Viewpoints

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

Steve Rodosky Jim Moore, Ph.D. Jared Gross

Managing Director Managing Director Senior Vice President
Portfolio Manager Product Manager Product Manager

During its most recent Quarterly Refunding, the United States Treasury Department met
with the private sector members of the Treasury Borrowing Advisory Committee (TBAC)
to discuss longer term issues related to the management of the Federal debt. Among
several topics considered by the group was the possible issuance by Treasury of
extremely 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 currently
un-served demand from long term investors such as pension funds and insurance
companies.

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 risks
therein.

Q: Treasury has never issued debt longer than 30 years, although some high
quality corporate and sovereign issuers have done so sporadically. Is the market
ready to accept a steady supply of very long debt?
Rodosky: At this point, it still seems unlikely we’ll see such long-dated securities being
issued. That said, for any security there’s a right price and a wrong price. At the right
price, the market is certainly ready to accept more supply of long-dated debt. Of course, it
must 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. The
auction 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 is
better than what Treasury can achieve at the 30-year point.

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

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

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well as interest rate derivatives. Indeed, one reason corporate issuance and derivatives
volume is so low in the very long maturities is the lack of a “value-anchor” used to price
such issuance.

Q: It is suggested that the natural investor for this type of instrument would be an
entity with extremely long duration liabilities, such as an insurance company or
defined benefit pension plan. What makes a new, very long Treasury bond
attractive to these investors relative to the current 30-year bond?
Moore: Defined Benefit pensions and life insurance annuity and structured settlement
contracts have cash flows that run well past 30 years, stretching out some 50-75 years or
more. Even though the baby boomers are on the doorstep of retirement, a typical
pension 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 total
current value of all liabilities, these longer-dated liabilities generally represent 10-20% of
the total duration and 25-35% of convexity for all liabilities. Most investors who do not
deal with long-dated liabilities or levered books do not think a lot about convexity, or how
duration 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 find
convexity dear.

Why is convexity so valuable? Mainly because as rates fall, a more convex bond will rally
more than a less convex bond; and as rates rise, a bond with more convexity will typically
sell off less than a less convex bond. One major swap dealer told me he’d give up 15-20
bps in yield for 50-year bond versus a 30-year bond in a flat yield curve environment as
the 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 come
from 50-year Treasuries alone, but also from the products that its existence spurs. At the
end of December 2010, roughly 24% of all outstanding 15+ year Treasury bonds were
stripped, and much of that pool was held by pensions and insurers. It is likely that there
would be similar demand for 50-year strips.

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

Q: Although this is currently just a proposal, how would the Treasury actually
introduce such an instrument to its debt issuance calendar?
Gross: The Treasury’s debt management philosophy has always been based on three
pillars: obtaining the lowest cost of financing over time for the U.S. taxpayer, maintaining
regular 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 long
bonds would need to meet all three requirements.

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

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Once the groundwork has been laid, the penultimate step of an introduction would be an
announcement at a Quarterly Refunding, including the details of the instrument to be
issued and the schedule of issuance. This ultimately would be followed by adding the
auction (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 of
very long bonds along the following lines:
• With respect to the cost of debt financing, the issue boils down to whether
the new demand will allow Treasury to issue debt at yields that are
competitive 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 some
evidence to suggest that at very long maturities the yield curve may be
essentially flat or even inverted.
• The need to maintain regular and predictable issuance means that Treasury
would be unlikely to introduce an instrument that will only be needed for a
short period of time and then withdrawn. The primary basis for making this
judgment will be the magnitude of the federal government’s long term deficit
financing needs; which, at present, are sufficiently bleak as to make the case
forcefully.
• With respect to the capital markets, Treasury will want to select a maturity
point 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 may
capture only a few investors. Further, Treasury will be naturally reluctant to
commence issuance too far out on the curve because of the need to maintain
issuance for at least 10 or 20 years so as to link up with the existing 30-year
bond to form a continuous yield curve.

Q: The TBAC presentation included evidence from the U.K. suggesting that very
long bonds could be issued at yields lower than 30-year bonds. Is this a realistic
assumption in the United States?
Moore: The chart below shows the 50-year versus 30-year yield differentials for both the
U.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. market
showing wider variation than the French bond spreads.

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50-Year – 30-Year Spreads
0.20

0.15

0.10

0.05

0.00

-0.05
%

-0.10

-0.15

-0.20

-0.25

-0.30

-0.35
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 convexity
benefits of extremely long bonds and making them more attractive to investors. The
spread averaged -19 bps before November 2008 and -6 bps since. Second, the
accounting and regulatory pressures for better asset liability matching were more
stringent in the U.K. than in continental Europe, acting as a catalyst to LDI and tighter
asset/liability matching – again leading to higher demand.

By December 2005, the French 50-year OAT, which initially came to market at a slight
yield premium to the 30-year, began trading tight to the 30-year and has since traded in a
relatively narrow range of 05 bps lower yield than the on-the-run 30-year issue. Much of
the 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 a
reasonable expectation of where 50-year Treasuries might trade provided the issuance
size is approximately right to attract those with hedging demand without being too large in
absolute terms or relative to the 30-year supply.

Q: Given what we know about market demand, is there a sweet spot for the
maturity 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 created
and sold to end users, the coupon stream winds up residing on dealer balance sheets
until another source of demand shows up. Given balance sheet constraints in the dealer

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community, this creates a serious drag on the capacity of the market to absorb very long
issuance. The more inventory held on a dealer’s balance sheet, the less liquidity they’d
be able to provide (or warehouse) in other sectors. This could, in turn, adversely impact
the Treasury’s objectives of obtaining the lowest cost of financing over time and of
supporting deep and liquid capital markets

Given this, the least disruptive way to increase the longest maturity offered would be to
start relatively close to the 30-year point and gradually introduce further points if the
program is successful. Therefore, starting with a 40-year or 50-year bond would make the
most 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 manager
covering Treasury bonds, agencies and futures. He is the lead portfolio manager for long duration
strategies. Prior to joining PIMCO in 2001, Mr. Rodosky was vice president of institutional sales
with Merrill Lynch. He has 16 years of investment experience and holds a master's degree in
financial markets from Illinois Institute of Technology. He received an undergraduate degree from
Villanova University.

Jim Moore is a managing director in the Newport Beach office. He leads the global liability driven
investments product management team and is co-head of the investment solutions group. He is
also PIMCO's pension strategist. Prior to joining PIMCO in 2003, he was in the corporate derivative
and asset-liability strategy groups at Morgan Stanley and responsible for asset-liability, strategic
risk 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 finance
while at the Wharton School of the University of Pennsylvania, where he earned his Ph.D. with
concentrations in finance, insurance and risk management. He has 16 years of investment
experience and holds undergraduate degrees from Brown University

Jared Gross is a senior vice president in the Newport Beach office and a product manager for
liability driven investment products. He focuses on long duration and other pension investment
strategies. Prior to joining PIMCO in 2008, he was a senior relationship manager in Lehman
Brothers' pension solutions group, working with large corporate and public pension plans in the
U.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 Benefit
Guaranty Corporation and three years at the Treasury department, focusing on debt financing and
management and domestic securities market issues. He has 17 years of investment experience
and holds an undergraduate degree from Williams College.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the
bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation
risk; 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 not
backed by the full faith of the U.S. Government; portfolios that invest in such securities are not
guaranteed and will fluctuate in value. The value of most bond funds and fixed income securities
are impacted by changes in interest rates. Bonds and bond funds with longer durations tend to be
more sensitive and more volatile than securities with shorter durations; bond prices generally fall as
interest rates rise.

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