Management & Labor

Hybrid Treasury Bonds for Public Pension Funds

Federal-state collaboration could save taxpayers billions and help deter runaway inflation.
by | June 21, 2012

As I begin to focus more exclusively on the investments of public pension funds and less on their benefits design, I couldn't help but note yesterday's Wall Street Journal opinion page, where Todd Buchholz wrote a thoughtful piece entitled "Washington Should Lock In Low Rates." His thesis is that today's low treasury bond yields -- courtesy of global investment panic and the Federal Reserve's "operation twist" -- now give the federal government a once-in-a-generation opportunity to extend their maturities on new bond issues, to lock in today's low rates for the next 20 or even 30 years.

Those of us old-timers familiar with the now-extinct low-coupon Depression-era bonds that eventually became known as "flower bonds"* understand the implications of Buchholz's op-ed. The federal government really would be wise to lengthen its maturity schedule in today's favorable market for their paper. The problem is that no incumbent administration wants to pay any more for debt service than it must, so the White House would be happier with even-lower rate short-term paper and leave the problem of debt refundings to the next occupant.

This triggered a thought in my mind. There is always demand from private pension funds to invest in long-term bonds, to match the duration of their liabilities. The same used to be true of public pension funds until government bond yields plunged so low that they could no longer justify the higher expected investment returns they need to show to defend their actuarial discount rates. My column last week discussed that problem. Meanwhile the public funds also have a unique problem in that they have promised inflation-linked cost-of-living increases to their retirees, so they are extremely vulnerable to future inflation shocks which would devastate their fixed income portfolios.

In this light, it would be wonderful if the U.S. Treasury were to issue fixed-floating hybrid bonds that would offer a fixed yield for, say, 10 years and then pay a premium over inflation thereafter. These notes were widely used in the banking sector for preferred stock issues in the last decade, and I think they may offer some structural advantages on both sides. Pension funds would have a fixed coupon income in the coming dicey decade when government bonds offer the best diversification against stock market plunges, and they would later enjoy at least a modicum of protection against inflation.

I've always been a conceptual policy fan of inflation indexed bonds for the federal government because they penalize profligate regimes (think of Greece) that try to inflate their way out of a fiscal and entitlement trap. Floating rate paper will serve as a deterrent to runaway inflation, as it hits the budget of the inflator government and protects the little guys who own the paper either directly or through their retirement plan. As an investor, the problem has always been that the Treasury has issued so little of this paper that it trades today with scarcity value and thus offers very little premium over inflation -- and sometimes even less. So this isn't a panacea, but it is a reasonable element of a long-term federal debt management strategy that should be encouraged by taxpayers and investors nationwide.

Now I'm not going to claim enough expertise right now to say what the interest rates should be, or how exactly the folks at the office of debt management in the Treasury department should engineer this paper. My broader point is that there could be some real benefits for both federal and state/local taxpayers if they convened a meeting of the federal debt team with some of the pension experts and figure out what kind of paper would be most valued in the public portfolios in coming years.

*The term "flower bonds" was given to these low-coupon bonds when interest rates on newly bonds went much higher so Congress later threw a sop to underwater government bondholders (who helped to finance World War II) by making the bonds payable at par upon death in settlement of an individual estate's taxes, so they became associated with the condolences for the dearly departed with taxable estates.

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