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March 2011Ultra-Long Treasury Bonds: Examining the Potential Risks and Benefits

Steve Rodosky

Managing DirectorPortfolio Manager

Jim Moore, Ph.D.

Managing DirectorProduct Manager

Jared Gross

Senior Vice PresidentProduct Manager

During its most recent Quarterly Refunding, the United States Treasury Department metwith the private sector members of the Treasury Borrowing Advisory Committee (TBAC)to discuss longer term issues related to the management of the Federal debt. Amongseveral topics considered by the group was the possible issuance by Treasury ofextremely long term bonds with maturities greater than the current 30-year long bond.Maturities of 40, 50 and even 100 years were proposed as vehicles for meeting currentlyun-served demand from long term investors such as pension funds and insurancecompanies.

We have brought together three PIMCO experts for a Q&A session on the topic of

extremely long debt issuance by the U.S. Treasury and the potential benefits and riskstherein.

Q: Treasury has never issued debt longer than 30 years, although some highquality corporate and sovereign issuers have done so sporadically. Is the marketready to accept a steady supply of very long debt?Rodosky: At this point, it still seems unlikely well see such long-dated securities beingissued. That said, for any security theres a right price and a wrong price. At the rightprice, the market is certainly ready to accept more supply of long-dated debt. Of course, itmust be considered that pricing is something of a zero-sum game for any individual bond:what is a good deal for the Treasury and taxpayers is less of a bargain for investors. Theauction process serves the purpose of finding a price as close to neutral for all parties.The potential benefit of finding a new maturity point with currently unmet demand is that

the investors, for structural reasons, will happily pay a price for this new asset that isbetter than what Treasury can achieve at the 30-year point.

Liability Driven Investing (LDI) has blossomed in the last few years as pension staffshave increased their awareness of the risks embedded in their business. Hedging ofliability duration has taken place with the same menu of asset choices, however,indicating a growing disconnect between supply and demand. This suggests that therewould be a market for high quality, very long term assets.

Additionally, there may be some benefits to the broader capital markets if Treasury wereto go down this path. The presence of an ultra-long Treasury bond would provide abenchmark for pricing other debt instruments, such as corporate and municipal bonds, as


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March 2011well as interest rate derivatives. Indeed, one reason corporate issuance and derivativesvolume is so low in the very long maturities is the lack of a value-anchor used to pricesuch issuance.

Q: It is suggested that the natural investor for this type of instrument would be anentity with extremely long duration liabilities, such as an insurance company ordefined benefit pension plan. What makes a new, very long Treasury bondattractive to these investors relative to the current 30-year bond?Moore: Defined Benefit pensions and life insurance annuity and structured settlementcontracts have cash flows that run well past 30 years, stretching out some 50-75 years ormore. Even though the baby boomers are on the doorstep of retirement, a typicalpension plan, even if frozen to new benefit accruals, will not reach its maximum benefit

payout stage for 20 years or more from inception.

While pension liabilities past the 30-year mark may represent just 10% or less of the totalcurrent value of all liabilities, these longer-dated liabilities generally represent 10-20% ofthe total duration and 25-35% of convexity for all liabilities. Most investors who do notdeal with long-dated liabilities or levered books do not think a lot about convexity, or howduration changes with changes in interest rates or the second derivative of price change,but it can matter a great deal for life insurance risk managers and swaps dealers who findconvexity dear.

Why is convexity so valuable? Mainly because as rates fall, a more convex bond will rallymore than a less convex bond; and as rates rise, a bond with more convexity will typicallysell off less than a less convex bond. One major swap dealer told me hed give up 15-20

bps in yield for 50-year bond versus a 30-year bond in a flat yield curve environment asthe 50-year has nearly twice the convexity and only 10-20% more duration.

The full benefit to the pension and insurance hedging community probably will not comefrom 50-year Treasuries alone, but also from the products that its existence spurs. At theend of December 2010, roughly 24% of all outstanding 15+ year Treasury bonds werestripped, and much of that pool was held by pensions and insurers. It is likely that therewould be similar demand for 50-year strips.

Also, pensions and life insurers have demand for spread products. A 50-year referencepoint would likely spur additional creation of very long, high quality corporate bonds.

Q: Although this is currently just a proposal, how would the Treasury actuallyintroduce such an instrument to its debt issuance calendar?Gross: The Treasurys debt management philosophy has always been based on threepillars: obtaining the lowest cost of financing over time for the U.S. taxpayer, maintainingregular and predictable debt issuance, and supporting deep and liquid capital markets.Any change to the debt issuance patterns as significant as the introduction of very longbonds would need to meet all three requirements.

Major changes to the debt issuance calendar are usually signaled well in advance, boththrough the Quarterly Refunding process and in other public venues where Treasuryofficials are speaking. If Treasury is serious about this proposal we would expect to seefurther public discussion of the merits in the context of the three goals described above.


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March 2011Once the groundwork has been laid, the penultimate step of an introduction would be anannouncement at a Quarterly Refunding, including the details of the instrument to beissued and the schedule of issuance. This ultimately would be followed by adding theauction (or other issuance mechanism) as part of a subsequent Quarterly Refunding.

Q: What arguments might we expect to see from the Treasury going forward?Gross: I would expect the Treasury to make arguments and present evidence in favor ofvery long bonds along the following lines:

With respect to the cost of debt financing, the issue boils down to whetherthe new demand will allow Treasury to issue debt at yields that arecompetitive with the current issuance up to and including the 30-year point.Although one expects yield curves to be upward sloping, and therefore

longer maturity debt to be costlier than shorter maturity debt, there is someevidence to suggest that at very long maturities the yield curve may beessentially flat or even inverted.

The need to maintain regular and predictable issuance means that Treasurywould be unlikely to introduce an instrument that will only be needed for ashort period of time and then withdrawn. The primary basis for making thisjudgment will be the magnitude of the federal governments long term deficitfinancing needs; which, at present, are sufficiently bleak as to make the caseforcefully.

With respect to the capital markets, Treasury will want to select a maturitypoint that best meets the needs of the presumed long term investor base.Too close to the 30-year and the impact will be marginal, and too far out maycapture only a few investors. Further, Treasury will be naturally reluctant to

commence issuance too far out on the curve because of the need to maintainissuance for at least 10 or 20 years so as to link up with the existing 30-yearbond to form a continuous yield curve.

Q: The TBAC presentation included evidence from the U.K. suggesting that verylong bonds could be issued at yields lower than 30-year bonds. Is this a realisticassumption in the United States?Moore: The chart below shows the 50-year versus 30-year yield differentials for both theU.K. and French yield curves. Over the period since issuance, the spread has averaged -13 bps for the U.K. gilt market and -2 bps for the French market, with the U.K. marketshowing wider variation than the French bond spreads.


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March 2011

50-Year 30-Year Spreads

-0.35

-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Jan-10 Jul-10 Jan-11

%

UK 50 - 30 FR 50 - 30

Source: Bloomberg

Figure 1

Two things are worth pointing out about the U.K. market. First, before November 2008,the U.K. yield curve was inverted, which had the effect of increasing the convexitybenefits of extremely long bonds and making them more attractive to investors. Thespread averaged -19 bps before November 2008 and -6 bps since. Second, theaccounting and regulatory pressures for better asset liability matching were morestringent in the U.K. than in continental Europe, acting as a catalyst to LDI and tighterasset/liability matching again leading to higher demand.

By December 2005, the French 50-year OAT, which initially came to market at a slightyield premium to the 30-year, began trading tight to the 30-year and has since traded in arelatively narrow range of 05 bps lower yield than the on-the-run 30-year issue. Much ofthe demand comes from continental insurance companies and Dutch pension plans.

Taken together, the post-2008 U.K. market and the longer French history probably give areasonable expectation of where 50-year Treasuries might trade provided the issuancesize is approximately right to attract those with hedging demand without being too large inabsolute terms or relative to the 30-year supply.

Q: Given what we know about market demand, is there a sweet spot for thematurity of very long term bonds?Rodosky: A large portion of demand in the long end is for securities in stripped form,typically the principal component of the whole bond. As the principal strips are createdand sold to end users, the coupon stream winds up residing on dealer balance sheetsuntil another source of demand shows up. Given balance sheet constraints in the dealer


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March 2011community, this creates a serious drag on the capacity of the market to absorb very longissuance. The more inventory held on a dealers balance sheet, the less liquidity theydbe able to provide (or warehouse) in other sectors. This could, in turn, adversely impactthe Treasurys objectives of obtaining the lowest cost of financing over time and ofsupporting deep and liquid capital markets

Given this, the least disruptive way to increase the longest maturity offered would be tostart relatively close to the 30-year point and gradually introduce further points if theprogram is successful. Therefore, starting with a 40-year or 50-year bond would make themost sense, while a 100-year bond would be less realistic.

About the authors:

Steve Rodosky is a managing director in the Newport Beach office and a portfolio managercovering Treasury bonds, agencies and futures. He is the lead portfolio manager for long durationstrategies. Prior to joining PIMCO in 2001, Mr. Rodosky was vice president of institutional saleswith Merrill Lynch. He has 16 years of investment experience and holds a master's degree infinancial markets from Illinois Institute of Technology. He received an undergraduate degree fromVillanova University.

Jim Moore is a managing director in the Newport Beach office. He leads the global liability driveninvestments product management team and is co-head of the investment solutions group. He isalso PIMCO's pension strategist. Prior to joining PIMCO in 2003, he was in the corporate derivativeand asset-liability strategy groups at Morgan Stanley and responsible for asset-liability, strategicrisk management and capital structure advisory work for key clients in the Americas and Pacific

Rim. Dr. Moore also taught courses in investments and employee benefit plan design and financewhile at the Wharton School of the University of Pennsylvania, where he earned his Ph.D. withconcentrations in finance, insurance and risk management. He has 16 years of investmentexperience and holds undergraduate degrees from Brown University

Jared Gross is a senior vice president in the Newport Beach office and a product manager forliability driven investment products. He focuses on long duration and other pension investmentstrategies. Prior to joining PIMCO in 2008, he was a senior relationship manager in LehmanBrothers' pension solutions group, working with large corporate and public pension plans in theU.S. He held a similar position at Goldman Sachs. Mr. Gross also spent five years in Washington,D.C.: two years as an advisor to the executive director on investment policy at the Pension BenefitGuaranty Corporation and three years at the Treasury department, focusing on debt financing andmanagement and domestic securities market issues. He has 17 years of investment experienceand holds an undergraduate degree from Williams College.

Past performance is not a guarantee or a reliable indicator of future results. Investing in thebond market is subject to certain risks including market, interest-rate, issuer, credit, and inflationrisk; investments may be worth more or less than the original cost when redeemed. Certain U.S.Government securities are backed by the full faith of the government, obligations of U.S.Government agencies and authorities are supported by varying degrees but are generally notbacked by the full faith of the U.S. Government; portfolios that invest in such securities are notguaranteed and will fluctuate in value. The value of most bond funds and fixed income securitiesare impacted by changes in interest rates. Bonds and bond funds with longer durations tend to bemore sensitive and more volatile than securities with shorter durations; bond prices generally fall asinterest rates rise.


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March 2011This material contains the current opinions of the author and such opinions are subject to changewithout notice. This material has been distributed for informational purposes only and should not beconsidered as investment advice or a recommendation of any particular security, strategy orinvestment product. Information contained herein has been obtained from sources believed to bereliable, but not guaranteed. No part of this material may be reproduced in any form, or referred toin any other publication, without express written permission. Pacific Investment ManagementCompany LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. 2011,PIMCO.

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