20yr Bond Comeback: Treasury Uses 20/20 Vision Back To The 1980s?

After much consultation, the US Treasury will be re-adding the 20-year bond back into its suite of marketable debt products in an effort to expand its bond offerings. This is a timely launch in our view as it comes during an era where the US government is poised to run $1 trillion annual fiscal deficits for as far as the eye can see. We explore the significance of this new bond on the curve, ‘the signaling effect’, and macro/Fed implications.

Why Settle on a 20-year?

After gathering feedback from a broad array of bond market participants, the Treasury will be adding back a 20-year nominal coupon bond. The last 20-year Treasury bond was issued during the mid-1980s. This is also the latest new long nominal bond since the 2006 re-launch of the 30-year.

The Treasury under the Trump administration has been performing an ongoing study to expand the government’s financing tools. Yet the idea of a 20-year bond has been around for a while. A new active on-the-run 20-year should help enhance liquidity in the 10-year thru 30-year sector. It also aligns with the classic bond futures contract. In addition, given the value of the stripping component (that such a mid-point bond provides), that could be another reason why primary dealers have leaned towards the 20-year.

Prior to settling on a 20-year, the Treasury was exploring a range of new bonds (and even contemplated bringing to market a completely new 50-year or 100-year bonds). However, it was unclear that such securities would have the same liquidity characteristics, demand and auction patterns afforded to other Treasuries down the curve. Although such super-long bonds could have provided a stable cost of funding for the US government, they could also have bifurcated the Treasury market as we know it.

What do we Know so Far About the Upcoming 20-year?

According to the most recent Treasury refunding announcement, we will learn more about the timing of the first auction and issue sizes in May. The Treasury stated that the 20-year would be modeled after the existing suite of quarterly issued securities, the 10-year and the 30-year. The plan is to have a new 20-year issue in each refunding month (February, May, August, November) and then two individual monthly re-openings of such issues during each fiscal quarter. So, we will get four new bond CUSIPS but a total of twelve 20-year auctions per year (i.e. eight re-openings of those four new bonds). This pattern has proven to enhance liquidity in the 10-year and 30-year and should work out the same way for the 20-year. This pattern also helps align the 20-year with stripping convention and overall STRIPS fungibility.

Although they will have ‘dated dates aligned with the 15^th of the month’ like 10s and 30s, as per the Treasury, ‘the 20-year bond auction will settle at month-end or the first business day thereafter along with the other month-end nominal coupons, and will auction the same week as TIPS, in order to spread the auction supply of duration more evenly across the month’.

Watch the Hump: How Have 20-year Yields Behaved Over Time?

Keeping the classic bond future influence aside, when we use FRED spline yields to review 20-year levels, this data can serve to show the true value, in yield terms, of what Treasury long-term rates would be all else equal. In other words, given the segmentation of the curve (where different investor types have a preference to buy and consequently that demand pushes down rates) along with a reoccurring series of auctions (which creates liquidity and lowers all-in rates in its own right), the 20-year sector was a better gauge of the yield being commanded by market participants.

The 20-year has been known as the ‘hump of the curve’ at times because it can trade cheap versus the wings (i.e. 10s and 30s). That is not to say that long-end curves lack directionality with the level of rates, but instead they would just lag other curves and butterflies in terms of their rate changes.

Chart 1: Historical 20-year UST Yields Versus a Long-end Butterfly

Source: Macro Hive, St Louis Fed FRED

As seen in Chart 1, lately the 20-year yield point has kept pace with the bond rally. But it has not been able to ‘out-rally’ the 30-year bond (perhaps this is just the market building a slight discount in anticipation of its launch).

Chart 2: Flatter Curves Reduce per Annum Basis Point Pick Up

Source: Macro Hive, St Louis Fed FRED

In Chart 2 we take a closer look at the value proposition of the 20-year and the 30-year yields versus the 10-year. This is a very simplistic look and does not take into account extracting the value from convexity, which can provide the largest portion of total returns for long-end investors. It basically shows that when curves are flat, that translates into lower yield pickup. But we find it’s a clever way of seeing how 20-year rates behave on the curve.

On average, 20-year yield pickup to 10s are roughly 2bps per annum less than 30s (i.e. on a pure yield/yield comparison, going out to 30s still sees a slight yield pickup). However, that means, holding things constant the last 10 years of a 30-year bond is paying less than the first 10 years’ difference between what an investor gets from going to 20s from a 10-year note. This is another way of saying that traditionally 20-years offer good yield value.

There are risks, though. As seen during the global financial crisis (GFC), 20s were offering more per annum yield pickup given that many securities in that sector were being sold to raise liquidity. Although, a repeat of this would likely require margin calls and forced selling as happened in late 2008. It’s worth highlighting that the new 20-year would also cohabit the space on the curve which has the most rolled down off-the-run 30-year legacy bonds too. Also, if we go back to Chart 1, we notice that even when 20-year rates were rallying during GFC they underperformed on the curve.

Macro and Fed Implications

In the end a 20-year provides another point on the curve to spread out US debt funding (and with the latest CBO report projecting trillion-dollar deficits for years, we will need it). It also gives the US further capacity to expand its deficits if, for example, the US were to fall into a recession and needed to introduce even further fiscal spending to stabilize the US economy. Yet, for what it’s worth, from a macro perspective the last time the US Treasury launched former tenors (30s and 7-year) was a couple of years before or during the 2008 financial crisis. Is this an ominous signal, only time will tell.

Lastly the Fed will in practice be able to allocate proceeds of maturing securities into future 20-year bonds as ‘add-ons’, and, once launched, the Fed will likely tweak its UST POMO operations to also buy 20s with MBS proceeds. Plus, future QE and twist operations will likely see 20s playing an important role. This would only lengthen the Fed’s portfolio duration further.

George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)