Donald Trump wants to buy back Treasury bonds on the cheap

By Buttonwood

THE latest idea from Donald Trump, the Republican Presidential nominee, concerns the Treasury bond market. As pointed out before, Mr Trump's plans to cut taxes, maintain entitlement benefits and balance the budget, don't make sense. Instead, Mr Trump seems to be abandoning the balanced budget element, opting for Keynesianism with a twist. He told CNBC that

I would borrow, knowing that if the economy crashed, you could make a deal.

The idea, it seems, would be to get creditors to accept less than 100 cents on the dollar. This happens with corporate bankruptcies; if the market price has fallen to 60 cents on the dollar, and been snapped up by specialist hedge funds, then redeeming the debt at 70 cents on the dollar may be a good deal. Emerging economies have done the same in the past when they have fallen on hard times; it happened in Greece.

But with Treasury bonds, investors expect to get 100 cents on the dollar. It is the risk-free asset that underpins the entire global financial system.

Of course, if there were long-dated Treasury bonds trading at 90 cents on the dollar, say, then investors might sell for 95 cents. But it is not clear whether this would do the US government any good.

In what circumstances do Treasury bonds trade below face value? Remember that the coupon/price equals the yield. Take a bond that was issued with a 2% coupon. Inflation subsequently takes off and yields for bonds of the same maturity rise to 4%. No-one will want to buy a bond yielding 2% in such circumstances. So the bond price will fall until the yield hits 4%. How far it falls depends on the maturity of the debt. If it is due to be repaid next year, it is not going to drop very far below face value (100). If it is going to be redeemed in 2046, then it will fall quite a bit further.

Mr Trump worries (perfectly validly) about what will happen to the US's debt sustainability if bond yields move up several percentage points from here. But let's assume that does happen and lots of Treasury bonds are trading at 90 cents on the dollar. Investors might be willing to accept 95 cents upfront rather than wait till maturity.

But why would the government want to do that trade? The interest rate on Treasury bonds is fixed. If the government issues debt during a low-rate period, that's good news. To refinance that debt in a period of higher bond yields, the government would have to borrow from the market at much higher rates. (Unless that is, the government was running a budget surplus and could use cash to repay the debt. But that hardly seems likely given his spending and tax plans.)

Currently, most of the US's longer-term debt trades above par value because it was issued at a time when bond yields were higher. For example there is a bond with a 2030 maturity and a 6.25% coupon; it trades at 152 cents on the dollar. Would it be worth offering 155 cents on the dollar upfront, and refinancing the debt at today's lower rates? The dollar value of US debt would rise, not fall, in such circumstances.

In short, any voluntary deal with the market would require the government to pay fair value. And unless you think the Treasury bond market is mispriced (and it is the most liquid market on the planet), the government is unlikely to profit. It might be sensible for the government to alter the patterns of new Treasury issuance; borrowing long-term to lock in low rates for a generation. The Treasury has discussed the idea of refinancing illiquid bonds to improve market liquidity. But that is quite a different idea from Mr Trump's proposal; the interest savings would be trivial.

A forced deal, of course, would count as a default. Treasury bonds are at the heart of the financial system. Banks use them as collateral for loans; insurance companies hold them as reserves; pension funds own then to fund retirement benefits; mutual funds own them as well. Any default within the system would have cataclysmic consequences for the economy that would far outweigh any gains in refinancing costs. To cap it all, the Federal Reserve owns almost $2.5 trillion of Treasury bonds and the Social Security Fund some $2.8 trillion. So the government would, in part, be defaulting to itself.

In short, this seems like a completely nonsensical idea. Do you think it is possible that Mr Trump didn't think it through and just said the first words that came into his head? Couldn't be.