REPORT TO THE SECRETARY OF TBE TREASURY 

FROM THE 

TREASURY BORROWING ADVISORY COMMllTEE 

OF TEE 

- PUBLIC SECURITIES ASSOCIATION 

July 31,19% 

Dear Mr. Secretary: 

Since the Committee's last meeting on May 1, 1996, economic expansion has proceeded at a 

strong pace. Consumer spending rose briskly in the spring, reinforced by strength in employment and 

income. Manufacturing output has accelerated, and more recently the industrial-sector strength has 

broadened. While inflationary pressures have generally remained quiescent, signs of rising wage 

pressures are becoming evident. 

During this period, interest rates on Treasury Securities have increased uniformly by 20-30 

basis points throughout the yield me. Monetary policy has remained unchanged since January, 

although market participants perceive increased risks of the need for credit restraint. Eurodollar rates 

curdy reflect expectations of a 25-50 basis point increase in the Federal Funds rate by year-end. 

While market participants expect a slowdown in economic activity, many are skeptical that the 

slowdown will be decisive enough to fmestall a modest tightening in monetary policy. 

Within this context, to refid the $17.6 billion of privately-held notes maturing on August 15, 

19% and to raise $21.4 billion of cash, the Committee recommends that the Treasury auction $39.0 

billion of the following securities: 

$19.0 billion 3-year notes due August 15,1999; 

$10.0 billion re-opened 7 percent notes due July 15,2006; 

$10.0 billion 30-year bonds due August 15,2026. 

Of the 18 Committee members present for the meetmg, 16 voted in favor of this 

recommendation. The other two members hvored the issuance of $39.0 billion of securities 

comprising $19.0 b~n 3year notes, $9.0 billion re-opened 7 percent notes due July 15, 2006 and 

$1 1 .O billion 30-year bonds. While recognizing tradeofti that are apparent fiom quarter to quarter, the 

majority preferred an approach which emphasized consistency in the sizes of the 10- and 30-year 

issues. The minority view sought to take advantage of a re-opened 10-year note to offer a somewhat 

smaller amount of 10-year securities in order to issue a larger bond offering. This approach would 

reflect the relative &eness of the 30-year maturity sector versus the 10-year sector and would 

promote increased liquidrty in the bond sector. 
The Committee voted unanimously to re-open the 7 percent notes due July 15, 2006. Such a 

re-opening would likely improve liquidity in this issue - the first irregular cycle offering of 10-year 

notes. The Committee felt that if this issue was not re-opened, it may reduce the market's acceptance 

of additional 10-year notes issued with july 15 and October 15 maturity dates. 

If the Treasuy sought to issue a lesser amount of securities in the August refund'mg than the 

Committee's recommendation, by a vote of 16-2 the Committee prefers reducing the 3-year note. This 

is consistent with the Committee's long-held emphasis on longer-dated securities, as well as our earlier 

recommendation of a minimum size of $10.0 billion for 10- and 30-year securities. 

With the aim of achieving a cash balance of $40.0 billion on September 30, the Committee 

unanimously recommends that, for the remainder of the quarter, the Treasury meet its borrowing 

requirement in the following manner: 

Two 5-year notes totaling $12.5 billion each, to raise $6.0 billion of new cash; 

Two 2-year notes totaling $18.75 billion each, to raise $0.6 billion of new cash; 

Two 1-year bins totahg $19.25 bion each, to raise $0.7 billion of new cash; 

a Weekly issuance of 3- and 6-month bills through the remainder of the quarter, to pay 

down $19.4 billion of cash, 

The issuance of intra-quarter cash management bills to cover the cash low point in 

early September; and 

a Redemption on August 15 of the bonds Caned earlier, to reduce cash by $727 million. 

Including the $21.4 billion raised in the mid-quarter refund& as well as anticipated foreign 

add-ons of $5.3 billion, the proposed hncing schedule will raise a net amount of $13.9 billion. This 

amount, when added to the $31.1 billion already raised or announced in the quarter, will accomplish 

the total net market .borrowing requirement of $45.0 billion. 

- - 

For the October-December quarter, the Treasury estimates a net borrowing requirement in the 

range of $50-55 billion with a ash balance of $30.0 billion at the end of December. To accomplish the 

anticipated net bornwing requirement, the Committee umamody recommends the provisional 

financing schedule attached to this report. 
At the Treasury's request, the Committee considered a number of questions regarding the 

potential terms and conditions of idation-protection securities. The Committee recognizes that the 

Treasury's review of these questions builds upon an extensive body of research and analysis, both 

prepared at Treasury and subnutted as part of the public review and comment process. The Committee 

commends the Treasufi for the thoroughness of its efforts and encourages the Treasury to continue to 

maintain an open dialogue with market participants as it moves toward final decisions on the plan to 

issue such securities. 

In considering the swc question raised by the Treasury as to the relative market attraction 

of the so-called "Canadian-style" structure and a "current-pay" inflation floater, the Committee notes 

that there are a number of theoretical advantages and disadvantages to each structure, which will have 

different practical consequences for different segments of the investor marketplace. Since no one 

structure is Likely to be ideally suited to all potential investors, the issue is perhaps best approached 

from the standpoint of which market segment is likely to provide the most sigmficant, dependable longterm demand for inflation protected securities. In that regard, the Committee believes that pension 

fhds and insurance companies represent the segments with the greatest natural interest. For these 

types of investors, the current tax liability and duration risk issues raised by the Canadian model pose 

fewer complications, while the reinvestment risk features of that model are relatively attractive Also, 

the treatment of deflation risk is likely to be somewhat less complex with the Canadian structure, 

relative to the current pay model. Fudly, there is the relative advantage of existing market experience 

with the Canadian model. 

An important consideration with either model would be features which would enhance 

subsequent re-engineering via stripping. On this point, there were mixed views on the complexities of 

stripping either model and a clear sense that more analysis would be important. In this regard, the 

Committee noted favorably an idea advanced in comment letters that, were the Treasury to chose the 

Canadian model, it consider establishing an exchange mechanism whereby coupons with the same 

maturity date, but stripped &om diffkrent inflation-indexed issues, could be exchanged on the basis of 

index factors which would equate the coupons. The Committee would emphasize the importance of 

enhancing stripping features of this security, as that would go a long way to providing market 

mechanisms to adapt the security to changing patterns ofmarket demand. 

The Committee also discussed the relative importance of devising a structure which would 

promote liquid secondary markets for such securities. Any structural features which would enhance 

secondary market liquidity, without diminislung investor interest, would be an obvious plus. However, 

the Committee would stress that even under the best of ciramstanm, these instruments will not have 

the degree of secondary market liquidity eqioyed by conventional U.S. Treasury securities. What is 

important is that the&achieve adequate liquidty, given the needs of the investor base to which they will 

have most appeal. Those investors will most likely regard these assets as core holdings to protect 

against long-term inflation mcemkty risk, and as an attractive low-risk alternative to holdings of 

''real'' assets. Thus, they are less likely to require the high liquidity typical of Treasury securities and 

more likely to evaluate the liquidity of these instnunerits relative to that of substitute assets, which are 

far less liquid than long-term Treasury Securities. 
The Committee also considered the trade-offs between issuance in a range of sectors of the 

yield curve relative to a more focused initial program designed to promote a reasonable degree of 

market liquidity. Given the limited prospects for liquid secondary markets for these securities, and the 

Committee's sense that the most promising sources of investor demand favor longer-tem assets, the 

Committee preferred TI initial approach focused on issuance of longer-tern securities. 

As to speclfic maturity, on balance the Committee favored initial issuance of a 10-year rather 

than 30-year security, with regular re-openings whenever feasible. The factors weighmg in favor of 10-

year debt were the lower relative degree of risk in a 10-year security, particularly given uncertainties on 

liquidity and duration risk, the increased degree of intmediate-tm investment focus for defined 

contribution and 401(k) investment plans; the prospects for some broader appeal to individual 

investors; and the benchmark status of the 10-year sector for conventional Treasury debt securities. In 

time, and depending upon market acceptance of the instrument, there could well be demand for 

issuance of longer-term (20- to 30-year) inflation protection securities. Also, to the extent the 

Treasury develops practical solutions to the structural issues which would ficilitate stripping of these 

securities, this would lessen the risk of longer-dated issuance by providing a market-based mechanism 

for balancing supply and demand across maturity sectors. 

Regarding auction techniques, the Committee was strongly in favor of the use of siie price 

auctions for these securities, as that technique works best in offerings where there is a sigdcant 

degree of bidder information risk. This would be especially the case for such a new type of Treasury 

security. The Committee also believes that a longer-than-normal preauction when-issued trading 

periodwould facilitate price discovery and contribute to improved auction participation. As concerns 

the Treasury's right to award less than the hll amount of securities being offered, the Committee notes 

that the Treasury has such a right in all existing offerings and would naturally want to retain it for a 

new type of security. That option would, of course, be r&ected in the offering circular and other 

materials introducing the new security. In as much as the Committee would expect that the Treasury 

would only exercise that option in extreme and unusualcircumstances,we see no need for the Treasury 

to make sped efforts to highhght this aspect of the offering terms and conditions. 

In terms of'the choice of idhion index to be used in the inflation-protection securities 

program, the Committee unanimously recommends the CPI-U index. This index is the most widely 

known inflation index and is generally accepted as a reasonable indication of idation. It is similar to 

indices which other countries use for inflation-linked securities. The CPI-U is also published monthly, 

which reduces the lag time in ad. the accrualof principal. 

The Committee did not have a strong preference for a seasonally adjusted or non-seasonally 

adjusted series. However, a hahty in det- payment amounts is an important consideration. 

Therefore, the Committee supports the Treasury's position that revisions of an index reported at an 

earlier date should not be used for principal or interest calculations. 
Mr. Secretary, that concludes the Committee's report. We welcome any comments or 

questions. 

Respctfidy submitted, 

Richard M. Kelly 

Chairman