Debt Management: Treasury Has Refined Its Use of Cash Management Bills but Should Explore Options That May Reduce Cost Further
Published: 2006-03-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: One result of persistent fiscal imbalance is growing debt and net interest costs. Net interest is currently the fastest-growing "program" in the budget and, if unchecked, threatens to crowd out spending for other national priorities. This report was done under the Comptroller General's authority. GAO examined the Department of the Treasury's (Treasury) growing use of unscheduled short-term cash management bills (CM bills). Specifically GAO (1) describes when Treasury uses CM bills and why, (2) describes the advantages and disadvantages of CM bills, (3) describes steps taken by Treasury to reduce the overall borrowing costs associated with CM bills, and (4) identifies possible options Treasury could consider to reduce the use and cost of CM bills further.
section_title: What GAO Found
paragraphs: Treasury makes large, regularly occurring payments, such as Social Security and federal retirement payments, in the beginning of each month but receives large cash inflows in the middle of each month from income tax payments and note issuances. Because regular bills alone are not sufficient to fill these intramonth cash financing gaps, since 2002 Treasury has increasingly issued CM bills to bridge this gap. CM bills allow Treasury to obtain cash outside of its regular borrowing schedule in varying amounts and maturities, but Treasury pays a premium for doing so. GAO's analysis found that Treasury paid a higher yield on CM bills than that paid on outstanding bills of similar maturity in the secondary market. Treasury has taken steps to reduce the use and cost of CM bills. Treasury added a 4-week bill to its regular auction schedule in 2001, which led to reduced CM bill issuance, shorter terms to maturity, and lower borrowing costs in 2002. Treasury has also fine-tuned CM bill issuance by borrowing closer to the time when it needs cash. However, borrowing costs associated with CM bills have increased since 2003. While Treasury has made progress towards reducing the cost of CM bills, it may be possible to do more. GAO's analysis indicates that the yield differential has increased as short-term rates have risen. If these rates rise further, as market participants expect, so will the yield differential. While Treasury does not vary its debt management strategy in response to changing interest rates, it should be mindful of their effect on the relative cost of unscheduled CM bills and explore options to reduce the frequent use of CM bills and ultimately overall borrowing costs. GAO identified options worth exploring such as any additional opportunities for closer alignment of large cash flows; possible options for increasing earnings on excess cash balances; and introduction of a shorter-term regular instrument.

section_title: Letter
paragraphs: One result of persistent fiscal imbalance is growing debt and net interest  costs.  Net interest on the federal debt is currently the fastest-growing  “program” in the budget.  The Congressional Budget Office (CBO) projects  that interest cost will increase by more than 50 percent over the next 5  years.  If unchecked, interest spending threatens to crowd out spending for  other national priorities such as educating our children, safeguarding the  environment, and ensuring national security.
The Department of the Treasury’s (Treasury) primary debt management  goal is to finance the government’s borrowing needs at the lowest cost over  time.  To meet this objective, Treasury issues debt through auctions in a  “regular and predictable” pattern across a wide range of securities  including nominal bills, notes, and bonds, and Treasury Inflation-Protected  Securities (TIPS).  According to Treasury, because investors and dealers  rely upon the routine availability of Treasury securities they tend to pay a  slight premium, which lowers Treasury’s borrowing costs.
Since 1975, Treasury has supplemented its regular and predictable auctions  with unscheduled cash management bill (CM bill) auctions to finance  short-term cash needs while providing short notice to market participants.   However, Treasury officials and researchers indicated that Treasury pays a  premium on CM bills in part because of their irregularity and short-term  nature. We examined Treasury’s use of CM bills to provide insights into  options Treasury might consider to reduce CM bill use, the premium paid  on CM bills, and ultimately government borrowing costs.
This report is part of GAO’s ongoing work on Treasury’s cash and debt  management practices and was done under the Comptroller General’s  authority.  We examined general patterns of CM bill issuance over the last  10 fiscal years—fiscal years 1996–2005, but focused on the last 4 fiscal  years after Treasury introduced a new regular 4-week bill in 2001 to reduce  the use of CM bills.  The objectives of this report are to (1) describe when  Treasury uses CM bills and why, (2) describe the advantages and  disadvantages of CM bills, (3) describe steps taken by Treasury to reduce  the overall borrowing costs associated with CM bills, and (4) identify  possible options Treasury could consider to reduce the use and cost of CM  bills further.
subsections: section_title: Background
paragraphs: Congress has delegated to Treasury the power to borrow the money needed  to operate the federal government and manage the government’s outstanding debt subject to a statutory limit. Treasury’s primary debt  management goal is to finance the government’s borrowing needs at the  lowest cost over time.  To meet this objective, Treasury issues debt through  auctions in a “regular and predictable” pattern across a wide range of  securities.  Treasury does not “time the market”—or take advantage of  lower interest rates—when it issues securities.  According to Treasury,  because investors and dealers rely upon the routine availability of Treasury  securities they tend to pay a slight premium, which lowers Treasury’s  borrowing costs.  In addition, Treasury also states that to support liquidity,  it must issue “enough but not too much” at each auction.  If Treasury  issued too little, it could not sustain a deep and liquid secondary market for  its securities. If it issued too much, Treasury creates concern among  primary market participants that they may find it difficult to distribute their  holdings in the secondary market.
Treasury publishes a schedule with tentative announcement, auction, and  settlement (issue) dates up to 6 months in advance of regular security  auctions.  Depending on the type of security, Treasury typically auctions  and then issues a security within a week or less.  Treasury generally issues  short-term regular bills with 4-, 13-, and 26-week maturities every Thursday  and issues 2- and 5-year notes at the end of each month.  Three- and 10-  year notes are issued in the middle of each quarter and Treasury reopens  10-year notes 1 month after their initial issuance.  In addition, Treasury  issues TIPS in 5-, 10-, and 20-year maturities in certain months according to  the TIPS’ maturity.  Finally, Treasury issues 30-year bonds in the middle of February and reopens the bonds in the middle of August.  Figure 1 depicts  Treasury’s April 2005 borrowing schedule.
Treasury supplements its regular and predictable schedule with flexible  securities called CM bills.  Unlike other securities, Treasury does not  publish information on CM bills on its auction schedule.  Instead, Treasury  generally announces CM bill auctions anywhere from 1 to 4 days ahead of  the auction.  The term to maturity—or length of time the bill is  outstanding—varies according to Treasury’s cash needs.  CM bills allow  Treasury to finance very short-term cash needs—for as little as 1 day— while providing short notice to market participants.
The United States Treasury is not alone in using CM bill-type instruments to  finance short-term needs and smooth cash flows.  For example, in the  United Kingdom, the Debt Management Office (DMO) issues CM bills to  meet temporary cash flow needs that the DMO cannot conveniently meet  through its structured bill auctions and to help smooth cash flows.  The  Bank of Canada, which auctions securities for Canada’s debt management,  issues CM bills to help it minimize the level and cost of carrying cash  balances.  Australia uses short-term securities with 5-, 13-, and 26-week  maturities to bridge within-year cash flow mismatches, but may vary the  maturities and issue shorter-term securities of 3 to 6 weeks.
section_title: Objectives, Scope, and Methodology
paragraphs: To understand when Treasury uses CM bills, we analyzed CM bills issued  over the last 10 fiscal years—fiscal years 1996–2005.  This time period  provides a sufficiently large sample of CM bills—121—and allowed us to  analyze and show trends in CM bill use before, during, and after the  following events:  4 years of surpluses, five debt issuance suspension  periods (DISP) declared by the Secretary of the Treasury, and the  introduction of two new debt instruments—TIPS in 1997 and the 4-week  bill in 2001.  CM bill data were obtained from the Bureau of the Public Debt  (BPD).  BPD’s online database has 22 different features for each Treasury  security, including the amount, announcement, auction and issue dates, the  maturity date, and the yield.  We examined these features as well as others  examined in earlier studies of CM bills to identify patterns of CM bill  auctions, issuance, and maturity.
To understand why CM bills are issued or mature at these times, we  examined Treasury’s cash flows from fiscal years 1996–2005 using publicly  available data from the Financial Management Service’s (FMS) Daily  Treasury Statements.  We also met with Treasury officials from the Office  of Debt Management and the Office of Fiscal Projections.  We reviewed  Treasury documents, including quarterly refunding statements and policy  statements, and Treasury Borrowing Advisory Committee reports and  minutes from quarterly refunding meetings.
We obtained views on the perceived advantages and disadvantages of CM  bills for Treasury, Federal Reserve operations, and investors in meetings  with Treasury officials, Federal Reserve officials, market participants,  including primary dealers and money market fund managers, and market  analysts.  We also reviewed financial and economic literature.  We did not  identify any key advantages or disadvantages of CM bills for Federal  Reserve operations and as a result these operations are not a focus in this  report.
To describe the key disadvantage of CM bills for Treasury—higher yields— we estimated the differential between CM bill yields and the yields on  outstanding Treasury bills of similar maturity at the time of auction using  data from BPD and the Wall Street Journal (WSJ).  To determine whether  certain features might reduce the yield paid on CM bills, we regressed the  yield differential on key features.  We determined which features to  examine on the basis of previous studies of CM bills and Treasury auctions,  our interviews with Treasury and market participants, and our own  analysis.  While we analyzed the yield differential for all CM bills issued  during fiscal years 1996–2005, we focused on the 55 CM bills issued during  fiscal years 2002–2005 because the introduction of the 4-week bill in 2001  substantially reduced CM bill maturities and caused a structural change in  the CM bill market.  For more information on our statistical analysis, see  appendix I.
Because CM bill rates are determined in auctions, we examined auction  performance to determine whether there is any relationship between  selected performance measures and the yield differential.  We also  examined whether CM bill auctions perform as well as regular 4-week bill  auctions because the 4-week bill is more similar to a CM bill—in terms of  issuance amount variance and its term to maturity—than other Treasury  securities.  We evaluated each of the 284 CM and 4-week bill auctions in  fiscal years 2001–2005 (years since the introduction of the 4-week bill)  using proprietary data from the Treasury Auction Database (TAD) and  GovPX—an interdealer broker database with information on primary  dealer transactions for all U.S. Treasury securities. We analyzed auction  performance measures mentioned in Treasury interviews, Treasury studies  of auctions, Borrowing Advisory Committee minutes, and economic and  financial literature/textbooks describing or evaluating Treasury auction  performance.  See appendix II for more information on our analysis of CM  bill auctions.
We identified possible options to reduce the use and cost of CM bills on the  basis of our analysis of CM bill use, the yield differential, and CM bill  auction performance.  We discussed these options with Treasury, market  participants, and others and we include their comments as appropriate.
In order to assess the reliability of data used in this study, including  proprietary data from TAD and GovPX, and the publicly available data from  FMS, BPD, and WSJ, we examined the data to look for outliers and  anomalies and addressed such issues as appropriate.  In general, we chose  databases that were used by Treasury and researchers to examine Treasury  markets and auction performance.  Where possible and appropriate, we  corroborated the results of our data analysis with other sources.  On the  basis of our assessment we believe the data are reliable for the purposes of  this review.
We conducted our review in Washington, D.C., from February 2005 through  March 2006 in accordance with generally accepted government auditing  standards.
section_title: Treasury Uses CM Bills to Help Fill Cash Financing Gaps
paragraphs: Treasury frequently faces a cash financing gap of about 2-weeks duration  because of timing differences of large cash inflows and outflows.  Treasury  makes large regular payments (e.g., Social Security and federal retirement)  in the beginning of the month and it often receives large cash inflows in the  middle of the month from income tax payments and note issuances.   Because regular bills alone are not sufficient to fill this cash financing gap,  Treasury has increasingly used CM bills since 2002.  Treasury has also  relied on CM bills when nearing the debt ceiling to help pay its bills while  keeping debt under the statutory limit.
subsections: section_title: Large Cash Outflows Occur at the Beginning of the Month
paragraphs: Treasury’s largest cash outflows generally occur in the beginning of the  month.  For example, in fiscal year 2005, almost one-quarter of the  government’s annual fiscal cash outlays (withdrawals excluding debt  redemption) were paid in the first 3 days of each month.  On or around the  1st of every month Treasury paid about $14 billion to active duty military  personnel, military and civilian retirees, and others.  In the beginning of  some months, Treasury also paid up to $6 billion for Medicare.  On or  around the 3rd of every month it paid about $21 billion in Social Security  benefits.  In total, Treasury made $718 billion cash payments in the first 3  days of months in fiscal year 2005.
These large payments in the beginning of the month are not anticipated to  decline soon.  A Treasury official explained that Social Security benefits  paid on the 3rd of the month are anticipated to remain relatively steady for a  number of years and then decline because of steps taken by the Social  Security Administration (SSA) in 1997 that have helped smooth cash  payments out of Treasury.  (Fig. 2 describes these steps in more detail.)
However, because beneficiaries receiving benefits before 1997 continue to  receive their benefits at the beginning of the month, we estimate the large  payments could last another 10 years.  Other federal benefit programs  continue to pay all or most of their benefits at the beginning of the month.   If these payments were, like Social Security, spread throughout the month,  it would help smooth cash flows and might reduce Treasury’s need to use  unscheduled large CM bills at the beginning of the month.
section_title: Large Receipts Often Occur in the Middle of the Month
paragraphs: In contrast to outlays, Treasury’s largest cash inflows generally occur in the  middle of the month. Although the majority of federal tax receipts are  already fairly smoothed throughout the year, most corporate and  nonwithheld individual tax payments are made in the middle of certain months throughout the year. Treasury receives large corporate tax  payments on (or around) the 15th of March, April, June, September, and  December.  During fiscal year 2005, Treasury received just over $213 billion  of cash on these days.  Treasury also had large receipts in the middle of  January, April, June, and September from nonwithheld individual estimated  tax payments, and after April 15 from the settlement of prior year  individual income tax liability.
In addition to tax receipts, net cash raised from note issuances (i.e.,  issuance less redemption) on or around the 15th of the month more than  tripled from $78 billion in fiscal year 2002 to $297 billion in fiscal year 2005.   However, some large midmonth cash inflows from note issuance will not  endure because Treasury shifted 5-year note auctions from the middle to  the end of each month beginning in February 2006.  As a result, cash  inflows from new 5-year debt issuance shifted from the middle to the end of  the month.
section_title: Regular Bill Issuances Alone Are Not Sufficient to Fill Cash Financing Gap
paragraphs: To achieve the lowest borrowing costs over time, Treasury seeks to provide  the market with a high degree of stability in the amount issued of each  security, with the requisite stability increasing with issuance maturity.   Treasury officials said they try to limit swings in regular bill offerings.  This  means regular bill issuances cannot suddenly increase by the amount  needed to make large payments in the beginning of the month nor suddenly  decrease in the middle of the month to absorb large inflows.  In practice,  Treasury only varied the amount of 13- and 26-week bills by $2 billion (less  than 10 percent of the average amount issued) from week to week in fiscal  year 2005.  Since Treasury introduced the 4-week bill in 2001 to help reduce  cash balance swings, its issuance size varies more than that of other regular  Treasury bills.  In fiscal year 2005, the size of the 4-week bill varied by as  much as $13 billion (more than three-quarters of the average amount  issued).  Even so, to meet cash needs—which in fiscal year 2005 averaged  almost $60 billion at the beginning of the month—Treasury has come to  rely on CM bills.
section_title: Treasury Has Increasingly Used CM Bills to Fill Frequent Cash Financing Gaps
paragraphs: The combination of low cash balances in the beginning of the month with  large cash inflows in the middle of the month has led to a general pattern of  CM bill issuance.  Our analysis shows that from 2002 to 2005, on average  about half of CM bills were issued in the first 3 days of the month.   According to Treasury officials, Treasury decides to issue CM bills when it  has low cash balances, which often track the timing of large payments.  In  fiscal year 2005, for example, Treasury issued 11 of its 21 CM bills in the  first 3 days of the month when it had below average cash balances (the  average cash balance for fiscal year 2005 was $25.5 billion) (see fig. 3).  The  amounts issued varied from $4 billion to $42 billion.
The maturity dates of CM bills have varied over the 10-year period we  examined, but since 2002 CM bills have increasingly matured on the 15th of  the month when Treasury receives large cash inflows.  In fiscal year 2005,  Treasury set 68 percent of its $268 billion CM bill borrowings to mature in  the middle of March, April, June, September, and December when Treasury  receives large corporate and individual income taxes.  In these 5 months  Treasury received 72 percent ($213.3 billion) of fiscal year 2005 corporate  income tax deposits. With only one exception, all CM bills issued in fiscal  year 2005, regardless of when Treasury issued them, matured on or around  the 15th of the month (see fig. 4).
Since 2002, Treasury has increasingly filled the approximately 2-week  financing gap by issuing CM bills at the beginning of the month and setting the maturity date of these CM bills for the middle of month.  Table 1  shows that since 2002, 23 CM bills—or more than 40 percent of the number  of CM bills issued—have been issued on the 1st–3rd days of the month and  matured on the 15th day of the month.  These CM bills accounted for more  than half of the total dollar amount of CM bills issued in the last 4 fiscal  years.
section_title: Treasury Also Uses CM Bills to Help Smooth Cash Flows during the April Tax Season
paragraphs: Over the last 10 years Treasury has relied on multiple CM bills to help  manage cash flows in April.  The large cash balance swings in April could  not be accommodated by changes in the regular bill issuance schedule  according to Treasury officials and our analysis.  To help smooth large April  cash flows, Treasury consistently issued three or more CM bills every year  between fiscal years 1996 and 2005 that matured in the later half of April  (on the 15th or later), when Treasury typically received large tax receipts.   For example, in fiscal year 2005 Treasury issued three CM bills—two  matured on April 15 and one matured on April 18—totaling $47 billion and  received about $41 billion in corporate and nonwithheld income and  employment tax payments on those dates.
section_title: Treasury Does Not Control the Timing of All Cash Flows
paragraphs: Better aligning or smoothing cash inflows and outflows could reduce or  eliminate the frequent financing gap thereby reducing the need for some  CM bills but Treasury does not have authority to control the timing of all  cash flows.  Treasury is a passive agent; it collects and disburses federal  funds at agencies’ request.  It does not determine when major benefit  payments are made.  For example, the payment dates of civil service and  railroad retirement are set by law.  Due dates for tax payments are also set  by federal statute.
Treasury does have some control over debt-related cash flows and has  considered how changes in its schedule affect cash flows.  For example,  when making changes to its schedule in 2001, Treasury maintained monthly  issuance of 2-year notes, which are issued at the end of the month and  could help pay regular benefit payments in the beginning of the following  month.  More recently, Treasury moved 5-year note issuance from the  middle to the end of the month.  This change more closely aligns 5-year  note issuance with the beginning of the next month’s payments and may  reduce CM bill issuance in the early part of months.
However, regular securities can only help fill cash financing gaps  temporarily.  No regular security that matures on the same day another is  issued can be used to fill cash financing gaps over the long run because, in  a steady state, most, if not all, of the cash raised at each issuance would be  needed to pay maturing securities.  As a result, Treasury would not raise  large amounts of new cash.  In addition, Treasury generally sets the issue  amount for longer-term securities to cover long-term deficit needs, not  short-term cash shortfalls, and thus the new cash raised with the 5-year  note may not cover the full amount of cash needs in the beginning of the  month.  Although Treasury will likely raise new cash at the end of the  month with the 5-year note until 2011 when 5-year notes issued in 2006  begin to mature, the change in the auction schedule is not likely to  eliminate the need for CM bills.
section_title: Treasury Also Relies on CM Bills When Approaching the Debt Ceiling
paragraphs: When debt is nearing the statutory limit, Treasury has to take a number of  extraordinary steps to meet the government’s obligation to pay its bills  while keeping debt under the ceiling.  Treasury also issues CM bills,  among other actions, to accomplish these goals.  CM bills, like other  Treasury securities, are subject to the debt limit.  However, CM bills allow  Treasury to borrow cash for shorter time periods than regular bills.  On  occasion, Treasury has changed scheduled auctions for its regular  securities and instead issued CM bills so that the debt ceiling will not be  reached.  For example, because of debt limit constraints Treasury delayed  the 4-week bill auction scheduled for Tuesday, November 16, 2004.   Treasury then auctioned a 5-day CM bill for $7 billion on November 17,  2004.  In another example, Treasury said that inaction on the debt ceiling in  2002 led to reduced issuance of 4-week bills and larger, more frequent CM  bill issuance than it would have done otherwise.  During the five DISPs  within the last decade, Treasury issued 19 CM bills totaling $300 billion.  As  table 2 shows, Treasury issued most of these CM bills during the lengthy  DISPs in fiscal years 1996 and 2003.
CM bills will continue to be a useful tool for Treasury when it approaches  the debt ceiling, but, as discussed on page 20 of this report, Treasury pays a  premium for the flexibility CM bills provide.
section_title: CM Bills Cannot Be Used in All Circumstances and Other Alternatives No Longer Exist or Are Limited
paragraphs: Although CM bills offer a means to raise cash in as little as a day, CM bills,  like other Treasury securities, cannot be used when financial markets are  closed or not functioning properly.  Previously, Treasury could obtain cash  on short notice outside financial markets, but this capability ceased more  than twenty years ago.  Treasury was also able to draw on compensating  balances when financial markets closed after September 11, 2001, but these  balances were terminated in 2004.
In the past, Treasury had access to a cash draw authority.  Intermittently  between 1942 and 1981, Treasury was able to directly sell (and purchase)  certain short-term obligations from the Federal Reserve in exchange for  cash.  Treasury used the cash draw authority infrequently and mostly in  times of war or armed conflict.  The Federal Reserve held special short- term certificates purchased directly from Treasury on 228 days between  1942 and 1981.  In the years Treasury used this authority, it borrowed on  about 11 days on average per year.  The Treasury Draw Policy, as amended  in 1979, stated that Treasury could use the cash draw authority only in “unusual and exigent circumstances.”  Congress allowed this authority to  expire in 1981.
Prior to March 2004 Treasury could use compensating balances— noninterest bearing cash balances that were used to compensate banks for  various services—as a source of short-term funding when markets were  closed or during DISPs.  Treasury officials said that compensating balances  were not viewed as a substitute backup facility for Treasury to obtain cash  in the short term and were only used in extraordinary circumstances.  For  example, on September 11, 2001, Treasury had to cancel the auction of   4-week bills, which would have settled on Thursday, September 13, 2001.   Because of the auction cancellation, Treasury lacked sufficient cash to pay  about $11 billion of maturing 4-week bills on Thursday, September 13.   Treasury obtained sufficient cash by drawing down compensating cash  balances.  However, in March 2004, compensating balances were replaced  with direct payments to the banks.
More recently, in the aftermath of Hurricane Katrina, when cash balances  fell more than expected, Treasury obtained cash by canceling a planned  cash investment.  Treasury periodically auctions excess cash to banks  through its Term Investment Option (TIO) program.  Treasury invests cash  through TIOs for a fixed term at a rate determined through a competitive  auction process.  Treasury intended to award a $5.5 billion investment  option on Friday, November 25, 2006.  However, additional spending in  response to Hurricane Katrina caused Treasury’s cash balance to fall to an  unexpected low level on November 23, 2005.  In response, Treasury did not  follow through on the planned investment option.
Using these investments as a source of cash in the future requires that  Treasury actually have excess cash to invest and that it knows it will need  the cash before investment. Reliance on excess cash is limited since  Treasury has placed increased emphasis on minimizing cash balances in  order to reduce overall borrowing costs.  One possible consequence of this  practice is an increased risk that incorrect cash flow predictions or  emergencies could lead to Treasury overdrawing its Federal Reserve Bank  account.  As a result, an important issue for future consideration is how  Treasury might obtain funds to finance government operations should  normal financial market operations be degraded significantly or closed  because of a catastrophic emergency.
section_title: CM Bills Generally Had Higher Yields than Outstanding Bills of Similar Maturity but Lower Borrowing Costs than Currently Available Alternatives
paragraphs: CM bills provide Treasury with flexibility to obtain cash outside its regular  borrowing schedule, but Treasury generally paid a higher yield on CM bills  than outstanding bills of similar maturity paid in the secondary market.   The differential between CM bill yields and similar maturing outstanding  bills—hereafter called the “yield differential”—varied greatly from fiscal  year 1996 through 2005.  We found several factors, both within and  outside Treasury’s control that affected the yield differential.  Despite their  higher yield, CM bills are generally less costly than maintaining higher cash  balances or issuing 4-week bills as means to obtain the cash needed to  make large payments, such as Social Security and federal retirement, at the  beginning of the month.
subsections: section_title: CM Bill Yields Closely Track Other Short-Term Rates
paragraphs: CM bill yields closely track the level of short-term interest rates prevailing  at the time of auction.  This is because investors see other short-term  instruments as close substitutes for CM bills.  They can either buy new bills  or buy existing bills in the secondary market.  In general, investors will not  accept a lower yield (bid a higher price) for a new bill than that available on  an existing bill.  Conversely, investors would not offer a lower price to  obtain a higher yield than prevailing in the market since they would likely  be underbid.  As a result, CM bill yields follow other short-term yields  within a narrow range.
Short-term yields change over time in response to changes in economic  activity, the demand for credit, investors’ expectations, and monetary  policy as set by the Federal Reserve.  CM bill yields declined from about 5.8  percent in 2000 to 1.1 percent in 2004.  This decline reflected the overall  reduction in short-term rates driven largely by the Federal Reserve’s  monetary actions and other market forces.  The Federal Reserve started  lowering the federal funds rate—the interest rate at which banks lend  reserves to other banks overnight—in early 2001, and by 2002 the federal  funds rate was at levels not seen since the early 1960s.  Beginning in the  summer of 2004, the Federal Reserve began to increase the federal funds  rate.  At the same time, CM bill yields increased to an average 2.5 percent in  fiscal year 2005 (see fig. 5).
section_title: CM Bill Yields Were Generally Higher than Yields on Outstanding Bills of Similar Maturity
paragraphs: Treasury paid a higher yield on most CM bills issued during our study  period than outstanding bills of similar maturity paid in the secondary  market.  The average yield differential fell from 47 basis points in fiscal  year 2001 to 5 basis points in fiscal year 2004 (see fig. 6).  In fiscal year  2005, yield differentials grew and CM bill yields were about 14 basis points  higher on average than outstanding bills of similar maturity.
Our analysis identified two important factors behind the yield differential  decline: lower short-term Treasury yields and reduced CM bill issuance.   The first effect was somewhat temporary while the latter effect could last.   The level of short-term interest rates is largely driven by Federal Reserve  policy and market forces rather than by Treasury.  Treasury bill yields have  risen and may continue to rise and eventually reach levels that prevailed in  the late 1990s, thereby erasing the portion of the decline in the yield  differential caused by lower interest rates.  However, because the 4-week  bill is now a permanent feature of Treasury’s auction schedule and has  reduced Treasury’s reliance on CM bills, the portion of the decline in the  yield differential attributable to relatively lower CM bill issuance is likely to  endure.  The experience during fiscal years 2002–2005 as a whole suggests  that the yield differential could remain about 13 basis points below pre- 2002 levels.  These findings are discussed in more detail later in this report.
The large reduction in the yield differential has helped reduce borrowing  costs associated with CM bills.  The daily cost associated with the 47-basis- point yield differential in fiscal year 2001 was about $12,900 per $1 billion.  In fiscal year 2001, Treasury borrowed $19.2 billion (annualized amount  outstanding) using CM bills. Of the $1.06 billion in total borrowing costs  associated with CM bills in that year, $70 million was associated with the  yield differential.  Since then, the average yield differential has declined  and was 14 basis points, or about $3,800 a day per $1 billion borrowed, in  fiscal year 2005.  During fiscal year 2005, Treasury borrowed about $8  billion (annualized amount outstanding) using CM bills.  Total borrowing  costs were $215 million and the borrowing cost associated with the yield  differential was about $12.8 million.  Treasury could achieve savings by  further reductions in the yield differential.
section_title: CM Bill Yields Were Similar to Yields on Overnight Repurchase Agreements
paragraphs: CM bills may have higher yields because, according to Treasury officials  and market participants, they are bought for a different purpose than  regular bills.  According to market participants, some money market funds  and foreign central banks purchase CM bills but for the most part they are  not widely used as an investment tool because of their irregularity and  short-term nature.  Instead, CM bills are primarily used by primary dealers  as collateral for repurchase agreements.  A repurchase agreement is a form  of short-term collateralized borrowing used by dealers in government  securities.  Figure 7 describes repurchase agreements in more detail.
We found the yields of CM bills to be near the yields of overnight  repurchase agreements.  In fiscal year 2005, CM bill yields were within 2  basis points of overnight repurchase agreement yields. Although  repurchase agreements and CM bills are both short-term investments, there  are some differences.  For example, repurchase agreements are subject to  federal, state, and local taxes whereas CM bills are exempt from state and  local taxation.  Also, CM bills, like regular Treasury bills, are risk free  whereas repurchase agreements issued by private borrowers involve some  risk.  The high-quality collateral in a repurchase agreement (e.g., Treasury  securities or agency securities) reduces the credit risk faced by the lender  and allows borrowers to obtain cash at a lower cost than they would obtain  otherwise.  However, the lender is still exposed to credit risk because if  the borrower fails to repay the loan, the market value of the collateral may  be less than the amount owed.  Repurchase agreements are structured  carefully to reduce this credit risk exposure, for example, by lending less  than market value of the security used as collateral.  Nevertheless,  repurchase agreements have more risk than securities issued by Treasury  and accordingly have higher yields than Treasury securities of similar  maturity, which are risk free and are the floor for short-term rates in the  money market.
section_title: Our Analysis Identified Some Features That Affect the Yield Differential
paragraphs: Our statistical analysis found that, all other things equal, the amount of CM  bills issued was positively correlated with the yield differential, meaning  that increases in the amount of CM bills issued relative to the amount of  similar-maturing Treasury bills outstanding increased the yield differential,  and decreases in the amount issued reduced the yield differential.  We  also found that CM bills that were part of a “multiple tranche”— successively issued CM bills maturing on the same day—tended to have  higher yield differentials, and CM bills maturing around large tax payment  dates tended to have lower yield differentials. Changes in the general level  of short-term yields also affected the yield differential.  While the amount  and timing of CM bills is somewhat under Treasury’s control, the general  level of short-term yields in the economy is not.
Although CM bill yields are determined in auctions, we did not find a  statistically significant relationship between the auction performance  measures we examined—such as participation, distribution of auction  awards, and preauction activity in the when-issued market—and the yield  differential.  However, we found that in more concentrated auctions  Treasury was less likely to pay more than the yield indicated in the when- issued market at the time of auction, which is a positive auction result.
subsections: section_title: The Amount of CM Bills Issued Was Positively Correlated with the Yield Differential
paragraphs: While an increase in the relative amount of CM bills might enhance liquidity  and thereby reduce their yields, investors might require a higher yield to  acquire relatively large amounts of CM bills.  Our statistical analysis found  that increases in the amount of CM bills issued relative to outstanding bills  with similar maturity increased the yield differential.  For example, if  Treasury had increased its fiscal year 2005 CM bill issuance by $10 billion,  the average yield differential would have been about 4.2 basis points higher  according to our analysis.  Conversely, reducing the amount of CM bills  issued tended to reduce the yield differential.  Earlier research by others  had similar findings.
According to our analysis, the reduced use of CM bills since the 4-week bill  was introduced contributed to the overall decline in the yield differential.   From fiscal years 1996–2001, the amount of CM bills issued was almost   70 percent of outstanding bills with similar maturity.  In fiscal year 2002, the  share declined to 30 percent.  At the same time, the yield differential  declined from about 35 basis points (fiscal year 1996–2001 average) to  4 basis points in 2002.  According to our analysis, about 35 percent of the  yield differential decline can be attributed to Treasury’s reduced use of CM  bills.  CM bill issuance has remained low relative to outstanding bills with  similar maturity since 2002.  These results suggest that the 4-week bill  reduced both the use and cost of CM bills as Treasury intended.
section_title: Issuing CM Bills in Multiple Tranches May Increase the Yield Differential but Reduce Overall Borrowing Costs
paragraphs: We also found that consecutive CM bills maturing on the same day—called  “multiple tranches”—tended to increase the yield differential.  In recent  years, Treasury has increasingly issued consecutive, small CM bills with the  same maturity date—rather than one larger CM bill—which reduces the  average amount outstanding and ultimately reduces borrowing costs.  In  2005, three-quarters of the CM bills issued were part of a multiple tranche.   Our analysis suggests that issuing consecutive CM bills that mature on the  same date might increase the yield differential by 6 basis points over a  single CM bill.  Market participants suggested if they suspect Treasury  might reopen the CM bill later, they may bid less aggressively on a CM bill,  which would result in lower prices and higher yields for CM bills.
The evidence that issuing in multiple tranches increases the yield  differential should be viewed with caution.  The estimated coefficient is  only significant at the 10 percent level and is sensitive to the inclusion of  other explanatory variables.  For example, with the inclusion of a variable  representing the number of days advance notice before auction, the  coefficient of multiple tranche CM bills is no longer significant even at the  10 percent level.  Moreover, the lower cost of multiple tranches resulting  from smaller average issues and shorter term to maturities most likely  offsets any increase in the yield.  For more information on the cost-saving  effects of multiple tranches, see pages 38–39.
section_title: CM Bills Maturing on Large Tax Payment Dates May Have Lower Yield Differentials
paragraphs: Increasingly Treasury has issued CM bills that mature on individual and  corporate tax payment dates and, according to our analysis, this practice  may be leading to lower yields and borrowing costs.  Our statistical  analysis shows the yield differential on CM bills maturing on or near April  15 or on other tax payment dates (generally the 15th of March, June,  September, and December) is 12 basis points lower than other CM bills.   This may be explained by empirical evidence suggesting that regular  Treasury bills whose maturity dates immediately precede corporate tax  payment dates have special value because corporate treasurers may wish  to invest excess cash in securities whose cash flows can be used to  liquidate cash liabilities.
Almost 50 percent (27 of 55) of CM bills Treasury issued over the last 4  fiscal years matured on large tax payment dates.  In the last 2 fiscal years,  Treasury set at least one CM bill to mature on each of the large tax payment  dates.  So, to a large extent, Treasury has already captured the cost-savings  from this feature.  It is also important to note, however, that the 12-basis  point difference is unlikely to offset even an extra day of borrowing.  CM  bills maturing on dates other than large tax payment dates with shorter  maturities are likely to cost less than CM bills maturing on a corporate tax  payment date with longer maturities because debt is outstanding for a  shorter period of time.
section_title: Yield Differential Rises and Falls with Short-term Yields
paragraphs: Our analysis showed that the yield differential rises and falls with the  overall level of Treasury bill yields.  Figure 8 shows short-term Treasury  yields declined from an average of about 4.8 percent in fiscal year 2001 to  1.05 percent in fiscal year 2004.  At the same time, the average yield  differential fell from 47 basis points to 5 basis points.  Our analysis suggests  the decline in short-term yields explained about 35 percent of the decline.   Since mid-2004 when short-term rates started to increase consistent with  Federal Reserve actions, the yield differential has started to widen again to  about 14 basis points in fiscal year 2005.  Thus, absent Treasury actions,  further increases in short-term rates are likely to lead to higher CM bill  yield differentials in the future.  If short-term Treasury yields return to the  1996–2001 average of approximately 5 percent, we found that the yield  differential could exceed 20 basis points and the additional cost of CM  bills—assuming current issuance patterns—could increase from $11  million to about $19 million a year.
The yield differential may also be attributable in part to variables that are  hard to measure, such as predictability.  According to Treasury officials, a  regular and predictable borrowing schedule is attractive to investors and  helps to achieve Treasury’s objective of lower borrowing costs over time.   However, both the timing and amount of CM bill auctions are by nature less  predictable than regular Treasury bills.  Providing too much advanced  notice of CM bill issuance would reduce Treasury’s flexibility to adjust the  amount and timing of issuance to best meet cash needs.  It could also cause  Treasury to use conservative estimates of its cash needs and borrow more  than it actually needs.  Treasury’s challenge is to provide market  participants enough notice to avoid paying too high a premium for  uncertainty without reducing its flexibility.  Improving cash forecasting  could help Treasury determine the amount of CM bills to be issued sooner  rather than later and thus provide market participants more notice of CM  bill auctions.
Treasury provides limited information on the timing and amount of CM bill  auctions ahead of the announcement.  The Quarterly Refunding process is  Treasury’s way to provide market participants with information and get  their feedback about changes to its auction schedule and the issues actively  under discussion by Treasury.  As part of each Quarterly Refunding,  Treasury usually issues a statement indicating that it plans to issue CM bills  in the coming quarter.  Treasury provides general information on the timing  of CM bills, such as “early March” or “early April” but does not provide the  actual date it expects to issue CM bills.  In contrast, Treasury publishes  the auction schedule, including announcement, auction, and issue dates for  its regular bills up to 6 months in advance.  Treasury typically does not  provide an estimated issue amount for CM bills or regular bills in its  Quarterly Refunding statements.
Despite the general notice given by Treasury and the somewhat regular  pattern of CM bill issuance in recent years, market participants cannot  always predict the timing of CM bill auctions with certainty.  For example,  in fiscal year 2005, a prominent money market analyst predicted the exact  date of 6 (out of 21) CM bill auctions at least 1 week ahead of the auction  announcement and was off by 1 or 2 days for 9 CM bill auctions.  However,  the analyst’s predicted dates for 2 CM bill auctions were off by 6 days, and  the analyst did not predict the remaining four CM bill auctions.
Not only the timing, but also the amount of CM bill issues cannot be  predicted with certainty.  Treasury uses CM bills to manage cash balance  swings and as a result, the amount of CM bills issued varies more than  regular and predictable securities.  Thus, it is not surprising that market  participants cannot predict with certainty the amount of CM bill issuance.   Issuing in multiple tranches may exacerbate the issue.  For example, one  market analyst predicted Treasury would auction one CM bill in the first  week of December 2004 for $28 billion and one CM bill the following week  for $7 billion.  Instead, Treasury auctioned three CM bills totaling   $42 billion in the first week and none the following week.  Several market  participants we spoke with said that uncertainty surrounding the amount  offered affects their bidding and ultimately Treasury’s borrowing terms.  If  market participants are uncertain of the amount, they may not bid as  aggressively, which potentially reduces the price and increases the yield  Treasury pays on CM bills.  In addition, the relative inflexibility of  Treasury’s demand for cash to avoid a negative cash balance might explain  the higher yields on CM bills.
section_title: Most Measures We Examined Suggest CM Bill Auctions Perform Less Well Than 4-week Bill Auctions
paragraphs: Given that CM bill auctions are less predictable than regular Treasury bill  auctions, it is not surprising that CM bill auctions do not perform as well as  regular bill auctions by some measures.  Better auction performance can be  characterized by greater participation and more preauction activity in the  when-issued market.  These factors theoretically reduce Treasury’s  borrowing costs.  By most measures of participation and activity we  examined, CM bill auctions perform less well than 4-week bill auctions.   However, some other measures indicate that Treasury obtained a better  price at CM bill auctions compared with 4-week bill auctions and that there  is stronger demand for CM bills than 4-week bills.
In order to lower borrowing costs, Treasury seeks to encourage more  participation in auctions.  In general, large, well-attended auctions improve  competition and lead to lower borrowing costs for Treasury.  We found that  fewer bidders in total are awarded CM bills than 4-week bills.  For example,  of the 55 CM bill auctions held between 2002 and 2005, more than half had  16 or fewer awarded bidders.  In contrast, only about 4 percent of the 209   4-week bill auctions had 16 or fewer awarded bidders while about 50  percent had at least 22 awarded bidders.
We also found that preauction trading activity is sparse before CM bill  auctions. Treasury auctions are preceded by forward trading in markets  known as “when-issued” markets.  The when-issued market is important  because it serves as a price discovery mechanism that potential  competitive bidders look to as they set their bids for an auction. When- issued trading reduces uncertainty about bidding levels surrounding  auctions and also enables dealers to sell securities to their customers in  advance of the auction so they are better able to distribute the securities  and bid more aggressively, which results in lower costs to Treasury.  We  counted the number of preauction trades on the day of CM bill auctions and  found that when-issued trading is lower prior to CM bill auctions than  regular 4-week bill auctions.
A broad range of participants generally improves competition and  theoretically maximizes the price investors pay for Treasury securities.   Alternatively a higher concentration—a large share of the auction awarded  to few participants—could reduce competition and restrict a security’s  supply in the secondary market, preventing its efficient allocation among  investors.  We evaluated the share of the auction awarded to the top five  bidders—a measure used by Treasury in its own studies of auction  performance—and found that the share was 60 percent or higher in over  half (34 of 55) of CM bill auctions from fiscal year 2002 through 2005.  In  contrast, the share exceeded 60 percent in only 18 percent (37 of 209) of   4-week bill auctions in the same period.  While a higher concentration  theoretically reduces competition and the price investors pay, according to  Treasury a high concentration ratio in CM bill auctions may imply some  bidders really want a particular bill, which may drive the price up and yield  down.
Although greater participation, a broader distribution of awards, and more  preauction activity in the when-issued market theoretically improves  Treasury’s borrowing costs, we did not find a statistically significant  relationship between these factors and the yield differential.  However, we  did find that concentration was negatively correlated with the auction  spread.  The auction spread is the difference between the yield Treasury  obtains at auction and the yield in the when-issued market at the time of  auction.  A positive spread (where the auction yield is more than the  contemporaneous when-issued yield) indicates Treasury paid a higher yield  than expected, which is a negative auction result.  Our statistical analysis  suggests that Treasury was less likely to pay more than the expected yield  indicated in the when-issued market in more concentrated auctions.  In  other words, higher concentration seemed to improve Treasury’s auction  results.  App. II provides more information on our CM bill auctions  analysis.
section_title: CM Bills Are Generally Less Costly than Currently Available Alternatives
paragraphs: Treasury could maintain higher cash balances or issue regular Treasury  bills (e.g., the 4-week bill) to avoid issuing a CM bill to meet short-term  cash shortfalls.  When evaluating CM bills relative to other alternatives, it is  important to look at total borrowing costs—not just the yield.  Treasury’s  borrowing costs are based on the amount borrowed, the yield it pays to  borrow, and the time the debt is outstanding.  We found that CM bills are  generally less costly than currently available alternatives despite their  higher yield.
subsections: section_title: CM Bills Are Generally Less Costly than Running Higher Cash Balances
paragraphs: To avoid issuing a CM bill, Treasury could run higher cash balances to  bridge cash financing gaps.  However, it is generally more cost-efficient to  repay debt and then issue a CM bill than run higher cash balances because  the interest earned on excess cash balances is generally insufficient to  cover borrowing costs.  Treasury’s current cash balance target is $5 billion,  which represents the amount to be held at the Federal Reserve.  Treasury  invests excess cash above the $5 billion target in Treasury Tax and Loan  (TT&L) accounts.  TT&L accounts are held at financial institutions and  earn interest rates equal to the federal funds rate less 25 basis points.  The  rate earned on TT&L accounts is generally less than the average rate  Treasury pays on CM and regular short-term bills.  As a result, Treasury  faces a negative funding spread.  The funding spread varies over time and  depends on Treasury bill rates relative to the federal funds rate—increases  in Treasury bill yields relative to the federal funds rate increase Treasury’s  negative funding spread, and declines in Treasury bill yields relative to the  federal funds rate reduce Treasury’s negative funding spread.
As a result of the negative funding spread, Treasury strives to minimize  cash balances in order to reduce overall borrowing costs.  To do this,  Treasury has worked toward improving cash forecasting.  Treasury has  reduced the average cash forecasting error by one-half over the last 6 years  according to Treasury officials.  They credited improvements to better  technology and communication with their “lockbox banks” that process  certain tax payments.  For example, the Electronic Federal Tax Payment  System provided actual cash flow information to Treasury forecasters  through electronic notification of pending tax payments, replacing  imperfect forecasts.
Increasing the earnings on excess cash balances is another way to narrow  the negative funding spread.  Figure 9 below describes steps Treasury has  taken to increase earnings on its excess cash balances.
To make large payments when cash balances are low, Treasury can issue a  CM or a regular Treasury bill, although as explained earlier Treasury tries  to limit changes in the size of regular bill issuance from week to week.   When comparing the cost of a CM bill with the cost of a 4-week bill—the  regular bill with the shortest maturity—we see that the CM bill is generally  less costly for shorter-term needs (i.e., less than 28 days) despite its higher  yield.  While the 4-week bill may have a lower yield, the amount borrowed  is generally outstanding for a longer period.  For example, Treasury issued  a CM bill on June 3, 2005, for $16 billion.  The daily cost of borrowing was  about $1.3 million.  If Treasury had borrowed $16 billion using the 4-week  bill issued the day before, the daily borrowing cost would have been only  $1.2 million but the amount would have been outstanding for 16 days  longer and cost an additional $18.4 million (see table 3).  However, the  extra cost of the 4-week bill would be partially offset by the amount earned  on cash balances.
To compare the total cost of the 4-week bill with the cost of a CM bill  requires also looking at what happens to the cash that would have been  used to pay the maturing CM bill.  CM bills are typically issued in months  with midmonth cash inflows.  If Treasury issued a 4-week bill instead of a  CM bill in these months, these midmonth cash flows could be held in TT&L  accounts. However, since Treasury generally earns less on excess cash  balances than it pays to borrow, the additional borrowing costs associated  with the 4-week bill may not be completely offset.
section_title: Treasury Has Refined Its Use of CM Bills but Costs Have Begun to Increase
paragraphs: Treasury has taken steps to reduce use and overall cost of CM bills.   Lowering borrowing costs of CM bills could be achieved by combinations  of reducing the dollar amount issued or reducing the term to maturity (i.e.,  the number of days outstanding).  Recognizing that CM bills were a  relatively costly way to absorb cash balance swings, Treasury introduced  the 4-week bill in 2001 to help reduce the use of CM bills.  Treasury has also  increasingly issued CM bills in multiple tranches, which contributes to  smaller average issues, shorter terms to maturity, and lower total  borrowing costs.  Borrowing costs declined in 2002 as Treasury reduced  the use of CM bills for longer-term borrowing (i.e., 28 days or more) and  short-term rates declined.  However, borrowing costs associated with CM  bills have increased since 2003.
subsections: section_title: Treasury Initially Reduced the Amount of CM Bill Issuance Following the Introduction of the 4-week Bill
paragraphs: Treasury has reduced reliance on CM bills since 2001.  Initially, Treasury  reduced the total amount of CM bills issued by more than half from $346  billion in fiscal year 2001 to only $124 billion in fiscal year 2002 (see fig. 10).   This was the lowest amount issued in the previous 6 years.  The decline in  CM bill issuance, however, was only temporary.  Since 2002, Treasury has  increased its use of CM bills and in fiscal year 2005, Treasury issued $268  billion in CM bills.
In 2001, Treasury said that CM bills were not the most cost-efficient means  to absorb cash balance swings.  At that time, the yield differential was  about 47 basis points and the amount of CM bills issued was about 20  percent of Treasury’s short-term financing.  Treasury introduced the 4-week  bill in 2001 to help reduce the need for CM bills by helping to smooth  swings in cash balances.  In general, shorter-term securities provide  Treasury greater flexibility to adjust cash balances and outstanding debt in  response to actual cash needs.  From fiscal year 2002 through 2005, CM  bills represented only 7 percent on average of Treasury’s short-term debt  issuance.  However, according to Treasury, the ability of the 4-week bill to  absorb cash balance swings is limited to swings in cash balances that are  longer than the two-week cash financing gap at the beginning of most  months.
section_title: Issuing CM Bills in Multiple Tranches Has Helped Reduce Borrowing Costs
paragraphs: Treasury has taken steps to borrow cash closer to the day it is needed,  which contributes to smaller average issues, shorter terms to maturity, and  lower borrowing costs.  Since 2003, Treasury has increasingly issued CM  bills in multiple tranches—successive shorter-term CM bills that mature on  the same day.  For example, instead of issuing one $30 billion or $40 billion  CM bill on the 1st that matured on the 15th, Treasury might issue three  smaller CM bills on the 1st, 3rd, and 7th (all matured on the 15th).  As  mentioned earlier, issuing in multiple tranches may increase the rate paid,  but it allows Treasury to borrow closer to the time when cash is needed and  ultimately reduces borrowing costs by reducing the average term to  maturity and annualized amount outstanding.  Table 4 shows how issuing in  multiple tranches would have reduced borrowing costs in June 2005.
The move toward multiple tranches has led to smaller CM bill issues on  average.  Figure 11 shows that the average CM bill issue has declined by  more than half since 2001.
Following introduction of the 4-week bill in 2001, Treasury reduced the use  of CM bills for longer-term borrowing (i.e., 28 days or more).  Figure 12  shows that Treasury has reduced the average term to maturity (i.e., length  of time outstanding) for CM bills issued by about half since 2001.  Prior to  fiscal year 2002, Treasury issued CM bills with terms as long as 83 days.   Since 2002, the longest maturing CM bill was 19 days.
Lower average issue sizes together with the reduced term to maturity  contributed to lower borrowing on an annual basis (see fig. 13).  After  Treasury introduced the 4-week bill in 2001, the annualized amount of CM  bills outstanding declined dramatically from $19.2 billion in fiscal year 2001  to $3.3 billion in fiscal year 2002.  However, since then the amount has  generally increased as Treasury increased the use of CM bills to finance  intramonth cash financing gaps.  From fiscal year 2003 to fiscal year 2004,  the annual amount outstanding more than doubled to $8.1 billion.  Treasury  issued a similar amount of CM bills in fiscal year 2005.
section_title: Borrowing Costs Declined Dramatically in 2002 but Have Since Increased
paragraphs: While Treasury’s actions from fiscal years 2001 to 2002 reduced CM bill  borrowing costs, overall declining interest rates also helped.  Borrowing  costs began declining in 2001 and dropped dramatically in 2002 (see fig.  14).  Treasury’s smaller CM bill issuances and reduced term to maturity  helped reduce the annual amount outstanding.  According to our analysis,  these actions taken by Treasury contributed to about $610 million of the  reduction in borrowing costs from 2001 to 2002.  We estimated that the  remaining decline was due to reductions in the yield paid on CM bills.  As  noted earlier the yield differential varies with the overall level of short-term  yields in the economy.  As these yields declined so did the yield  differential—by 43 basis points from fiscal year 2001 to 2002.
However, since 2003 the borrowing costs associated with CM bills have  increased.  Our analysis indicates that almost all of the increase in CM bill  borrowing costs is due to increasing rates.  While Treasury cannot control  the overall level of short-term interest rates in the economy, it can continue  to take steps to reduce the use of CM bills and, according to our analysis,  the CM bill yield differential.
section_title: Options Exist That May Reduce the Use and Cost of CM Bills
paragraphs: We identified a range of options that may reduce the use or cost of CM bills.   The most promising options in our view—exploring ways to better align  cash flows and increasing the earnings on cash balances—are discussed  first.  Other options, such as introducing a new shorter-term regular bill and  enhancing the transparency of CM bill auctions, are discussed later.
subsections: section_title: Better Aligning Cash Flows Might Reduce Cash Financing Gap
paragraphs: Given that Treasury has increasingly used CM bills to fill regular cash  financing gaps, taking steps to better align large cash flows might help  reduce the use of CM bills.  There are three ways to do this:  smoothing the  payment of large federal expenditures, smoothing the payments of  corporate and nonwithheld individual tax payments, and aligning increased  debt issuance with large payments.  If cash flows had been aligned to better  fill the frequent cash financing gaps, Treasury may not have needed the 11  CM bills it issued on the 1st through the 3rd of the month that matured on the  15th of the month during fiscal year 2005 and could have reduced CM bill  borrowing cost by as much as $174 million or about 80 percent in fiscal  year 2005.
Statutory and regulatory changes would be required to change the timing of  federal benefit payments and tax collections.  While implementing any  changes is outside debt managers’ control, Treasury could start a  discussion with other agencies and Congress to identify the costs and  benefits of alternatives to align or more evenly distribute federal  expenditures and tax receipts and seek any statutory authority necessary  to better smooth them.  However, changing the timing of benefits and tax  collections, either jointly or independently, will have direct and indirect  effects not only on borrowing costs but also on individuals, nonfederal  entities, and federal government operations.  These of course, would have  to be considered when making decisions about whether and how to smooth  federal cash flows.  Looking at SSA’s experience with spreading the  payments for new Social Security beneficiaries throughout the month may  be useful.
Treasury could also explore aligning increased borrowing capacity with  large payments in the beginning of the month to help reduce the cash  financing gap and reduce the use of some CM bills.  Overall borrowing  needs are projected to be significant and grow over the long term and  Treasury will need to consider changes to its debt portfolio and auction  schedule to increase borrowing.  Cash flow considerations can be a  tiebreaker when choosing between equally attractive alternatives.  In the  past, when making changes to the range of maturities offered, Treasury has  considered aligning cash inflows with outflows in the beginning of the  month.  Going forward, Treasury may reduce its reliance on CM bills—at  least temporarily—by continuing to consider adjustments that would better  align its increased debt issuance with its largest cash payments in the  beginning of the month.
section_title: Increasing Earnings on Cash Balances Would Reduce the Costs Associated with Running Higher Cash Balances to Avoid Issuing CM Bills
paragraphs: Currently, Treasury faces a negative funding spread and as a result it is  more costly to maintain high cash balances to meet upcoming payments  than issue a CM bill.  However, increasing the earnings on cash balances  would reduce the costs associated with running higher cash balances and  may ultimately reduce the use of some CM bills.  Treasury previously  explored increasing the rate earned on TT&L accounts; however, banks  objected.  Since then, Treasury introduced the TIO program, which pays  higher rates on cash balances than the TT&L program.  Increasing balances  in TIOs relative to the TT&L accounts would help Treasury increase  earnings on its cash balances.  However, Treasury would lose some  flexibility because TIO balances are not callable in the event cash balances  unexpectedly fall below cash needs.
Treasury could also explore broader options to increase earnings on cash  balances.  For example, some countries’ debt management offices engage  in reverse repurchase agreements.  In a reverse repurchase agreement,  Treasury would lend market participants cash to purchase securities in the  secondary market.  The borrower would then return the cash borrowed  plus interest at a specified time, usually overnight.  Reverse repurchase  agreements could potentially narrow Treasury’s negative funding spread  because repurchase agreement rates are generally higher than rates earned  on TT&L accounts.  Treasury could explore the benefits and cost of  designing a new system to perform these transactions but implementing  reverse repurchase agreements would require legislative authority  according to Treasury.
section_title: Shorter-term Regular Bills Might Reduce the Need for Some CM Bills
paragraphs: Another way to smooth cash flows would be to introduce a shorter-term  instrument.  The 4-week bill was partially successful in smoothing cash  flows throughout the year and reducing the use of CM bills.  However, in  recent years, Treasury has increasingly used CM bills to fill cash financing  gaps that frequently occur in the first two weeks of the month.  Introducing  a regular shorter-term bill might help fill the frequent cash financing gap  and reduce the use of CM bills further.  A new bill that matures on  Thursdays like other regular bills would not give the Treasury the same  flexibility as CM bill issuance because the beginning-of-month outflows and  midmonth inflows often fall on different days of the week.  Alternatively, a  new short-term security with specific issue and redemption dates (rather  than day of the week) might help the Treasury manage cash flow gaps.
In Treasury’s view, a shorter-term security would not likely generate market  interest in a way that would distinguish it, on a cost basis, from CM bills.   However, our analysis of CM and similar-maturing outstanding bills in the  secondary market shows that buyers pay higher prices (or accept a lower  yield) for short-term bills than Treasury currently accepts (or pays) for CM  bills.  Market participants we spoke with expressed mixed views on the  demand for another short-term Treasury security.  While some said there  may not be enough demand for a short-term instrument, others said that  bills maturing on the 15th, for example, would have natural buyers and give  investors more flexibility by offering another maturity date for short-term  instruments.  Our analysis shows that CM bills maturing on the 15th of  months when tax payments are due likely have lower yields than CM bills  maturing on other days.  Treasury can examine whether it would obtain  better prices on a shorter-term bill with issue and maturity dates on specific  days of the month.
section_title: Enhancing Transparency of CM Bill Auctions May Reduce CM Bill Yields
paragraphs: Increased transparency on the potential size of CM bills might improve  bidding in CM bill auctions and potentially reduce the yield Treasury pays  on CM bills.  While market participants might expect Treasury to issue CM  bills in the beginning of the month, market participants told us that they do  not always know the size of the CM bill offering.  As a result, they may not  bid as aggressively.  However, there are tradeoffs to consider.  In order to  provide market participants more advanced notice on the general size and  timing of CM bills, Treasury would have to improve its own cash  forecasting.  Also, Treasury achieves lowest-cost financing in part by  providing the market with certainty.  Trying to add certainty to CM bill  issuance would eliminate the benefit of flexibility they provide and may  actually increase borrowing costs.
section_title: Relaxing the 35-percent Cap on CM Bill Auction Awards May Reduce CM Bill Yields
paragraphs: Treasury limits the maximum auction award to a single bidder to 35 percent  of the total amount offered to the public.  The 35-percent cap is intended,  in part, to foster a liquid secondary market for a new issue by ensuring  adequate and wide distribution of the supply of a security among investors  and prevent temporary shortages or “short squeezes.”  However, our  analysis suggests that relaxing the 35-percent rule for CM bill auctions (and  thus allowing higher concentration) might promote more aggressive  bidding, improve auction prices for Treasury, and thus reduce the  borrowing costs associated with CM bills.  There are a number of issues to  explore.  For example, market participants may come to expect poorer  liquidity for CM bills, which may lead to less aggressive bidding over time.   Further, there would be a higher risk of a squeeze in the CM bills market,  although the risk would be relatively small in our view because CM bill  trading is sparse both before auctions and after auctions according to our  analysis.  (See app. II for more information.)  Treasury could explore  adjusting the per-bidder cap on an experimental basis and determine  whether there are benefits of relaxing the existing 35-percent rule in CM  bill auctions.
section_title: Exploring Other Countries’ Short-term Cash and Debt Management Practices May Provide Useful Insights
paragraphs: Lastly, exploring other countries’ practices may provide useful insights.   For example, other countries’ debt management offices use repurchase  agreements as a tool to support their cash management.  Exploring other  countries’ experiences may provide insights on the benefits and costs of  repurchase agreements for a central government.  Although repurchase  agreements generally have slightly higher yields than CM bills, they provide  an alternative way to obtain cash for short periods, usually overnight.  In  fiscal year 2005, Treasury announced that it was examining the feasibility  of a securities lending facility, which would operate much like a repurchase  agreement.  Although this facility is still in its early proposal process,  Treasury generally intends to lend securities that are in such short supply  that they may threaten the settlement of Treasury market transactions in a  timely manner.  In return, Treasury would receive cash or bonds.  While  Treasury intends borrowers to use this facility at their discretion and does  not plan to use it for Treasury’s own cash needs, it might also consider how  the facility would affect its cash balances and whether the lending facility  could be used to obtain cash for very short periods.
section_title: Conclusion
paragraphs: In the face of persistent federal deficits and growing net interest costs,  reexamining debt management practices is warranted.  Treasury has made  progress toward reducing the cost of CM bills, but it may be possible to do  more.  This report presents options worth exploring that taken alone or in  combination may further reduce federal borrowing costs by reducing either  the use or the cost of unscheduled CM bills.  CM bills will continue to be a  necessary debt management tool to meet unexpected cash needs when  Treasury has low cash balances or when Treasury is nearing the debt  ceiling.  However, in recent years, Treasury has increasingly used CM bills  to fill cash financing gaps that frequently occur in the first two weeks of the  month.  Our analysis indicates that the yield differential between CM bills  and outstanding bills of similar maturity has increased as short-term rates  have risen.  If these rates rise further, as market participants expect, and  return to levels consistent with a longer-term historical average, the CM bill  yield differential is likely to rise above levels seen in recent years.  While  Treasury does not vary its debt management strategy in response to  changing interest rates, it should be mindful that increasing rates are likely  to raise the relative cost of unscheduled CM bills.  As a result, Treasury  should consider options, including better aligning cash flows and  increasing earnings on cash balances, that may reduce the frequent use of  CM bills and ultimately overall borrowing costs.
section_title: Recommendation for Executive Action
paragraphs: We identified options that could potentially reduce the use and cost of CM  bills.  We recommend that Treasury explore options such as those  discussed in this report and any others it identifies that may help Treasury  meet its objective of financing the government’s borrowing needs at the  lowest cost over time.  We recognize that there are a number of tradeoffs to  consider.  In its exploration, Treasury should consider the costs and  benefits of each option and determine whether the benefits—in the form of  lower borrowing costs—to the federal government (and so to taxpayers)  outweigh any costs imposed on individuals, businesses, and other  nonfederal entities.  Treasury should also consider how options may be  combined to produce more beneficial outcomes.
Implementing some of these options would require changes to statute or  regulations.  If Treasury determines that any of these changes would be  beneficial, we encourage Treasury to begin discussions with relevant  federal agencies and the Congress about obtaining the necessary  authorities.
section_title: Agency Comments
paragraphs: We requested comments on a draft of this report from Treasury and the  Federal Reserve.  In oral and written comments, Treasury generally agreed  with our findings, conclusions, and recommendations.  Treasury said that it  is committed to continuing to explore ways to further reduce financing  costs through changes in the use of CM bills and that many of the options  we identified are embodied in its current debt management policy.   Treasury emphasized that statutory authority is needed for some options,  particularly changing the timing of receipts and expenditures and  improving earnings on excess cash balances.  Treasury also suggested  some technical changes throughout the report that we have incorporated  as appropriate. Treasury’s comments appear in appendix IV.  In addition,  the Federal Reserve Board provided technical comments that we  incorporated as appropriate.
As you know, 31 U.S.C. § 720 requires the head of a federal agency to  submit a written statement on actions taken to address our  recommendations to the Senate Committee on Homeland Security and  Governmental Affairs and to the House Committee on Government Reform  not later than 60 days after the date of this report. A written statement must  also be submitted to the House and Senate Committees on Appropriations  with the agency’s first request for appropriations made more than 60 days  after the date of this report. Because agency personnel serve as the primary  source of information on the status of recommendations, we request that  the agency also provide it with a copy of your agency’s statement of action  to serve as preliminary information on the status of open  recommendations.
We are sending copies of this report to the Chairs and Ranking Members of  the House Committee on Ways and Means, the Senate Committee on  Finance, the House Committee on Financial Services, the Senate  Committee on Banking, Housing and Urban Affairs, and other interested  parties. We will also make copies available to others upon request. In  addition, the report will be available at no charge on GAO’s Web site at  http://www.gao.gov.  If you or your staff have any questions about this  report please contact Susan J. Irving at (202) 512-9142 or irvings@gao.gov  or Thomas J. McCool at (202) 512-2700 or mccoolt@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 V.
section_title: Detailed Methodology and Findings of Statistical Analysis of Cash Management Bill Yield Differential
paragraphs: To identify which cash management bill (CM bill) features, if any, explained  the higher yields paid on CM bills, we performed a statistical analysis of CM  bills issued during fiscal years 1996–2005.  The dependent variable in the  regressions was the difference between a CM bill’s investment yield at the  time of auction and the investment yield on similar-maturity Treasury bills  (i.e, the “yield differential”), where the latter is measured by the weighted  average yield on Treasury securities that mature immediately before and  after the CM bill.  We regressed the yield differential on key CM bill  features including announcement period, term to maturity, issuance  amount, and whether the CM bills were off-cycle or a reopening of a  previous issue.  We also examined the effects of CM bills with different  issue and maturity dates, such as whether the CM bills were issued on the  1st–3rd, matured on a large tax payment date, or were issued during a debt  issuance suspension period (DISP). While we analyzed the yield differential  for all CM bills issued during fiscal years 1996–2005, we focused on the 55  CM bills issued during fiscal years 2002–2005 because the introduction of  the 4-week bill in 2001 led to a significant reduction in the amount and term  to maturity of CM bills and caused a structural change in the CM bill  market.
Our empirical results suggest that several variables affected the yield  differential during the period studied.  Lower yield differentials appeared to  be associated with lower short-term interest rates, relatively low CM bill  auction amounts, and maturity around large tax payment dates.  There is  also some evidence that CM bills have higher yields when issued in multiple  tranches, which are successively issued CM bills with the same maturity  date.  Despite these findings, the opportunity for Treasury to achieve  additional savings by further exploiting characteristics that affect CM bill  yields appears limited.
subsections: section_title: Previous Research Based on Earlier Data Suggests Some CM Bill Features May Reduce Costs
paragraphs: The existing literature on CM bills and their costs is limited.  In an early  study of CM bills issued from 1980 through 1988, Simon found that from 1  day before to 1 day after announcement, the average interest rate  differential between CM bills and adjacent-maturity Treasury bills  increased by 20 basis points to a statistically significant 28 basis points.   An analysis of variance demonstrated that the increase in the differential  was greater for CM bills that had shorter maturities, were part of larger  issues, or had shorter when-issued periods.  In a later study, Simon found  that from January 1985 through October 1991 CM bills cost about 6 basis  points more than regular bills. There have been many fundamental  changes in the way Treasury raises short-term cash since the article’s  publication that may make its findings less applicable now.  These changes  include the move from multiple-price to single-price auctions, the growth  of the repurchase agreement market and the prevalence of off-cycle CM  bills.  Most important was the addition of the 4-week Treasury bill to  Treasury’s regular borrowing schedule in 2001, which led to a significant  reduction in the amount and term to maturity of CM bills.
In a study of the effect of reopenings on the liquidity of Treasury bills,  Fleming included a binary variable identifying CM bill reopenings.   Fleming studied Treasury bills issued from 1996 to 2000 and found that  reopenings of any kind had a positive and significant effect on yields.   Moreover, the CM bill variable was significantly positive for 13-week bills,  demonstrating that regular bills reopened as CM bills tend to have higher  yields.  Fleming interpreted the results as showing that the yield-reducing  effect of enhanced liquidity is more than offset by the yield-increasing  effect of an increase in supply.
In a recent paper, Seligman evaluated the differential between CM bill  yields and the yields on Treasury bills with similar maturity dates.
Seligman found that CM bills that were issued off-cycle or were large  (relative to outstanding Treasury bills of similar maturity) had higher yields  than other CM bills.  In contrast, CM bills with longer durations or that had  2-day notices before auction had lower yields than other CM bills.  This  study suggested that Treasury could reduce the yields of CM bills by  avoiding off-cycle issuances, reducing their relative size, issuing CM bills  with longer terms, and giving 2 days notice in advance of auctions.
However, the data in Seligman’s study covered auctions held between 1990  and 1999.  Seligman’s sample did not cover more recent CM bill auctions  that occurred since 2001 when the 4-week bill was introduced and only  very short-term CM bills were issued.  Hence, the findings of his study may  not apply to the current environment.
In another recent study based predominantly on auctions held before the  introduction of the 4-week Treasury bill, Christopher found that the cost of  CM bills, as measured by the spread between CM bill and repurchase  agreement yields, is negatively influenced by the time between the sale of a  security and the settlement date.  The rationale offered for this finding is  that the delay allows administrative efficiencies.  Christopher, like  Seligman, found that longer-maturity CM bills have lower yields than  shorter maturities.  She suggests that the optimum maturity of a CM bill is  nearly 93 days.  This finding highlights the inapplicability of earlier  research to the current environment when 4-week Treasury bills are  available to help meet short-term financing needs.
section_title: Comparing CM Bill Yields with Secondary Market Yields on Similar-maturing Treasury Bills
paragraphs: Choosing the appropriate reference point for CM bill yields is important,  and differed in earlier studies.  Christopher focused on the difference  between CM bill and repurchase agreement yields instead of the difference  between yields on CM bills and Treasury bills with similar maturities,  which was the focus of Simon’s earlier research, Seligman’s, and our own  research.  Although repurchase agreements and CM bills are both means to  obtain cash in the short-term, they have a major difference—CM bills, like  regular Treasury bills, are risk free whereas repurchase agreements issued  by private borrowers involve some risk.  As a result, we focus on the  difference between CM bill and outstanding Treasury yields because it  provides a more direct indicator of the higher yield that Treasury pays  when issuing CM bills.  Financial market analysts we spoke with agreed  that this yield differential measure was an appropriate focus for our  research.
Specifically, our estimate of the yield differential is the difference between  a CM bill’s yield and the average secondary-market yield on other Treasury  bills that are most similar (in terms of maturity) to the CM bill on the day of  auction.  That is, we compare CM bill yields with yields on the two nearest- maturing—one before and one after—Treasury bills.  CM bill yields were  obtained from the Bureau of the Public Debt (BPD) while rates on similar- maturity outstanding Treasury bills were obtained from the Wall Street  Journal (WSJ).  For each Treasury bill, the bid and ask rates were  converted to yields and averaged.  Next, the weighted average yield for the  two bills nearest in maturity to the CM bill was derived.  The weights were  based on the relative difference in each bill’s maturity date from that of the  CM bill, with the Treasury bill having a closer maturity date receiving a  greater weight and the weights summing to one.  In the final step, the  weighted average Treasury bill yield was subtracted from the CM bill  auction yield to obtain the yield differential.
There are limitations of our yield differential estimate.  For example, any  effect from the announcement of CM bills on yields for similar-maturing  bills is not captured.  If the announcement of a CM bill 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 CM bills  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 CM bills would be higher than outstanding  securities that did not include CM bills.  However, few CM bills issued in  fiscal years 2002–2005 were reopenings.  Alternatively, if the yield curve  were upward sloping and concave, the curvature of the yield curve would  result in a positive estimate of the spread even before considering the  effects of other factors and create a positive bias in our calculation of the  yield differential.
section_title: The Introduction of the 4-week Treasury Bill Reduced CM Bill Maturities and Their Relative Importance in Short-term Financing
paragraphs: Table 5 provides data on key attributes of CM bills, many of which we used  in an attempt to explain the yield differential.  The table divides the data  into two subperiods.  The first subperiod covers auctions held from fiscal  year 1996 through fiscal year 2001 before the introduction of the 4-week  Treasury bill, while the second subperiod includes auctions held from fiscal  year 2002 through fiscal year 2005 after the 4-week bill’s introduction.
Table 5 highlights the significant difference in CM bill maturities between  the two subperiods.  For the 66 CM bills auctioned in fiscal years 1996  through 2001, the average maturity exceeded 27 days while the longest- maturity CM bill had a term of 83 days.  In contrast, in the 55 CM bill  auctions held from fiscal year 2002 through 2005 the average maturity of  the CM bills was only 9.6 days while the longest-maturity CM bill had a term  of 19 days.  In the more recent period even the maximum maturity of 19  days was much shorter than the average maturity of 27.4 days during the 6  years before 4-week Treasury bills were introduced.
Treasury also reduced its reliance on CM bills for short-term financing after  2001.  The average dollar amount of CM bills issued at each auction  declined from $21.6 billion in fiscal years 1996 through 2001 to only $14.8  billion in fiscal years 2002 through 2005.  In contrast, Treasury increased  issuance of regular short-term Treasury bills.  Before fiscal year 2002 the  average amount of outstanding Treasury bills with similar maturities to  newly auctioned CM bills was $33.1 billion.  The average rose to   $65.9 billion in the more recent period.  As a result, newly auctioned CM  bills averaged less than one-fourth of the average amount of outstanding  Treasury bills with similar maturities during the more recent subperiod  compared with three-fourths during the earlier subperiod.  This reflects the  importance of 4-week Treasury bills during the later period.
Many of the features listed in table 5 were represented by binary variables  set equal to 1 if a CM bill had the characteristic and 0 if it did not.  Binary  variables include: auction during a DISP, issuance on the 1st–3rd days of the  month, maturation on a tax due date and a combination of issuance on the  1st–3rd days and maturation on a large tax due date.  Additional binary  variables capture whether or not a CM bill matured between April 15 and  the end of the month and whether or not a CM bill was part of a multiple  tranche.  For each binary variable, table 5 shows the percentage of CM bills  that had a particular feature.  Among the most notable change in these  characteristics between the two subperiods was the more than twofold  increase in the share of CM bills issued off-cycle from 39 percent to   86 percent.
section_title: Our Study Focused on CM Bills Issued during Fiscal Years 2002–2005
paragraphs: Because of the dramatic decrease in CM bill maturities and reduced  reliance on CM bills for short-term financing after the introduction of the   4-week bill, our effort to identify characteristics that might affect the yield  differential focused on CM bill auctions held from fiscal years 2002 through  2005.  Column A of table 6 provides the estimated coefficients and  summary statistics for an equation that includes attributes that have a  significant effect on the yield differential.  Using the same specification for  the 66 CM bill auctions for the earlier period that extended from fiscal  years 1996 through 2001 produced results that differ significantly from the  estimates for the more recent period.  Testing this specification for  structural change using a Chow test resulted in an F-statistic of 5.18, which  permitted us to reject the hypothesis that the relationship remained stable  between the two periods at the .01 level of confidence.  This test result  provided support for our decision to focus on auctions held after the  4-week Treasury bill was introduced.
section_title: Yield Differential Is Positively Correlated with Level of Treasury Bill Yields
paragraphs: Our analysis suggests that investors may require a proportionate rather  than an absolute differential as compensation for unscheduled CM bills.   While previous research has not examined whether the yield differential is  correlated with the overall level of Treasury bill yields, figure 8 in the main  text indicates that the differential may tend to move in the same general  direction as the level of secondary-market yields on Treasury bills with  similar maturity.  The estimated coefficient of the Treasury bill yield shown  in column A of table 6 is 0.038, which suggests that a 1-percentage-point  increase in the Treasury bill yield is associated with a 3.8-basis-point  increase in the yield differential.  During fiscal year 2005, for example, the  average yield on Treasury bills with maturities comparable to newly  auctioned CM bills was 2.42 percent and the yield differential averaged 13.5  basis points.  If the yields on comparable-maturity Treasury bills had been 5  percent instead of 2.42, the results imply that yield differentials would  have been about 10 basis points higher in fiscal year 2005 than they actually  were.  A continuation in the rise in Treasury bill yields that began in 2004 is  therefore likely to result in an increase in the yield differential.
section_title: Yield Differential Is Positively Correlated with Auction Amounts
paragraphs: Our results show that as the supply of a CM bill rises relative to the supply  of similar investment alternatives, the relative price of the CM bill declines  and the yield differential increases. The results for the 55 auctions held  from fiscal years 2002 through 2005 suggest that the yield differential rises  with an increase in the ratio of the amount of CM bills auctioned to the  average amount of similar-maturity Treasury bills outstanding, as shown by  the positive and significant coefficient of 0.282 for this variable.  The  variable’s significant positive coefficient is consistent with the results of  Simon, Fleming, and Seligman.  In studying the relationship between  auction size and yields, Seligman noted that an increase in the relative  amount of CM bills auctioned could have two opposite effects on their  relative yields. On the one hand, a higher relative amount could increase  liquidity and therefore reduce the yield differential.  On the other hand, a  higher yield differential might be necessary to attract sufficient investor  interest when the amount of CM bills being auctioned is large relative to  outstanding Treasury bills with similar maturities.  Our results suggest the  supply effect dominates.
The estimated coefficient—0.282—of the average amount of similar- maturity Treasury bills outstanding implies that a $1 billion increase in the  amount of CM bills auctioned would raise the yield differential 0.43 basis  points in 2005, other things constant.  This coefficient can also be used to  indicate how much higher the yield differential might have been if CM bills  had remained as important a source of short-term Treasury financing in  fiscal year 2005 as they were in the years before the 4-week Treasury bill  was introduced.  Multiplying the coefficient of 0.282 by 0.687, which was  the average ratio of the amount of CM bills to the average amount of  similar-maturity Treasury bills from 1996 through 2001, rather than the  actual 2005 ratio of 0.190 raises the yield differential 14 basis points.  In  other words, if CM bills were used as intensively in fiscal year 2005 as they  were during earlier years before the 4-week Treasury bill’s introduction, the  yield differential might have been 28 basis points in 2005 instead of the  actual differential of 14 basis points.
section_title: Maturity on or around Large Tax Payment Dates Reduces Yield Differential
paragraphs: Our work suggests that maturity on or around a tax due date, which is a  feature not studied in previous research, reduces the yield differential.   Table 6 shows that there is a 12 basis point reduction for CM bills that  mature from the 15th to the end of April.  Similarly, CM bills that mature on  tax due dates other than April 15 (i.e., the 15th of March, June, September,  or December) tend to have lower yield differentials by nearly 12 basis  points.  This may be explained by empirical evidence suggesting that  regular Treasury bills whose maturity dates immediately precede corporate  tax payment dates have special value because corporate treasurers may  wish to invest excess cash in securities whose cash flows can be used to  liquidate cash liabilities.
section_title: CM Bills Issued in Multiple Tranches May Require Higher Yield Differentials
paragraphs: Financial market participants informed us that CM bills issued in several  tranches may lead to cautious bidding and therefore require higher yields  to attract investors.  Multiple-tranche CM bills are CM bills that are issued  on different days within a short period that have the same maturity date.   Previous research has not studied this feature of CM bills.  Reliance on  multiple-tranche CM bills increased from slightly less than one-third of  issues in the earlier subperiod to approximately one-half of CM bills issued  during fiscal years 2002–2005.  To test whether multiple-tranche issues  affect CM bill yields, we included a variable identifying this type of CM bills  in the equation shown in table 6, column A.
The results suggest that CM bills that are part of a multiple tranche might  have yields that are 6.0 basis points higher than other CM bills.  However,  while the coefficient is significant at the 10 percent level, it is not  significant at the 5 percent level.  Moreover, the estimated multiple- tranche coefficient is not as robust as other coefficient estimates.  For  example, with the inclusion of a variable representing the number of days  advance notice before auction in column E, the coefficient of multiple- tranche CM bills is no longer significant even at the 10 percent level.   Accordingly, the evidence that multiple-tranche issues increase the yield  differential should be viewed with caution.
section_title: Yield Differential Is Not Affected by Timing of Issuance
paragraphs: We also tested whether the issuance of CM bills on the 1st–3rd days of the  month or during DISPs affected the yield differential.  Because one-half of  all CM bills were issued on the 1st–3rd days of the month in recent years,  these issues might in some sense be considered more regular and thus  require lower yields than CM bills issued at other times.  However, the  estimated coefficient of a variable identifying CM bills issued on the 1st–3rd  days of the month was insignificant.
CM bills have been a useful tool for Treasury when approaching the debt  ceiling.  From fiscal years 2002 through 2005, 20 percent of CM bills were  issued during DISPs—a period for which the Secretary of the Treasury has  determined that obligations of the United States may not be issued without  exceeding the debt ceiling.  While the coefficient of a variable identifying  CM bills issued during DISPs had a negative sign, it was not significantly  different from zero.
section_title: Several Findings from Earlier Studies Are No Longer Supported
paragraphs: Studies by Seligman and Christopher identified several other variables that  had significant effects on the differential between yields on CM bills and  either the yield on regular bills with similar maturity or the yield on  repurchase agreements.  As noted earlier, however, these studies  employed samples consisting either entirely or mainly of observations from  CM bill auctions held before the introduction of the Treasury bill in fiscal  year 2001.  The only finding from earlier studies that appears to remain  valid in this new environment of shorter-maturity CM bills is that an  increase in the ratio of CM bills auctioned to the outstanding amount of  similar-maturing bills tends to increase the yield differential.
Both Seligman and Christopher found that CM bills with longer terms to  maturity were relatively less costly.  The equation in Column B of table 6  includes a variable for a CM bill’s term to maturity.  In contrast to earlier  findings, we found that the coefficient for term to maturity is positive and  insignificant.  This may be because CM bills are now concentrated at the  very short end of the maturity spectrum leaving little room for increases in  maturity to affect the yield differential.
Christopher found that the number of days between the auction of a CM bill  and the settlement date reduced the differential between the CM bill yield  and the yield on repurchase agreements. The explanation for this  relationship is that the delay allows administrative efficiencies.  However,  the estimated coefficient of the number of days between auction and  settlement (in column C of table 6) is insignificant.
In the sample of CM bill auctions that Christopher studied, CM bills that  were auctioned on a Wednesday and had a maturity date beyond the end of  the month tended to have lower yields.  Since the inception of the 4-week  Treasury bill and the truncation of CM bill maturities, only 4 of 55 issues  were in this category.  In an equation that also included the other variables  in column A of table 6, the coefficient for a binary variable designating such  issues had a t-statistic of only 0.161 which led to the rejection of the  hypothesis that CM bills auctioned on Wednesdays and maturing after the  end of the month have lower yields.
Instead of issuing a new security, Treasury may add to, or reopen, an  existing issue, increasing the amount outstanding of the issue.  CM bill  reopenings are fungible with previously issued regular bills and may enjoy  their liquidity.  Seligman found that CM bills issued off-cycle were  significantly more costly than those that reopened a previous issue.   However, contrary to Seligman’s results, our analysis indicates that off- cycle CM bills are not more costly than reopenings.  Column D of table 6  shows the sign of the coefficient of the off-cycle variable is negative rather  than positive although, more relevantly, the coefficient is not significantly  different from zero.  The descriptive statistics in table 5 show that 86  percent of CM bills issued during the more recent period were issued off- cycle compared with about 40 percent in the earlier period.  Off-cycle  issuance has become a regular feature of CM bills and does not command  an extra return.
Seligman also hypothesized that an increase in the number of business days  between CM bill announcement and auction would reduce the yield  differential.  While his estimates suggest that 2 business days advanced  notice reduces the yield differential, he found that increasing the  announcement period beyond 2 days did not further reduce the differential.   In contrast, we found that the sign for the coefficient of the number of days  of advance notice was positive and significant, as shown in column E of  table 6.  This has the unexpected implication that increasing the number of  business days notice before auction increases rather than reduces the yield  differential. Because markets usually penalize uncertainty, this result  appears counterintuitive and should be studied further to determine  whether it arose because of a statistical problem such as the correlation  between the advanced notice variable and an omitted variable that may be  unobservable.
section_title: Selected CM Bill Features Reduce Yields but Opportunities for Additional Exploitation of These Features May Be Limited
paragraphs: Our analysis of CM bill yield differentials from fiscal year 2002 through  2005 revealed several features of CM bills that affect the yield differential;  however, Treasury’s ability to achieve additional savings by further  exploiting these features may be limited.  The average yield differential was  substantially lower during the period from fiscal years 2002 through 2005  than it was in the preceding several years.  The two most important factors  behind the yield differential decline between the pre- and post-2002 period  were (1) the substantial decline in the general level of short-term rates and  (2) the major reduction in the ratio of CM bills issued to the average  amount of Treasury bills outstanding.  The level of short-term interest rates  is largely determined by Federal Reserve policy and market forces rather  than Treasury.  Treasury bill yields may continue to rise and reach levels  that prevailed in the early period, thereby erasing the portion of the decline  in the yield differential caused by lower interest rates.  However, because  the 4-week bill is now a permanent feature of Treasury’s auction schedule  and has reduced Treasury’s reliance on CM bills, the portion of the decline  in the yield differential attributable to the reduced ratio of CM bills to  similar-maturity Treasury bills is likely to endure.  The experience from  fiscal year 2002 through 2005 as a whole suggests that the yield differential  could remain about 13 basis points below pre-2002 levels.
While Treasury may have some ability to change the relative amount of CM  and regular bills issued, the mix is affected by cash flow patterns largely  beyond its control.  Aligning cash outflows and inflows could reduce the  amount of CM bills issued, but Treasury does not have authority over the  timing of all cash flows.  However, Treasury does have control over debt- related cash flows.  Efforts to better align the timing of net increases in  debt with its largest cash payments could reduce both the size of CM bills  and the yield differential.
To the extent that Treasury can increase the share of CM bills that mature  on dates when taxes are due, additional savings might be achieved.   Already more than 60 percent of CM bills met this criterion in fiscal year  2005, so the possibility of achieving further savings through this feature  may be minimal.  Moreover, Treasury’s short-term borrowing needs do not  uniformly occur shortly before large tax due dates.
Nearly one-half of CM bills issued since fiscal year 2002 have been issued in  multiple tranches.  Our results provide somewhat limited evidence that  multiple tranche issues may be more costly.  Even if such issues were to  require higher yields, however, multiple tranche issues have the advantage  of reducing borrowing costs by minimizing the duration of the amounts  borrowed in later tranches.  For example, instead of borrowing $20 billion  for 10 days, Treasury might use two tranches to borrow $10 billion for 10  days and $10 billion for 9 days, thereby saving 1 day’s interest on the  second tranche.  Accordingly, the savings that multiple tranche CM bills  provide by reducing the number of days that interest is paid on later  tranches is likely to more than offset the higher yields such issues might  entail.
Finally, the positive correlation found between the number of days of  advanced notice and the yield differential appears counterintuitive and  probably should not be used as a basis for reducing the notification period.
section_title: Analysis of CM Bill Auctions
paragraphs: Given that CM bill auctions are innately less predictable than regular  Treasury bill auctions, it is not surprising that, by some measures, CM bill  auctions are less successful than regular auctions.  Better auction  performance can be characterized by greater participation, a broader  distribution of awards, and more preauction activity in the when-issued  market.  These factors theoretically improve Treasury’s borrowing costs.   By most measures of participation and activity we examined, CM bill  auctions perform less well than 4-week bill auctions.  However, some other  measures indicate that Treasury obtained a better price at CM bill auctions  compared with 4-week bill auctions and that there is stronger demand for  CM bills than 4-week bills.  However, we did not find a statistically  significant relationship between any auction performance measures and  yield differentials.  We did find that in more concentrated auctions,  Treasury was less likely to pay more than the yield indicated in the when- issued market at the time of auction.
subsections: section_title: Trading Activity Was Lower Prior to CM Bill Auctions than 4-week Bill Auctions
paragraphs: Treasury auctions are preceded by forward trading in markets known as  “when-issued” markets.  The when-issued market is important because it  serves as a price discovery mechanism that potential competitive bidders  look to as they set their bids for an auction. When-issued trading reduces  uncertainty about bidding levels surrounding auctions and also enables  dealers to sell securities to their customers in advance of the auction so  they are better able to distribute the securities and bid more aggressively,  which results in lower costs to Treasury.
However, we found that trading activity is sparse before CM bill auctions.  We counted the number of preauction trades on the day of CM bill auctions  and found that when-issued trading is lower prior to CM bill auctions  compared with regular 4-week bill auctions (see table 7).  There is  generally more activity after CM bill auctions than before the auction.
section_title: Yield Treasury Paid on CM Bills Generally Reflected Market Information at the Time of the Auction
paragraphs: To evaluate the yield obtained at auction, Treasury’s auction studies used  the difference between yields at auction and the contemporaneous when- issued yield at time of an auction, usually 1:00 p.m.  We refer to this  measure as the contemporaneous auction spread.  According to Treasury,  this is a good benchmark to measure auction yields because potential  bidders have a choice between purchasing securities at auctions or  purchasing securities in the when-issued market.  A negative spread (where  the auction yield is less than the contemporaneous when-issued yield)  indicates Treasury paid a lower yield than expected, which is a positive  auction result.  Alternatively, a positive spread (the auction yield is greater  than the contemporaneous when-issued yield) indicates Treasury paid a  higher yield than expected from information in the market at the time of  auction.  This would indicate a poor auction result.  By this measure, CM  bill auctions performed better than 4-week bill auctions.  The  contemporaneous auction spread of CM bill auctions from fiscal year 2002  through 2005 was approximately zero (see table 8), which implies that the  yield Treasury paid on CM bills generally reflected market information at  the time of the auction.  In contrast, the auction spread for 4-week bill  auctions averaged a positive 0.3 basis points for fiscal years 2002 through  2005.  The information derived from the auction spread depends in part on whether the when-issued market is liquid around the time of the auction.   Because the level of trading activity is relatively sparse before CM bill  auctions, the information provided by the contemporaneous auction  spread may be limited.
section_title: CM Bill Auctions Are More Concentrated and Have Fewer Awarded Bidders than 4-week Bill Auctions
paragraphs: In order to lower borrowing costs, Treasury seeks to encourage more  participation in auctions.  In general, large, well-attended auctions improve  competition and lead to lower borrowing costs for Treasury.  For example,  in the 1990s Treasury switched its auctions from multiple-price to uniform- price format in order to encourage more aggressive bids and a broader  distribution of auction awards.  Treasury found that the share of the  auction awarded to the top five competitive bidders declined under the  new auction format to about 35 percent for 2-year notes and 36 percent for  5-year notes.  Using similar estimates of bidder participation in CM bill  auctions, we found that the share of the auction awarded to the top five  bidders was 60 percent or higher in over half of CM bill auctions held  during fiscal years 2002–2005.  The share exceeded 60 percent in only 18  percent (37 of 209) of 4-week bill auctions held during fiscal years 2002– 2005.
Treasury limits the maximum auction award to a single bidder to 35 percent  of the offering in part to foster a liquid secondary market for a new issue.   A higher concentration could reduce competition and restrict a security’s  supply in the secondary market preventing its efficient allocation among  investors and possibly generating a “short squeeze.”  The term “short  squeeze” is used by market participants to refer to a shortage of a security  relative to willing buyers for the same security.  These squeezes arise  because Treasury allows dealers to sell the security short to its customers  (or other dealers) in the when-issued market before securities are  auctioned.  Lack of competition could also result in lower prices (higher  yields) at auction.  In contrast, we found generally negative correlations  between concentration measures and auction spreads for CM bill auctions.   In other words, in more concentrated auctions, Treasury was less likely to  pay more than the yield indicated in the when-issued market at the time of  auction.  According to Treasury, a high concentration ratio in CM bill  auctions may imply some bidders really want a particular bill, which drives  the price up and yield down.
Not only are CM bill auctions more concentrated, but fewer bidders in total  are awarded CM bills than 4-week bills.  According to Treasury officials,  short-term securities have a more limited audience.  From fiscal year 2002  through 2005, about 17 bidders on average were awarded CM bills in each  auction compared with 22 bidders in 4-week bill auctions.  More than half  of the CM bill auctions had 16 or fewer awarded bidders.  In contrast, only  about 4 percent of 4-week bill auctions had 16 or fewer awarded bidders.
Although greater participation, a broader distribution of awards, and more  preauction activity in the when-issued market theoretically improves  Treasury’s borrowing costs, we did not find a statistically significant  relationship between these factors and the yield differential.
section_title: More Common Performance Measures Indicate High Demand for CM Bills but Greater Uncertainty in CM Bill Auctions Compared with 4-week Bill Auctions
paragraphs: More commonly cited measures of auction performance, such as bid-to- cover ratios and auction tails (difference between the high and average  discount rates) provide information on the demand for Treasury securities  and the dispersion of bids, but these measures are limited.  The bid-to- cover ratio is the ratio of the amount of bids received in a Treasury security  auction compared with the amount of accepted bids.  In general, higher  ratios signal higher demand for the security being auctioned.  From fiscal  year 2002 to 2005, the bid-to-cover ratio for CM bill auctions averaged 3.17  (see table 9).  In contrast, the bid-to-cover ratio for 4-week bills averaged  only 2.30.  This suggests a stronger demand for CM bills than regular 4- week bills; however, these results should be interpreted with caution.   Some market participants suggested that a high bid-to-cover ratio may arise  because many dealers participate in CM bill auctions to fulfill auction  requirements that are less costly to meet by participating in short-term CM  bills auctions than in auctions of longer-term securities.
Auction tails—the number of basis points between the high and average  discount rates—are a measure of the dispersion of the bids.  Auction theory  suggests that the more diverse the beliefs of the bidders and the more  uncertain they are about the demand for the bills, the more dispersed the  bids submitted.  In contrast, narrower tails indicate strong bidding and  therefore lower costs to Treasury.  When evaluating the auction tails of CM  bills compared with regular Treasury securities, we found that CM bill tails  were slightly larger than 4-week bill auctions (see table 10).
In summary, most measures suggest CM bill auctions perform less well  than 4-week bill auctions.  However, the low participation and high  concentration of CM bill auctions do not explain why Treasury paid higher  yields on CM bills than investors paid for similar-maturing bills in the  secondary market.
section_title: Selected Bibliography
paragraphs: Bikhchandani, Sushil, Patrik L. Edsparr, and Chif-fu Huang. “The Treasury  Bill Auction and the When-Issued Market:  Some Evidence.” Draft (Aug. 30,  2000).
Christopher, Jan E.  “Determinants of the Spread between Repo and Cash  Management Bill Yields: Technical Report.” Unpublished manuscript  (2005).
Fleming, Michael J.  “Are Larger Treasury Issues More Liquid?  Evidence  from Bill Reopenings.” Journal of Money, Credit, and Banking, vol. 34, no.  3 (August 2002): 707–35.
Garbade, Kenneth D. “Treasury Bills with Special Value.”  Fixed Income  Analytics (Cambridge, Mass.:  MIT Press, 1996): 181–197.
Garbade, Kenneth D., and Jeffrey F. Ingber, “The Treasury Auction Process:   Objectives, Structure and Recent Adaptations.” Current Issues in  Economics and Finance, vol. 11, no. 2, Federal Reserve Bank of New York  (February 2005).
Garbade, Kenneth D., John C. Partlan, and Paul J. Santoro.  “Recent  Innovations in Treasury Cash Management.” Current Issues in Economic  and Finance, vol. 10, no. 11, Federal Reserve Bank of New York  (November 2004).
Malvey, Paul F. and Christine M. Archibald.  Uniform-Price Auctions:   Update of the Treasury Experiences.  Department of the Treasury, Office of  Market Finance (Oct. 26, 1998).
Nyborg, Kjell G. and Suresh Sundaresan. “Discriminatory versus Uniform  Treasury Auctions: Evidence from When-issued Transactions.” Journal of  Financial Economics, vol. 42 (1996): 63–104.
Seligman, Jason.  “Does Urgency Affect Price at Market?  An Analysis of  U.S. Treasury Short-Term Finance.” Journal of Money, Credit, and  Banking (forthcoming).
Simon, David P. “Segmentation in the Treasury Bill Market: Evidence from  Cash Management Bills.” Journal of Financial and Quantitative Analysis,  vol. 26, no. 1 (March 1991): 97–108.
Simon, David P. “Further Evidence on Segmentation in the Treasury Bill  Market.” Journal of Banking and Finance, vol. 18 (1994): 139–51.
section_title: Comments from the Department of the Treasury
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to the contacts named above, Jose Oyola (Assistant Director),  Richard Krashevski, Naved Qureshi, and Melissa Wolf made significant  contributions to this report.  Jennifer Ashford also provided key assistance.