBO, net interest payments as a percentage of total  revenues will increase from 9.9 percent in fiscal year 2010 to 20.7 percent  in fiscal year 2020.
Treasury says its existing suite of securities will leave Treasury well- positioned to meet federal government borrowing needs in fiscal year  2010. Looking beyond 2010, sustained increases in debt in the medium and  long term mean that communication with all types of investors to  accurately gauge market demand will become increasingly important for  Treasury.

	Treasury and Investors Communicate through Both Formal and Informal Channels; Market Participants Identified Challenges and Suggested Improvements to Both

		Treasury and Investors Communicate through Both Formal and Informal Channels

Sufficient information from market participants, including their likely  demand for Treasury securities, is critical for debt management decisions.  Treasury receives market information through multiple formal and  informal channels. (See fig. 5.) Formal communication channels are  quarterly meetings with TBAC and with the primary dealers held as part of  Treasury’s quarterly refunding process. TBAC is currently comprised of  primary dealers, investment managers, hedge funds, and a small broker  dealer. According to Treasury officials, TBAC was once more weighted  towards primary dealers than it is now. Buy-and-hold investors of Treasury  securities are currently underrepresented. TBAC quarterly meetings serve  as a forum for Treasury officials to discuss economic forecasts and the  federal government’s borrowing needs with knowledgeable market  participants. Treasury officials pose questions on specific debt  management issues in advance and TBAC members present their  observations to Treasury on these issues and economic conditions. While  TBAC meetings are closed due to the sensitivity of the matters under  discussion, Treasury releases TBAC meeting minutes at a press conference  1 day after each meeting and announces the details of its quarterly  refunding and any changes to its auction calendar or to debt management  policies. Treasury officials told us that Treasury seeks to promote market  stability by reserving the release of any new information for the formal  quarterly announcements.
Treasury also surveys all 18 primary dealers quarterly and meets with half  of them one quarter and the other half the following quarter. Primary  dealers are those banks and securities broker-dealers that are designated  by FRBNY and maintain active trading relationships with FRBNY. Primary  dealers are also required by FRBNY to participate in all Treasury auctions.  Primary dealers account for a majority of purchases at auction, some of  which they purchase for themselves and some of which they purchase for  their customers. Treasury meets with half of the primary dealers before  each quarterly refunding to obtain estimates on borrowing, issuance, and  the federal budget deficit, as well as input on a variety of debt  management discussion topics, posed in advance. The only information  about these meetings that is released to the public is the agenda.
Treasury officials also receive information from FRBNY’s Markets Group,  which has approximately 400 staff engaged in market surveillance. FRBNY  provides morning and afternoon briefings, hosts a daily afternoon  conference call, and provides a daily report on delivery fails in the  secondary market for Treasury securities. FRBNY will also conduct  specific market research at the request of Treasury. According to Treasury  officials, the Office of Debt Management (ODM) relies on FRBNY for some  of its market information. FRBNY is able to carry out large data- collection operations because of its greater resources, which supplements  market data Treasury already collects.
In addition to its formal communication with the market, Treasury  continually collects information through informal channels, but this  communication is not conducted or logged in a systematic manner. ODM’s  informal communication includes both ad hoc and regular telephone and  e-mail contact between six ODM officials and staff and approximately 500  foreign and domestic financial organizations. Treasury also has seven  market-room staff who maintain continuous contact with market  participants. Treasury also maintains regular informal contact with  representatives of foreign central banks. In addition, Treasury regularly  contacts primary dealers to discuss operational issues in the Treasury debt  market as well to gather information about what they expect to occur in  the Treasury debt market on a given day. Treasury staff and officials also  reach out to investors by speaking at and attending conferences sponsored  by market participants and meeting with large investors globally.

		Investors Reported Mixed Satisfaction with Treasury’s Receipt of Information from End- Investors

Responses to our survey of the largest domestic holders of Treasury  securities indicate that their views vary on the extent to which Treasury  receives sufficient information and input from end-investors. Overall,  survey responses suggested room for improvement in Treasury’s practices  for gathering market information.
Our survey asked respondents the extent to which they believed Treasury  receives sufficient information and input from end-investors. They were  presented with five response categories that included very great extent,  great extent, moderate extent, some extent, and little or no extent, as well  as a no basis to judge response choice. Seventeen of the 38 respondents  who answered this question on our survey (see fig. 6), answered either  some extent or little or no extent. This compares with only 10 respondents  who answered very great extent or great extent. “No basis to judge” responses have generally been excluded from our totals except in  cases where large numbers of respondents gave this response. over $201 billion in Treasury securities. The commercial-banking sector  held $125 billion.
In contrast to the mostly positive responses of mutual funds and  commercial banks, respondents from the remaining sectors—life  insurance companies, property casualty insurance companies, and state  and local government retirement funds—were more likely to respond  negatively. As shown in figure 8, 12 of 20 respondents from life insurance  companies, property casualty insurance companies, and state and local  government retirement funds answered some or little or no extent when  asked whether they believe Treasury currently receives sufficient  information from end-investors. Both of the life insurance companies that  completed our survey chose little or no extent. Treasury officials have  agreed that they could receive better input from end-investors and have  made it a priority to improve investor outreach.
The survey findings were consistent with information we received during  interviews with investors conducted in June 2009 that indicated that many  investors in liability-driven sectors, such as life insurance and pension  funds, both lack formalized means of communication with Treasury and  believe such contact would be beneficial. These investors may have a  different demand portfolio than those in other market sectors with whom  Treasury maintains closer contact. For example, there may be greater  interest in these sectors in buy-and-hold securities like TIPS. With deb levels predicted to continue to rise in the medium and long term, the  importance of good information from a range of investors in all sectors  increases in importance.

		Market Participants and Experts Suggested Ways for Treasury to Improve Its Collection of Information from End-Investors

Respondents to our survey of the largest domestic holders of Treasury  securities suggested ideas for improving Treasury’s collection of  information from end-investors. The most frequently suggested ideas  involved increasing the range of investors from whom Treasury obtains  information. Survey respondents told us that they thought Treasury could  better gauge market demand for securities if a broader range of investors  were represented on TBAC. Survey respondents suggested changes su ch  as broadening membership or rotating membership more frequently.  Multiple survey respondents told us that some types of end-investors,  particularly liability-driven investors such as insurance companies and  pensions fund to Treasury.  s, have limited formal means of communicating their views  Survey respondents also suggested that Treasury could better gauge  market demand through a periodic collection of market data from a broa range of end-investors. They suggested that the periodic data collection  could be in the form of a survey, interviews, focus groups, or addition al  data reporting by market participants. These responses echoed wh at  market experts told us, that Treasury could benefit from periodic  “temperature-taking” of the market through surveys or interviews and  from changes to the organization or composition of the groups from which  Treasury routinely receives market information and advice. Several surveyrespondents told us that a good model for a future Treasury survey might resemble the survey we conducted. While Treasury has not conducted a  survey of end-investors in the  by organizations like SIFMA.  past, similar surveys have been conducted  Treasury staff and officials agree that more inclusive representation on  TBAC would be desirable, but they also said that increasing the number of  members (to even the TBAC charter limit of 20 members) could impede  optimal committee functioning. Treasury staff told us that if the committee  were to become too large, it might be difficult to allow enough time for  members to provide feedback and contribute to discussions. Treasury staff  and officials told us that they could broaden TBAC membership to include  one or more representatives of buy-and-hold investors such as insurance  companies or endowments. Treasury staff and officials also told us that  one of Treasury’s priorities is to improve investor outreach and t information more systematically. Treasury officials told us that  improvements to how Treasury communica be a priority for ODM in 2010 and beyond.

		Investors Reported Increased Demand for TIPS and Suggested Actions for Treasury to Take That Could the TIPS Market

			Investors and Market Experts Reported an Increased Demand for TIPS

As previously noted, one challenge for Treasury will be to gauge inve demand for Treasury securities in order to finance historically large  deficits expected in the medium and long term. Faced with this challenge,  communication with investors becomes essential. When we surveyed  major domestic holders of Treasury securities in August 2009, many  survey participants indicated that their demand could increase for TIPS.  As seen in table 1, as of July 31, 2009, survey respondents reported holding $143 billion in TIPS—which represented approximately 26 percent of the  total marketable TIPS outstanding. This amount also constituted  approximately 21 percent of the survey respondents’ total portfolio of  Treasury securities. This share allocated to TIPS may indicate that our  survey respondents already viewed TIPS favorably. According to Treasury  data, TIPS generally represent a much smaller percentage of total  outstanding Treasury securities. At the time of our survey in August 2009,  TIPS constituted only 8 percent of all Treasury marketable securities  outstanding.  stor  The increased investor interest in TIPS, as reported through our survey corroborates information we received from individu conducted earlier with large domestic holders of Treasury securities. The  investment managers we interviewed at public and private pension fund s,  mutual funds, insurance companies, and commercial banks expressed  continued or growing interest in TIPS during 2009.
At the start of 2009, financial-market experts were recommending that  investors purchase TIPS and other inflation-protected investments. Over  the course of the year, mutual funds began reporting large inflows into  inflation-protected funds, which consist mostly of TIPS. During 2009, the  five largest inflation-protected bond mutual funds increased their total net  assets by almost 70 percent. The largest of these funds saw its net assets  increase by an average of almost $1 billion per month in 2009. Also during  2009, one of the largest fixed income managers introduced three new  mutual funds designed to protect investors against inflation. One o new funds is intended to provide a hedge against inflation but also pro tax-efficient income by allocating at least half of its investments to  municipal bonds. The other two new funds are intended to produce  monthly income payments that consist of both inflation-adjusted interest  and principal. These two funds consist primarily of investments in TIPS  and have initial target maturity dates of 2019 and 2029.

			Recent Changes to TIPS Suggest That Treasury Is Responding to Investor Concerns about the Liquidity of TIPS

GAO and others have recommended that Treasury take action to improve  the liquidity of TIPS, which could lower Treasury’s cost of borrowing.  Prior to 2009, holdings of Treasury securities by sectors that we surveyed  had been in decline for nearly two decades. (As seen in fig. 9.) By the  onset of the financial crisis in 2008, the share of Treasury securities  relative to each sector’s total assets was less than half their historical  averages for the preceding two decades. By the end of 2007, no sector  reported holding more than 5-½ percent of its total assets in Treasury  s ecurities.
In 2009, Treasury decided to increase TIPS issuance, reversing the trend of  the past few years. As we previously reported, Treasury reduced the  annual gross amount of TIPS issuance by 19 percent from 2006 to 2008.  Treasury then gradually increased total TIPS issuance in 2009 by 4 percent  to $58 billion. During the August 2009 TBAC press conference, Treasury  officials stated that they are committed to the TIPS program and to issuing  TIPS in a regular and predictable manner across the yield curve. Further,  during the November 2009 and February 2010 TBAC meetings, Treasury  officials announced that they planned to gradually increase TIPS issuance  and would consider making changes to the TIPS auction calendar by  increasing the number of TIPS auctions. These changes, which are meant  to improve TIPS liquidity, are based on Treasury’s own analysis and on  input that Treasury received from market participants and GAO. At the  time of this report, Treasury had already begun to increase TIPS issuance.  The size of the 10-year TIPS auction held in January 2010 was $10 billion— an increase of 25 percent over the previous 10-year TIPS auctions that held  in July 2009.
If investors continue to express and demonstrate interest in TIPS,  Treasury may be able to issue a greater amount of TIPS at a lower cost  than in past years. Survey respondents who anticipated a change in their  demand for TIPS said that any reallocation into TIPS would most likely be  drawn from holdings of nominal Treasury securities or non-Treasury  assets. Investments into TIPS were less likely to come from an overall  increase in total assets. As previously reported, if Treasury has to increase  the supply of nominal securities substantially to fund larger deficits, yields  may have to rise in order to attract enough buyers due to the saturation of  the nominal Treasury market. Therefore, issuing TIPS may make sense  since a substantial shift in the composition of Treasury issuance into TIPS  from nominal Treasuries could also lead to lower interest rates paid on the  remaining nominal Treasury issuance. The most common reasons cited by  our survey respondents for this specific anticipated shift into TIPS were  inflation protection and TIPS’ valuation relative to other investments—the  same reasons most often cited for a general interest in TIPS. Compared to  other sectors that we surveyed, mutual fund companies and state and local  government retirement funds also responded that some of their  investments in TIPS were dedicated based upon active allocation  decisions made by clients.
Treasury has also responded to investor concern about the maturity of  TIPS issued across the yield curve by reintroducing the 30-year TIPS. At  the November 2009 TBAC meeting, there was general consensus to  eliminate the 20-year TIPS and replace it with the 30-year TIPS. TBAC  members thought this change may allow Treasury to lower its cost of  borrowing while it would create a TIPS issue that could be better  compared to the 30-year nominal issuance point. Following the TBAC  meeting, Treasury announced that it would discontinue the auctions of the  20-year TIPS and reintroduce the 30-year TIPS starting in February 2010.

			Options Exist to Improve TIPS Auction Participation, Which Could Improve TIPS Liquidity

As we reported previously, investors demand a premium for less-liquid  TIPS, which increases Treasury’s borrowing costs. Through our survey,  market participants identified a number of options to improve  participation at TIPS auctions, which could improve TIPS liquidity. Most  respondents to our survey were more likely to purchase TIPS in the  secondary market rather than at auction. The most common reasons listed  for this were infrequency of TIPS auctions, portfolio needs, relative  valuation, and liquidity. On average, survey respondents planned to  purchase almost 80 percent of their TIPS in the secondary market. Over  half of survey respondents said that although they never participate in  Treasury auctions, they were active in the secondary market at least  monthly.
Survey respondents said that increasing the dollar amount of TIPS issued  per auction and increasing the frequency of TIPS auctions could help  improve participation during TIPS auctions. Survey respondents also  pointed out that a clearer commitment from Treasury to the TIPS program  would improve TIPS liquidity. In interviews with us in February 2010,  some primary dealers said that Treasury should modify its current TIPS  auction schedule to decrease the amount of time between TIPS auctions,  thereby staggering the supply of TIPS so that issuance is not as  concentrated. Since 2005, Treasury has held eight TIPS auctions every  calendar year—two auctions each in January, April, July and October. At  the May 2010 TBAC press conference, the Assistant Secretary for Financial  Markets, Mary Miller, said that Treasury will be adding a second reopening  of the 10-year TIPS, which would lead to six 10-year TIPS auctions a year.  According to Treasury, these changes would help improve TIPS liquidity  while diversifying its funding sources.

			A More Liquid TIPS Market Could Support a TIPS Futures Market, Which in Turn Could Further Enhance the TIPS Market

The combination of increased TIPS issuance, Treasury’s statements of  commitment to TIPS, and the reintroduction of the longer-dated 30-year  TIPS, could help sustain a viable TIPS futures market. In interviews and  in published material, some financial-market experts have noted the lack  of a viable futures trading market for TIPS. Some of these experts have  speculated that a successful futures contract could bolster the liquidity of  TIPS. In a public discussion with the Chicago Mercantile Exchange Group  (CME) in March 2009, Acting Assistant Secretary for Financial Markets  Karthik Ramanathan explained that futures products help increase the  liquidity, depth, and price transparency of the U.S. Treasury market.
According to market experts, however, the lack of liquidity in the current  TIPS market would make it difficult to sustain a viable TIPS futures  product. In interviews with GAO in February 2010, primary dealers  expressed different opinions on the structure of a potential inflation  futures contract. We heard preferences for both a cash-settled index as the  basis for an inflation futures contract and also an inflation futures contract  with a basket of deliverables similar to how futures contracts for nominal  securities are structured. Primary dealers told us that if TIPS were to  become more liquid, then a TIPS futures contract might succeed, and that  this in turn could further increase the liquidity of TIPS.

		One of the Most Important Groups through Which Treasury Receives Market Information Has Expressed Concerns about the Increase in Direct Bidding in Treasury Auctions

One of Treasury’s important channels of communication is with primary  dealers. Primary dealers that we interviewed told us that they are satisfied  with their communication with Treasury. They told us they had recently  raised concerns about what they see as consequences of the recent  increase in direct bidding in Treasury auctions.
Direct bidders are financial institutions that, like primary dealers, can bid  for and buy Treasury securities competitively at auction directly from  Treasury instead of in the secondary market. Unlike primary dealers,  direct bidders are not required to participate in all Treasury auctions. Most  Treasury securities are bought at auction by primary dealers. A much  smaller, but growing volume of securities is purchased by direct bidders.
In April 2004, Treasury stated that there were 825 “investors” making use  of the auction system that allows direct bidding. Three months later, a  Treasury press release announcing the new version of TAAPSLink, the  communications system through which auction market participants are  provided Internet-based access to Treasury auctions, said that over 600  “firms” used the on-line bidding system. This is the most recent  information that Treasury has disclosed to the market on the potential  number of direct bidders at an auction.
Direct bidding has grown in size and volatility since 2008. Figure 10  illustrates both the overall increase in participation and the volatility of  that participation. Direct bidder purchase share in auctions for 5- and 10- year notes and 30-year bonds began to trend upward and show greater  variation starting on October 30, 2008, and then hit a 5-year high of almost  30 percent at the March 11, 2010, auction of 30-year bonds. During this  period, the average direct-bidder purchase share of 5- and 10-year notes  and 30-year bonds was 5.8 percent with a standard deviation of 5.3  percentage points. This contrasts with the period between May 5, 2003,  and October 30, 2008, when direct bidders purchased an average of only  1.6 percent of 5- and 10-year notes and 30-year bonds. The standard  deviation during this time period was 3.9 percentage points.
Primary dealers have made public statements expressing concerns about  both the increase and the unpredictable role of direct bidders in Treasury  auctions. Through interviews, we learned that they had expressed their  concerns to both Treasury and the FRBNY. Primary dealers said they  believe both more direct bidding and the increase in the volatility of direct  bidding “dis-incentivizes” primary dealers because it means they have less  certainty of information surrounding a particular Treasury auction. For  example, if an investor purchases Treasury securities directly at auction  instead of going through a primary dealer, a primary dealer could have less  information available about the auction. Volatility in direct bidding also  increases uncertainty. Increased uncertainty could lead to primary dealers  making less aggressive bids, which could lead to increased borrowing  costs for Treasury. Some primary dealers also told us that an overall lack  of transparency regarding direct bidding potentially contributes to “sloppy  auctions.” A sloppy auction typically means poor reception or demand for  a Treasury auction relative to what was expected and leads to higher  yields at the auction. Treasury officials told us that they have not seen evidence of this and have also stated publicly that Treasury supports  broad access to the auction process and that direct bidding fosters  competition, therefore helping achieve its goal of the lowest cost of  borrowing over time.
According to primary dealers that we interviewed, part of the lack of  transparency surrounding direct bidding comes from not knowing the  exact number of direct bidders that could potentially bid at each auction  and what sectors of the market they represent. One source of information  that provides a breakdown of auction results by sector is Treasury’s data  on Investor Class Auction Allotments, which is released on the 7th  business day of each month. Primary dealers that we spoke with said t if Treasury were to provide this data on a more frequent basis it might  alleviate some of the uncertainty that currently exists in the market.

	Conclusions

In 2008 and 2009, Treasury successfully raised unprecedented amounts o cash in a very short period of time. However, absent policy changes, themedium- and long-term fiscal outlook means that Treasury will have to  continue to raise significant amounts of cash, while achieving its goal o the lowest cost of borrowing over time. Raising significant amounts of  cash at the lowest cost of borrowing over time requires sufficien competitive participation at auctions. Information from market  participants on their demand for Treasury securities, including the typ information that we received from our survey of the largest domestic  holders of Treasury securities, is critical to this effort.
Treasury initially raised cash to meet TARP and Recovery Act needs by  issuing primarily short-term debt, including CMBs, dramatically changing  the composition of its debt portfolio. In 2009, Treasury began to take s to return the composition of its debt portfolio to its pre–market cris is  structure. In September 2009 we reported that a more robust TIPS  program could benefit Treasury by diversifying and expanding its funding sources and reducing the cost of nominal securities. Treasury reaffir med  teps  its commitment to TIPS and announced plans to gradually increase  issuance of TIPS. Through our survey of the largest domestic holders of Treasury securities in August 2009, we found that Treasury can improve  the extent to which it receives sufficient information from end-inve We also found that options exist for Treasury to increase investor  participation in TIPS auctions and further improve TIPS liquidity. We  briefed Treasury on the findings contained in this report in October 2009,  December 2009, and March 2010.    stors.

	Recommendations Executive Action

The Secretary of the Treasury should continually review methods for  collecting market information and consider the following actions to help  r demand in the context of projected sustained increases in  gauge investo federal debt:    conducting a systematic and periodic sur vey of the largest holders  of Treasury securities in all sectors, and  increasing the number of representatives on TBAC and ensuring  resentation by including members that represent end- diverse rep investors.
The Secretary of the Treasury should continue term to maturity of CMBs, when appropriate. to reduce the amount and  The Secretary of the Treasury should consider increasing the number of   throughout the year in  TIPS auctions and distributing them more evenly order to improve participation in TIPS auctions.

	Agency Comments and Our Evaluation

We requested comments on a draft of this report from the Secretary of the  Treasury and received e-mailed comments on behalf of the Treasury from  its Deputy Assistant Secretary of Federal Finance. Treasury agreed with  our findings, conclusions, and recommendations, and said that the report  captured Treasury’s actions clearly and succinctly. Treasury officials also  pointed out that at the May 2010 quarterly refunding, they announced that  (1) they are increasing the frequency of investor class data releases, and  (2) they decided to increase the frequency of 10-year TIPS auctions, both  of which are consistent with our recommendations.
Treasury thanked us for our discussion of communications strategy and  for the information provided from our survey. They noted that Treasury is  always looking to improve its communication with market participants  and they agreed that this is particularly important now given ongoing,  elevated financing needs.
Treasury also provided technical comments, which are incorporated into  the report where appropriate.
We are sending copies of this report to interested congressional  committees, the Secretary of the Treasury, and other interested parties. In  addition, the report is available at no charge on the GAO Web site at  http://www.gao.gov.
If you or your staff have any questions concerning this report, please  contact Susan J. Irving at (202) 512-6806 or irvings@gao.gov. Contact  points for our Offices of Congressional Relations and Public Affairs may  be found on the last page of this report. GAO staff making key  contributions to this report are listed in appendix IV.

Appendix I: Methodology for the Analysis of the Cash Management Bill Yield Differential

We analyzed the yield differential for all cash management bills (CMB)  issued over a 2-year period beginning on January 1, 2008, and ending on  December 31, 2009, removing from our analysis any cash management bills  that were used for the Supplementary Financing Program (SFP). We used  two methods to analyze the yield differential between CMBs and  equivalent regular 4-, 13-, 26-, or 52-week Department of the Treasury  (Treasury) bills. First, we compared CMB yields to recently auctioned  Treasury bills of similar maturity. Second, we compared CMB yields to  average secondary market yields on Treasury bills of similar maturity.  There are limitations to both of these yield differential estimates. Neither  captures any effect from the announcement of CMBs on yields for similar  maturing bills. If the announcement of a CMB increased the yield on  similar maturing bills, then our estimate may be understated. Also, in some  cases, the surrounding Treasury bills we used could include CMBs that  were reopenings of regular Treasury bills. This would also lead to an  understatement of the yield differential because the yield on the  outstanding securities including CMBs would be higher than outstanding  securities that did not include CMBs.

	CMB Yields Compared to Recently Auctioned Treasury Bills of Similar Maturity

We compared CMB yields with the yields of similar Treasury bills that  were auctioned the same day, or immediately before and after the date of  the CMB auction. Once we identified two Treasury bills (one auctioned  before and one after each CMB) with a maturity closest to the CMB, we  derived a weighted average yield for the two bills. The weights were based  on the relative difference in each bill’s auction date from that of the CMB,  with the Treasury bill having a closer auction date receiving a greater  weight and the weights summing to 1. Then, the weighted average  Treasury bill yield was subtracted from the CMB auction yield to obtain  the yield differential. In the final step, the yield differential was applied to  the dollar amount of the CMB to obtain an estimate of the cost of issuing a  CMB instead of a regular Treasury bill.

	CMB Yields Compared to Average Secondary Market Yields on Treasury Bills of Similar Maturity

Taking a second approach, we also calculated the difference between a  CMB’s yield and the average secondary market yield on other Treasury  bills that are most similar (in terms of maturity) to the CMB on the day of  auction.
This method was used in our previous report on cash management bills issued in 2006. See  GAO, Debt Management: Treasury Has Refined Its Use of Cash Management Bills but  Should Explore Options That May Reduce Cost Further, GAO-06-269 (Washington, D.C.:  Mar. 30, 2006).

Appendix II: Survey Scope and Methodology

To help achieve our objective of determining what changes the  Department of the Treasury (Treasury) could make to better gauge end- investor demand and increase auction participation, we conducted a Web- based survey of domestic institutional investors in Treasury securities.

	Population and Sample Design

In June 2009, we conducted 12 structured interviews with the two largest  holders of Treasury securities in each of the following sectors: mutual  funds; commercial banks; life insurance companies; property casualty  insurance companies; state and local government retirement funds; and  private pension funds. Based on what we learned in these interviews, in  August 2009 we conducted a more comprehensive Web-based survey that  was sent to the 12 holders of Treasury securities that we interviewed in  June, as well as to additional holders of Treasury securities in each sector,  with the exception of private pension funds. Private pension funds were  excluded from the Web-based survey because our initial interviews  revealed that their funds are managed primarily by external investment  management companies represented in other sectors. Neither the  structured interviews nor the Web-based survey are generalizible.
We established two criteria for inclusion of a sector in the nonprobability  sample for our 12 structured interviews. First, the sector had to have  Treasury holdings in the top 20 of all sectors as of the third quarter of  2008, according to table L.209 of the Flow of Funds Account of the United  States. Second, the sector had to be identified by market experts that we  interviewed in February 2009 as having the potential to purchase large  quantities of Treasury securities in the future. Both criteria were used to  ensure that the sectors have a relevant financial stake in Treasury markets.
The household sector and federal-government retirement funds sector  were identified by the criteria, but not included in our sample. The  household sector was not included due to the difficulty of identifying,  ranking, and contacting individual household investors. In addition, it  would have been beyond our ability to survey a sufficient number of  households to reach the 50 percent market-share criterion that we later  applied to the other sectors. The federal-government retirement funds  sector was not included because the Thrift Savings Plan does not invest in  nominal Treasury securities and Treasury Inflation Protected Securities  (TIPS), and therefore, it was outside the scope of our survey.
To identify the organizations within each sector that would receive our  Web-based survey, we used rankings of the largest organizations in each  sector based on total assets (or an equivalent financial indicator). From  these ranked lists, we determined Treasury holdings for each organization,  and selected as many organizations as needed to represent at least 50  percent of the total amount of Treasury holdings for that sector (based on  table L.209 of the Flow of Funds Account of the United States, as of the  third quarter 2008).
This methodology was the same for the structured interviews mentioned above, except  that for the structured interviews we selected and interviewed the two largest  organizations in each sector.

	Analysis of Open- Ended Responses

Several survey questions solicited open-ended responses from  respondents. To analyze the responses to these questions, two GAO  analysts separately reviewed the responses and identified themes for each  item. They then developed a mutual list, which was used to independently  code survey responses. Independently coded responses were then  compared and successfully coded at 80 percent agreement or higher, with  any remaining disagreements reconciled through discussion. At least 80  percent agreement was obtained in all cases. The coded responses were  then used in two ways: (1) to obtain a sense of the range of perspectives  on a given point, and (2) to obtain an idea of the frequency or extent to  which a particular viewpoint or perspective was held by our survey  respondents.

Appendix III: Survey Instrument

	Treasury Auctions and Holdings - Continued

n. Other - Please select an answer and specify below. o. Other - Please select an answer and specify below. p. Other - Please select an answer and specify below.
If you answered "Other" in rows n through p above, please specify.
Specify entry in "n" above:  Specify entry in "o" above:  Specify entry in "p" above: Treasury Inflation-Protected Securities (TIPS) 8. If your organization currently invests in TIPS, what percentage of your organization's TIPS purchases is dedicated based on active allocation decisions made by clients? (Enter percentage below.) following maturities? (Select one answer in each row.) d. 30-year TIPS (if introduced) 10. What are the primary reasons your organization purchases TIPS or plans to purchase TIPS in the future? (Please list up to five reasons in order of importance.) 11. In your opinion, what effect, if any, would a 30-year TIPS have on demand for TIPS securities with other maturities?
Would increase demand   Would have no effect on demand   Would decrease demandNo basis to judge Treasury Inflation-Protected Securities (TIPS) - Continued 12. Do you anticipate any change in your organization's demand for TIPS from this year to next year?
Yes - Continue with question 13. No (Click here to skip to question 15) No basis to judge (Click here to skip to question 15)

	13. If you anticipate change in your organization's demand, what do you anticipate the change(s) will be?

(Check all answers that apply.)
A reallocation into TIPS from nominal Treasury securities A reallocation out of TIPS into nominal Treasury securities A reallocation into TIPS from an increase in total assets A reallocation out of TIPS from a decrease in total assets A reallocation into TIPS from non-Treasury assets A reallocation out of TIPS into non-Treasury assets Other change(s) - Please specify below. No basis to judge  If you answered "Other change(s)" above, please specify below. 14. What are the primary reasons behind the change in demand for TIPS from this year to next year? (Please list up to five reasons in order of importance.) 15. In your estimation, about what percent of your organization's TIPS purchases in the next year will be made through the following means? b. Secondary market:  Please enter any comments you may have relating to your answer to question 15 above. 16. Would the following actions by Treasury increase the likelihood that your organization would: 1) participate in a TIPS auction, and 2) buy more securities at each auction? (Select one answer in each row.) a. Increase the frequency of TIPS auctions and b. Increase TIPS issuance amounts per auction c. Purchase off-the-run TIPS securities d. Other - Please answer and specify below. e. Other - Please answer and specify below. f. Other - Please answer and specify below.
If you answered "Other" above, please specify other ways to increase participation or amount of securities bought.
Specify entry in d. above: Specify entry in e. above: Specify entry in f. above: 17. The liquidity of TIPS has been found to be less than nominal Treasury securities.
In your opinion, what actions could Treasury take to enhance the liquidity of TIPS? (Please list up to five actions in order of importance.)
Action #5: 18. In your opinion, what are the risks that your organization faces as an investor in Treasury markets? (Please list up to five risks in order of importance.) 19. In your opinion, what actions could be taken to address and mitigate the risks identified in question 18 above? (Please list up to five actions corresponding to the risks identified in question 18 above.)
Action #5: 20. In your opinion, to what extent, if at all, does Treasury currently receive sufficient information and input from end-investors?
Very great extent Great extent   Moderate extent  Some extent  Little or no extent  No basis to judge 21. How effective, if at all, do you consider each of the following communication channels between your organization and Treasury to be at providing Treasury with sufficient information and input from end-investors? (Select one answer in each row.) a. Direct contact with Treasury debt management b. Direct contact with Federal Reserve officials c. Direct contact with Treasury Borrowing Advisory Committee (TBAC) members d. Direct contact with Primary Dealers e. Direct participation in TBAC or Primary f. Other - Please select an answer and specify below. g. Other - Please select an answer and specify below. h. Other - Please select an answer and specify below.
If you answered "Other" in rows f through h above, please specify.
Specify entry in "f" above:  Specify entry in "g" above:  Specify entry in "h" above: 22. What actions could Treasury take to ensure that it receives sufficient information and input from end-investors? (Please list up to five actions in order of importance.)
23. Are you ready to submit your final completed questionnaire to GAO? (This is equivalent to mailing a completed paper questionnaire to us. It tells us that your answers are official and final.)
Yes, my questionnaire is complete - Click on the "Exit" button below to submit your answers. No, my questionnaire is not yet complete  You may view and print your completed questionnaire by clicking on the Summary link in the menu to the left.

Appendix IV: GAO Contact and Staff Acknowledgments

	Staff Acknowledgments

In addition to the contact named above, Jose Oyola (Assistant Director),  Tara Carter (AIC), Richard Cambosos, Stuart Kaufman, Mark Kehoe, Erik  Kjeldgaard, Richard Krashevski,, Margaret McKenna, Donna Miller, Dawn  Simpson, Jeff Tessin, Jason Vassilicos, Gregory Wilmoth, and Melissa Wolf  all made contributions to this report.

Summary:
Why GAO Did This Study

This report is part of GAO's requirement, under the Emergency Economic Stabilization Act of 2008, to monitor the Department of the Treasury's (Treasury) implementation of the Troubled Asset Relief Program and submit special reports as warranted from oversight findings. It evaluates Treasury's borrowing actions since the start of the crisis, and how Treasury communicates with market participants in the context of the growing debt portfolio and the medium- and long-term fiscal outlook. GAO analyzed market data; interviewed Treasury, the Federal Reserve Bank of New York, and market experts; and surveyed major domestic holders of Treasury securities.

What GAO Found

The economic recession and financial-market crisis, and the federal government's response to both, have significantly increased the amount of federal debt. While the composition of Treasury's debt portfolio changed in response to this increase, Treasury has taken a number of steps in the past year to return the composition of the debt portfolio to pre-market crisis structure. One action Treasury has undertaken has been to reduce its reliance on cash management bills (CMB). While CMBs provided Treasury with needed borrowing flexibility immediately following the financial market crisis in 2008, Treasury paid a premium for its sustained use of CMBs in 2008 and 2009. In recent months, Treasury also has begun to stabilize shorter-term bill issuance and increase issuance of longer-term coupons. Given the medium- and long-term fiscal outlook, Treasury will continue to be presented with the challenge of raising significant amounts of cash at the lowest costs over time. This makes evaluating the demand for Treasury securities increasingly important. Sufficient information from market participants on their demand for Treasury securities, including the type of information that GAO received from its survey of the largest domestic holders of Treasury securities, will be critical as Treasury moves forward to meet these challenges. In GAO's survey, investors reported increased demand for Treasury Inflation Protected Securities (TIPS) and suggested ways for Treasury to further improve TIPS liquidity and thereby lower borrowing costs. Treasury receives input from market participants through a variety of formal and informal channels, but overall satisfaction with these communication channels varies by type of market participant. Market participants suggested to GAO a number of changes including increasing investor diversification on the Treasury Borrowing Advisory Committee (TBAC) and regular collection of information from end-investors. Primary dealers, who are satisfied with their communication, raised concerns about the recent increase in direct bidding and its effect on Treasury auctions.