Treasury to Issue $1 Trillion in FY 2009

WASHINGTON - The Treasury Department's plans to issue more than $1 trillion in Treasury securities in fiscal 2009 to help raise revenues for the financial rescue plan are likely to further the recent pronounced move of municipal bond yields above Treasury yields, market participants say.

Facing mounting bills from the Troubled Asset Relief Program and other federal rescue measures, the Treasury has announced it will auction certain government securities more frequently, and will auction $25 billion of newly resurrected three-year notes today.

The Treasury last issued three-year notes in May 2007 and has revived the security to take advantage of low borrowing rates. The department will begin auctioning its 10-year bills monthly beginning in December instead of quarterly and will auction its 30-year bonds quarterly instead of twice a year.

The Treasury's borrowing needs could approach $1.4 trillion in the fiscal year, acting assistant secretary for financial markets Karthik Ramanathan said at a Nov. 4 meeting with the department's borrowing advisory committee. He said the federal deficit could rise to $988 billion during the fiscal year, almost double what was estimated in July, because weaker tax receipts in fiscal 2008 fell to the lowest level in five years.

The Federal Reserve's balance sheet could surge to $3 trillion - roughly 20% of gross domestic product - by the end of 2008, Richard Fisher, president of the Federal Reserve Bank of Dallas, said in a speech last week. But the Fed's holdings of Treasury securities have fallen from about 100% to less than one-third this year as it buys up illiquid assets from struggling banks, he said. As of Nov. 5 the Fed held $476 billion in Treasury securities.

The increased Treasury borrowing comes as municipals have cheapened considerably versus Treasuries and the ratio between 30-year munis and 30-year Treasuries since Aug. 8 has averaged 119.3% according to Municipal Market Data.

Municipal bonds have historically yielded less than Treasury securities because of their tax-exempt benefits. Following a marked swing of municipal yields above Treasury yields in March, in September, muni yields swung to their greatest level above Treasuries on record, according to data from Municipal Market Advisors.

Muni bonds historically have yielded 80% of Treasuries since that year, according to MMA data. But a triple-A rated 10-year tax-exempt general obligation bond returned 115% of the 10-year Treasury note on Nov. 6, down from a high of 127% on Oct. 23. Muni yields were last at 100% in March 2003, according to MMA.

"We were always taught that any time it's at 85% you've got value in munis," said Craig Elder, fixed-income analyst with Robert W. Baird & Co. in Milwaukee. But as the credit crisis snowballed, he said, investors showing a flight-to-quality drove down Treasury yields, while muni yields reached historic highs partly because mutual funds experienced the biggest weekly redemptions in history in October, forcing them to liquidate tax-exempt holdings.

The muni-to-Treasury ratio will likely return to normal by mid-2009, Elder said, as additional supply from the Treasury satiates the Treasury market and pushes up yields, and as munis gain value if President-elect Barack Obama follows through with proposals to raise rates for the two-highest income tax brackets.

But market fundamentals may be permanently altered in the credit crisis aftermath.

"We're headed to the new normal," said Matt Fabian, managing director at MMA in Concord, Mass. "The market is evolving to something different than it was over the last five years."

The muni-to-Treasury-yield ratio is not likely to return to normal because of lingering effects from the credit crisis, he said. Fabian said he expects credit spreads to be structurally wider and the yield curve to be steeper. Supply pressure and secondary market illiquidity will likely keep muni yields elevated above Treasuries, he said.

"Now we have yields high and ratios high," Fabian said. "It tells you something has changed in the market and you can't necessarily assume it will go back to how it used to be."

Investors' flight to quality has pushed down Treasury yields, allowing the department to borrow relatively cheaply, while the low yields have contributed to the higher ratio with munis. This may change if investors lose their appetite for Treasury securities.

T.J. Marta, an economist and fixed-income strategist with RBC Capital Markets, said foreign investors who buy the bulk of Treasuries may turn to private equity investments where the returns are greater.

"We're ramping up issuance right into the teeth of demand dropping off," he said.

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