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

Letter

Background

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.

Objectives, Scope, and Methodology

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.

Treasury Uses CM Bills to Help Fill Cash Financing Gaps

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.

Large Cash Outflows Occur at the Beginning of the Month

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.

Large Receipts Often Occur in the Middle of the Month

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.

Regular Bill Issuances Alone Are Not Sufficient to Fill Cash Financing Gap

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.

Treasury Has Increasingly Used CM Bills to Fill Frequent Cash Financing Gaps

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.

Treasury Also Uses CM Bills to Help Smooth Cash Flows during the April Tax Season

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.

Treasury Does Not Control the Timing of All Cash Flows

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.

Treasury Also Relies on CM Bills When Approaching the Debt Ceiling

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.

CM Bills Cannot Be Used in All Circumstances and Other Alternatives No Longer Exist or Are Limited

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.

CM Bills Generally Had Higher Yields than Outstanding Bills of Similar Maturity but Lower Borrowing Costs than Currently Available Alternatives

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.

CM Bill Yields Closely Track Other Short-Term Rates

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).

CM Bill Yields Were Generally Higher than Yields on Outstanding Bills of Similar Maturity

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.

CM Bill Yields Were Similar to Yields on Overnight Repurchase Agreements

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.

Our Analysis Identified Some Features That Affect the Yield Differential

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.

The Amount of CM Bills Issued Was Positively Correlated with the Yield Differential

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.

Issuing CM Bills in Multiple Tranches May Increase the Yield Differential but Reduce Overall Borrowing Costs

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.

CM Bills Maturing on Large Tax Payment Dates May Have Lower Yield Differentials

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.

Yield Differential Rises and Falls with Short-term Yields

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.

Most Measures We Examined Suggest CM Bill Auctions Perform Less Well Than 4-week Bill Auctions

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.

CM Bills Are Generally Less Costly than Currently Available Alternatives

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.

CM Bills Are Generally Less Costly than Running Higher Cash Balances

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.

Treasury Has Refined Its Use of CM Bills but Costs Have Begun to Increase

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.

Treasury Initially Reduced the Amount of CM Bill Issuance Following the Introduction of the 4-week Bill

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.

Issuing CM Bills in Multiple Tranches Has Helped Reduce Borrowing Costs

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.

Borrowing Costs Declined Dramatically in 2002 but Have Since Increased

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.

Options Exist That May Reduce the Use and Cost of CM Bills

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.

Better Aligning Cash Flows Might Reduce Cash Financing Gap

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.

Increasing Earnings on Cash Balances Would Reduce the Costs Associated with Running Higher Cash Balances to Avoid Issuing CM Bills

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.

Shorter-term Regular Bills Might Reduce the Need for Some CM Bills

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.

Enhancing Transparency of CM Bill Auctions May Reduce CM Bill Yields

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.

Relaxing the 35-percent Cap on CM Bill Auction Awards May Reduce CM Bill Yields

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.

Exploring Other Countries’ Short-term Cash and Debt Management Practices May Provide Useful Insights

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.

Conclusion

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.

Recommendation for Executive Action

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.

Agency Comments

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.

Detailed Methodology and Findings of Statistical Analysis of Cash Management Bill Yield Differential

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.

Previous Research Based on Earlier Data Suggests Some CM Bill Features May Reduce Costs

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.

Comparing CM Bill Yields with Secondary Market Yields on Similar-maturing Treasury Bills

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.

The Introduction of the 4-week Treasury Bill Reduced CM Bill Maturities and Their Relative Importance in Short-term Financing

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.

Our Study Focused on CM Bills Issued during Fiscal Years 2002–2005

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.

Yield Differential Is Positively Correlated with Level of Treasury Bill Yields

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.

Yield Differential Is Positively Correlated with Auction Amounts

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.

Maturity on or around Large Tax Payment Dates Reduces Yield Differential

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.

CM Bills Issued in Multiple Tranches May Require Higher Yield Differentials

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.

Yield Differential Is Not Affected by Timing of Issuance

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.

Several Findings from Earlier Studies Are No Longer Supported

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.

Selected CM Bill Features Reduce Yields but Opportunities for Additional Exploitation of These Features May Be Limited

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.

Analysis of CM Bill Auctions

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.

Trading Activity Was Lower Prior to CM Bill Auctions than 4-week 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.

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.

Yield Treasury Paid on CM Bills Generally Reflected Market Information at the Time of the Auction

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.

CM Bill Auctions Are More Concentrated and Have Fewer Awarded Bidders than 4-week Bill Auctions

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.

More Common Performance Measures Indicate High Demand for CM Bills but Greater Uncertainty in CM Bill Auctions Compared with 4-week Bill Auctions

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.

Selected Bibliography

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.

Comments from the Department of the Treasury

GAO Contacts and Staff Acknowledgments

GAO Contacts

Acknowledgments

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.