Federal Debt Management: Treasury Should Strengthen Policies for Market Outreach and Analysis to Maintain Broad-Based Demand for Securities

The Congressional Budget Office projects that federal deficits will reach $1 trillion in 2020 and average $1.2 trillion per year through 2029, further adding to the more than $16 trillion in current debt held by the public. As a result, Treasury will need to issue a substantial amount of debt to finance government operations and refinance maturing debt. To support its goal to borrow at the lowest cost over time, Treasury must maintain strong demand from a diverse group of investors for Treasury securities.

GAO prepared this report as part of continuing efforts to assist Congress in identifying and addressing debt management challenges. This report (1) identifies factors that affect demand for Treasury securities and (2) examines how Treasury monitors and analyzes information about the Treasury market to inform its debt issuance strategy.

GAO analyzed data on investor holdings of Treasury securities; surveyed a non-generalizable sample of 109 large domestic institutional investors across 10 sectors (67 responded); reviewed Treasury analysis and market research; and interviewed market participants across sectors, experts on foreign investors, and Treasury officials.

The large institutional investors GAO surveyed across multiple sectors identified liquidity, depth, and safety as the most important characteristics of Treasury securities. This combination supports reliable demand from different types of investors through changing market conditions. Many investors accept low yields because of these characteristics, keeping the Department of the Treasury's (Treasury) borrowing costs low.

Market participants GAO interviewed and surveyed identified risks that could degrade these key characteristics and reduce future demand:

Debt limit impasses could force Treasury to delay payments on maturing securities and interest, until sufficient funds are available, compromising the safety of Treasury securities.

Unsustainable levels of federal debt could cause investors to demand a risk premium and seek out alternatives to Treasury securities.

A reduced role for the U.S. dollar as the dominant reserve currency could diminish the advantages of holding Treasury securities for foreign investors, particularly foreign government investors who hold large amounts of dollar-denominated assets to assist in managing their exchange rates.

Changes in the Treasury secondary market where securities are traded— including high-frequency trading and a reduced role for broker-dealers who buy and sell for customers—could increase volatility and reduce liquidity.

Treasury regularly makes important issuance decisions—such as what types of securities to issue and in what quantities—to maintain broad-based demand and support its goal of borrowing at the lowest cost over time. Treasury officials said three key inputs support these decisions: market outreach; auction and market metrics (e.g., trading volumes); and analytical models .

However, Treasury has not finalized its policy for systematically conducting bilateral market outreach to ensure a thorough understanding of market demand. Treasury also does not have a policy governing important aspects of its analytical modeling, including following and documenting quality assurance steps to ensure that analytical methods are appropriate and available to future model developers and users. Codifying policies governing key information sources would help ensure that Treasury's decisions are based on the best possible information.

GAO recommends that Treasury (1) finalize its policy for conducting bilateral market outreach and (2) establish a policy for the documentation and quality assurance of analytical models.

Treasury agreed with these recommendations.

In 2018, the Department of the Treasury (Treasury) held more than 280  auctions where it sold Treasury securities (e.g., Treasury bills, notes, and  bonds) to investors, totaling more than $10 trillion in total borrowing. The  Congressional Budget Office projects that federal deficits will reach $1  trillion in 2020 and average $1.2 trillion per year through 2029; further  adding to the more than $16 trillion in current debt held by the public. As  a result, Treasury will need to issue a substantial amount of debt in the  coming decades to finance government operations and refinance  maturing debt held by the public.

To achieve its goal of financing the government’s borrowing needs at the  lowest cost over time, Treasury must maintain strong demand from a  diverse group of investors for the debt that it issues. Given the size of the  Treasury market, even a marginal reduction in the amount of interest paid  would significantly reduce the government’s borrowing costs. A decrease  in the total cost of borrowing of just one one-hundredth of a percent—or  one basis point—would save the government tens of millions of dollars  annually.

We prepared this report under the Comptroller General’s authority as part  of continuing efforts to assist Congress in identifying and addressing debt  management challenges. This report: (1) identifies factors that affect  demand for Treasury securities; and (2) examines how Treasury monitors  and analyzes information about the Treasury market to inform its debt  issuance strategy.

To identify the factors that affect demand for Treasury securities we  analyzed Treasury and the Federal Reserve System (Federal Reserve)  data, including Treasury holdings by type of investor and sector. We also reviewed economic literature about the demand for Treasury debt. We  administered an online survey to 109 of the largest institutions by total  assets or other equivalent financial indicator in 10 sectors: money market  funds, mutual and exchange-traded funds, state and local government  retirement funds, private pension plans, commercial banks, life insurance  providers, casualty insurance providers, broker-dealers, nonfinancial  corporations, and state and local governments. Sixty-seven market  participants (62 percent) completed the survey with between five and 11  respondents per sector. The survey results are not generalizable to all  investors in Treasury securities, but provide views on demand for  Treasury securities from some of the largest investors and risks they see  to the market. For more information on our survey methodology, see  appendix I.

We interviewed 11 market participants representing broker-dealers,  commercial banks, mutual funds, and public pension funds. We selected  market participants to ensure a diversity of viewpoints, taking into  consideration market sector, share of the Treasury market, and  recommendations by market experts. We also interviewed three  associations representing major sectors participating in the Treasury  market, such as asset managers and insurance companies, and a widely  recognized expert and commentator on the Treasury market. The views  expressed in these interviews are not generalizable to all market  participants.

To better understand recent trends in foreign holdings of Treasury  securities, we analyzed data from the Treasury International Capital  system and the Federal Reserve’s Financial Accounts of the United  States. We interviewed officials from the International Monetary Fund  (IMF), Bank for International Settlements, the Federal Reserve Board of  Governors, and the Federal Reserve Bank of New York. We also  coordinated with representatives of five audit institutions from selected  countries or regions that hold Treasury securities and we reviewed  relevant audit reports.

To examine how Treasury monitors and analyzes information about the  Treasury market to inform its debt issuance strategy, we assessed  Treasury’s approach against IMF and World Bank guidance for public  debt management and Federal Standards for Internal Control. The  control activities component of internal control—the actions management  establishes to achieve objectives and respond to risks—was significant to  this objective, along with the related principle that management should  implement control activities through policies. We assessed Treasury’s  policies and procedures for conducting market outreach and analytical  modeling.

We also assessed the documentation of Treasury’s analytical models  against our Assessment Methodology for Economic Analysis,  supplemented by Federal Reserve guidance. We reviewed analysis and  market research Treasury conducted to make recent issuance and  product decisions. We interviewed Treasury officials about how they  make debt-issuance decisions.

To assess the reliability of the data used in this study, including Treasury  auction data and information on the largest holders of Treasury securities,  we reviewed related documentation and traced data from source  documents, where possible and appropriate. In some cases, we  corroborated the results of our data analyses and interviews with other  sources. We used data sets that are commonly used by Treasury and  researchers to monitor changes in federal debt and related transactions.  Based on our assessment we believe that the data are reliable for  reporting on broad trends in Treasury security holdings.

We conducted this performance audit from June 2018 to December 2019  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

Treasury borrows money by issuing Treasury securities to finance the  federal deficit (i.e., the difference between current spending and  revenues), which includes paying interest on outstanding debt, and  refinancing maturing debt. According to Treasury’s Strategic Plan, the  primary objective of its debt management strategy is to finance the  government’s borrowing needs at the lowest cost over time. Treasury  reports that it achieves this objective by  issuing marketable debt with a regular and predictable framework—  meaning Treasury debt managers provide the market clear and  transparent information about planned issuance, and set a standard  calendar of auctions of each security type. managing its debt portfolio to mitigate “rollover risk”—the risk that it  may have to refinance its debt at higher interest rates;  fostering a healthy and liquid secondary market—the marketplace in  which Treasury securities are traded; and promoting a broad and diverse investor base.

To this end, Treasury issues securities in a wide range of maturities to  appeal to a broad range of investors, and in sufficient amounts to promote  liquid markets so investors can easily buy and sell Treasury securities.  Treasury’s regular and predictable auction framework also provides  investors greater certainty and better information to plan their  investments.

Treasury regularly issues nominal securities that range in maturity from 4  weeks to 30 years, inflation protected securities with 5-, 10-, and 30-year  maturities, and floating rate notes (see table 1). A nominal security  returns the face value of the security at maturity; an inflation-indexed  security repays the principal adjusted for inflation. Floating rate notes pay  interest quarterly at a rate that varies with changes in the indexed rate,  such as the discount rate on the 13-week Treasury bill.

The interest rates associated with the range of maturities of the nominal  securities issued by Treasury creates a “yield curve” which represents the  relationship between the maturity of an asset and its yield (the interest  rate paid by Treasury or cost of borrowing). Each security has different  cost and risk features for Treasury. Generally, Treasury must pay a  higher interest rate for longer-dated securities to compensate buyers for  waiting longer for principal to be repaid and accepting increased risk due  to uncertainty about future market conditions. But longer-dated  securities offer more certainty for budget planning because they lock in  interest rates for the duration of the security. Similarly, as Treasury offers  more of any given security, it may have to pay more interest to attract  investors. However, if Treasury offers too little of a specific security given  changing market demand, it could reduce the security’s liquidity in the  secondary market, which would increase the interest cost Treasury must  pay to compensate investors for less liquidity.

The mix of securities changes regularly as Treasury issues new debt and  funding needs change. Figure 1 shows the outstanding marketable debt  held by the public by security type between 2005 and 2019.

Treasury typically responds to long-term increases in borrowing needs by  taking the following steps:  Increasing the amount of securities offered at scheduled  auctions. In 2018, Treasury increased auction sizes for securities at  all maturities as borrowing needs increased. For example, Treasury  increased the average size of auctions for floating rate notes by 15  percent (from about $16.2 billion in 2017 to $18.6 billion in 2018) and  3-year notes by 32 percent (from about $25.9 to $34.1 billion).

Increasing the frequency of scheduled auctions. For example, in  2003 and 2008, Treasury adjusted the auction calendar to include  additional reopenings of 10-year notes. More recently, Treasury  added an October 5-year TIPS issue, with the first auction held on  October 17, 2019.

Introducing new types of securities to offer at its auctions. For  example, in 2014, Treasury introduced a 2-year floating rate note. In  October 2018, Treasury began auctioning a 2-month bill. According to  Treasury officials, the addition of the 2-month bill allowed Treasury to  issue more bills without increasing auction sizes for existing bills  beyond maximum sizes recommended by market participants.

In taking these steps, Treasury announces expected auction sizes each  quarter and publicly discusses the changes well in advance.

The Treasury Market Has a Diverse Investor Base

Treasury securities are held by a wide range of investors for a variety of  different reasons, including cash and liquidity management, collateral,  hedging, speculation, arbitrage, and as long-term “buy and hold”  investments. As shown in figure 2, these investors can be grouped into  three categories:

The Federal Reserve System (Federal Reserve), the U.S. central  bank, conducts monetary policy to promote maximum employment,  stable prices, and moderate long-term interest rates. As part of this  role, the Federal Reserve banks may buy and sell Treasury and other  securities in the secondary market and roll over holdings of Treasury  securities at auction as a noncompetitive bidder. The Federal  Reserve is the largest individual holder of Treasury securities, and as  of June 2019, held approximately $2.3 trillion in Treasury securities— or 14 percent of marketable debt held by the public.

International investors include both private investors and foreign  official institutions, including central banks and government-owned  investment funds. As of June 2019, foreign holdings represented 41  percent of marketable debt held by the public; about $6.6 trillion. Most  foreign holdings are from official sources (63 percent according to  available data), such as foreign central banks.

Domestic investors include banks, investment funds, pension funds,  insurance companies, state and local governments, and individuals.  As of June 2019, domestic investors held 45 percent of marketable  debt held by the public; more than $7 trillion. Figure 2 shows the  sectors that represent the domestic investor category.

Key Characteristics of Treasury Securities Support Reliable Demand but Changes in Policies or Market Conditions Pose Risks Low Risk and the Ability to Easily Buy and Sell Large Volumes of Treasury Securities Support Reliable, Broad-Based Demand

The combination of the liquidity, depth, and safety of the Treasury market  is unmatched in global markets. These characteristics make Treasury  securities a unique and critical asset for a broad range of investors.  Market participants and subject matter experts we interviewed and  surveyed identified liquidity, depth, and safety as the most important  characteristics of Treasury securities. As shown in figure 3, 63 of 67  market participants we surveyed from across 10 domestic sectors  reported that liquidity is one of the most important characteristics,  followed by depth and safety. Moreover, 55 of the 67 survey  respondents cited at least two of these characteristics as the most  important.

Liquidity, depth, and safety are interrelated characteristics of Treasury  securities (see fig. 4). For example, liquidity and depth are both related to  the size of the market and the willingness of market participants to buy  and sell securities at low cost. In addition, liquidity is enhanced by safety,  for example by minimizing the risk that trading could be disrupted by  default. Treasury securities are considered one of the safest assets in the  world because they are backed by the full faith and credit of the U.S.  government.

The importance of these characteristics was consistent across sectors, as  liquidity, depth, and safety support a variety of business practices and  needs. For example, Treasury securities serve as a close substitute to  cash for financial institutions and corporate treasurers, are one of the  cheapest and one of the most widely used forms of collateral for financial  transactions, and are a benchmark for pricing many other financial  products, such as corporate bonds, derivatives, and mortgages.

In addition, international investors and experts we interviewed said that  both foreign official sector and foreign private sector investors value the  liquidity, depth, and safety of the Treasury market. For example, foreign  central banks value the ability to buy and sell large quantities of securities  to assist in managing their exchange rates and, in times of economic  stress, provide foreign currency credit to their country’s businesses that  borrow or trade in U.S. dollars. Officials from a foreign central bank we  spoke with told us that Treasury securities are well suited for their  investment needs because of the combination of the large and deep  market—which accommodates high-volume transactions—and their  safety and liquidity.

The combination of liquidity, depth, and safety supports reliable demand  for Treasury securities through changing market conditions. A diverse  investor base helps to protect Treasury from large swings in interest costs  due to shifts in demand from particular sectors.

After liquidity, depth, and safety, the fourth most cited characteristic of  Treasury securities (25 of 67 survey respondents) was the ability to  purchase across the yield curve—that is, purchasing securities of various  maturities to match investment needs. In addition to issuing securities at  various maturities, Treasury’s strategic plan includes a goal to develop  new products to increase the investor base. As previously noted,  Treasury began issuing 2-month bills in October 2018. Market  participants we surveyed said there is potential demand for (1) a new  nominal security; (2) expansion of the floating rate note offerings; and (3)  a zero-coupon bond. (For more information on the survey results, see  appendix II.) “An increase in global risk (political or  economic) will determine flight to quality and  higher allocation to Treasuries.”

Many investors are willing to accept a lower yield on Treasury securities  in exchange for the liquidity, depth, and safety they provide. For example,  only 14 of the 67 market participants we surveyed cited the yield of  Treasury securities as one of the top three characteristics. Market  participants we surveyed and interviewed emphasized that there is no  true substitute for Treasury securities because other assets come with  additional risks or do not have the liquidity and depth of the Treasury  market. As a result, in times of economic uncertainty or stress, investors  often move quickly into Treasury securities—known as a “flight to  quality”—which increases demand and drives down yields.

Changes in U.S. Monetary Policy Operations, Financial Regulation, and Foreign Central Bank Needs Have Affected the Composition of Demand

While a broad and diverse investor base helps promote stability for the  Treasury market as a whole, demand for Treasury securities by different  types of investors fluctuates over time, reflecting changes in the  investment needs of particular sectors. Since the 2007-2009 financial  crisis, changes in monetary policy operations, financial regulation, and  foreign central bank needs have changed the composition of demand for  Treasury securities across different sectors. Figure 5 shows the overall  changes in holdings of Treasury securities by the three primary investor  groups—domestic investors, international investors, and the Federal  Reserve.

As part of its response to the 2007-2009 financial crisis, the Federal  Reserve substantially increased its purchases of longer-term Treasury  securities. In turn, these purchases substantially increased the overall  size and duration of the Federal Reserve’s holdings of Treasury securities  (see fig. 6). From 2008 to 2014, its holdings of Treasury securities  increased by 475 percent; from roughly $480 billion in 2008 to $2.7 trillion  in 2014. The average duration of the holdings also increased from 2.7  years in 2007 to a high of 7.8 years in 2013.

This substantial shift in the size and composition of the Federal Reserve’s  holdings began in late 2008 when the Federal Reserve undertook the first  of a series of large-scale asset purchase programs, often referred to as  quantitative easing, to better reduce long-term interest rates and improve  economic conditions. The Federal Reserve’s purchases of long-dated  Treasury securities, and other assets, substantially increased the size of  its balance sheet and meaningfully reduced interest rates on long-term  Treasury securities.One study estimated that quantitative easing  reduced interest rates on 10-year Treasury securities as much as 160  basis points (or 1.6 percentage points) (see sidebar).

Federal Funds Rate  A market determined interest rate that banks  charge each other to borrow reserves  overnight.

The Federal Reserve needed a new approach to managing short-term  interest rates while maintaining a large balance sheet. Therefore, in 2014,  the Federal Reserve outlined a new framework it intended to adopt for  implementing monetary policy when it began to increase interest rates for  the first time since the financial crisis. The new operating framework  entails setting two short-term interest rates to manage the federal funds  rate (see sidebar). Changes in these rates are intended to influence  other short-term interest rates (including rates on Treasury securities), the  availability of credit, and the economy as a whole to assist the Federal  Reserve in achieving its monetary policy objectives.

In response to the improving economy the Federal Reserve, in October  2017, began a process to slowly shrink its balance sheet by limiting the  reinvestment of proceeds from maturing securities, intending to return to  a smaller balance sheet and lower holdings of Treasury securities. In  January 2019, however, the Federal Reserve announced that it intended  to continue to operate with its post-crisis framework and would therefore  evaluate the appropriate time to stop shrinking its balance sheet. In  October 2019, the Federal Reserve announced that it would expand its  balance sheet, through purchases of Treasury bills, to satisfy increases in  the market’s demand for cash and keep the federal funds rate in its target  range. As a result of these announcements, the Federal Reserve will  continue to hold a much larger portfolio of Treasury securities and will  therefore continue to purchase much larger quantities of Treasury  securities on an ongoing basis.

If economic and financial conditions warrant, the Federal Reserve has  stated that it may again buy specific maturities of Treasury securities in  significant amounts to influence prevailing long-term interest rates to  improve economic conditions and thereby aid in achieving its monetary  policy objectives. The possibility of these purchases during future periods  of economic stress could increase current demand for Treasury securities  among market participants, even during normal times. This could keep  interest rates on Treasury securities somewhat lower than they would be  otherwise.

Some Financial Institutions Changed Their Holdings of Treasury Securities in Response to Regulations Issued after the 2007-2009 Financial Crisis

The implementation of recent financial regulations and reforms in the  wake of the 2007-2009 financial crisis resulted in changes in certain  domestic sectors’ holdings of Treasury securities, including money market  funds and banking institutions.

Money Market Fund  A money market fund is a type of mutual fund  that is required by law to invest in low-risk  securities. Money market funds act as  intermediaries between investors seeking  highly liquid, safe investments and corporate  and government entities that issue short-term  debt to fund operations. Money market funds  typically invest in short-term, highly liquid  securities, such as Treasury bills, and pay  dividends that generally reflect short-term  interest rates.

Money market fund reforms that took effect in 2016 resulted in a  significant increase in this sector’s holdings of Treasury securities (see  sidebar). This sector experienced significant volatility during the 2007- 2009 financial crisis as large numbers of investors rapidly withdrew from  these funds. To address this risk, the Securities and Exchange  Commission (SEC) placed a number of restrictions on prime money  market funds.

Prime funds invest primarily in taxable short-term corporate and bank  debt. The SEC regulations exempted government money market funds— which invest only in cash and U.S. government securities, including  Treasury securities—from certain requirements because these assets are  less risky and more liquid than other investments. Since these  exemptions make government funds particularly attractive, many  investors replaced prime money market fund investments with  government money market fund investments (see fig. 7).

Money market funds now represent one of the largest shares of Treasury  securities holdings among domestic investors, holding approximately 8  percent (around $743 billion) of the domestic total as of June 2019  (excluding the Federal Reserve). The five money market funds we  surveyed all reported that one of the top three ways they use Treasury  securities is to comply with regulations.

Following the financial crisis, U.S. and international regulators  implemented reforms intended to promote a more resilient financial  sector, including reforms aimed at the banking sector. Overall, these  reforms increased demand from large banking institutions for Treasury  securities.

The reforms strengthened global capital and liquidity standards to make  banking institutions more resilient and better able to lend in the event of  an economic shock. For example, through the “Liquidity Coverage Ratio,”  large banking institutions are now required to ensure they can cover  short-term cash needs by holding a proportionate amount of high-quality  liquid assets—cash reserves, Treasury securities, or Ginnie Mae  securities. Since Treasury securities are classified as part of the group  of most liquid assets, they are attractive for banks looking to meet these  requirements. “Changes in bank liquidity regulations steered  us to use more Treasuries in recent years.”

Overall, bank holdings of Treasury securities increased from less than 1  percent of the sector’s total assets in 2008 (just over $100 billion) to more  than 3 percent (over $800 billion) as of June 2019. The five banks we  surveyed all reported that one of the top three ways they use Treasury  securities is to comply with regulations.

Foreign Central Bank Holdings of Treasury Securities Have Changed over Time Based on the Need to Manage Their Exchange Rates

Foreign official demand for Treasury securities—which includes foreign  governments and central banks as well as government-owned investment  funds—has fluctuated based on economic conditions, especially the need  for foreign central banks to manage their exchange rates. After the 2007- 2009 financial crisis, foreign governments increased holdings of Treasury  securities from $1.5 trillion in 2007 to $4.1 trillion in 2015. In recent years,  foreign governments’ accumulation of Treasury securities has slowed  substantially. As of December 2018, they held about $4 trillion, or about  25 percent of all marketable Treasury securities. According to market  participants and subject matter experts we interviewed, this slowdown  does not imply a change in the nature of foreign demand for Treasury  securities, but rather is a consequence of foreign central banks’ changing  need for foreign reserves—many of which are held in the form of  Treasury securities—to assist in managing their currencies.

The U.S. dollar is the dominant currency used by foreign central banks in  their official foreign exchange reserves, referred to as a reserve currency  (see sidebar). As the reserve currency, foreign central banks buy and  sell U.S. dollars to influence the value of their currencies to help manage  their exchange rates, among other uses. To this end, foreign central  banks hold Treasury securities in part because they can be converted to  U.S. dollars quickly and in great quantity.

Foreign central banks often act to limit the impact of exchange rate  fluctuations and maintain the stability of their own currency. For  example, a fall in U.S. interest rates tends to reduce the demand for  dollars as private investors seek higher yielding assets abroad. In  response, foreign central banks buy dollars—often investing those dollars  in Treasury securities—and sell their own currency on foreign exchange  markets which reduces the demand for—and hence the value of—their  own currency relative to the dollar (see fig. 8).

Conversely, when U.S. interest rates began increasing in 2015, dollar- denominated assets became more attractive to private investors seeking  higher yields, which increased the value of the dollar relative to other  currencies. In response to this and other events, experts we spoke with  highlighted the role of China in particular— the largest foreign official  holder of Treasury securities—in selling Treasury securities during that  time period to help stabilize its exchange rate. Because U.S. interest  rates are cyclical, foreign central bank interventions will also be cyclical,  which implies their demand for Treasury securities will continue, to some  extent, to vary over time so long as the U.S. dollar is a dominant reserve  currency.

Treasury Market Faces Risks from Debt Limit Impasses, Rising Debt, and Changing Market Conditions That Could Compromise the Safety or Liquidity of Treasury Securities

Future changes in market conditions or policies—especially to the extent  those changes significantly affect the combination of liquidity, depth, and  safety of Treasury securities—could raise new and important risks to the  Treasury market. Market participants we interviewed and surveyed across  various sectors have raised concerns about risks that could affect  demand for Treasury securities: risks from a future debt limit impasse, the  sustainability of the federal debt, the dollar’s status as the primary reserve  currency, and changes in the structure of the market which might affect  liquidity, all of which could degrade the unique advantages of the  Treasury market.

Debt Limit  The debt limit is a legal limit on the total  amount of federal debt that can be  outstanding at one time. (31 U.S.C. §§ 3101,  3101A.)  It is not a control on debt but rather an after- the-fact measure that restricts the  Department of the Treasury’s authority to  borrow to finance the decisions already  enacted by Congress and the President.

Many market participants from all 10 sectors we surveyed and  interviewed identified delays in raising (or suspending) the debt limit as  potentially undermining the perceived safety of Treasury securities (see   sidebar). During these times, Treasury departs from normal cash and  debt management operations and takes extraordinary actions to avoid  breaching the limit. Once all of the extraordinary actions are exhausted,  Treasury may not issue debt without further action from Congress and  could be forced to delay payments until sufficient funds become available.  Treasury could eventually be forced to default on legal debt obligations.

We previously reported that delays in raising the debt limit can lead to  increased borrowing costs and significant disruptions in the Treasury  market. For example, there were lengthy impasses over the debt limit in  2011 and 2013. During the 2013 impasse, investors reported taking the  unprecedented action of systematically avoiding certain Treasury  securities (i.e., those that would mature around the dates when Treasury  projected it would exhaust the extraordinary actions available).  Consequently, interest rates for these securities increased dramatically  and liquidity declined in the secondary market where securities are traded  among investors. “Treasury securities are held for liquidity  management. It is critical that we have  confidence in the timely payment of principal  and interest on U.S. Treasury securities.  Gamesmanship by political parties that  impacts the confidence in timely payment on  U.S. Treasury securities simply is not  acceptable. We therefore are forced to invest  in other forms of liquid securities, or to modify  our participation in T-bills to avoid key dates  around debt limits.”

Overall, 48 of the 67 (72 percent) investors we surveyed reported that  they anticipated they would take similar action—such as avoiding  purchases of securities that would mature around the affected dates and  requiring higher yields for purchasing those securities—to manage  potential market disruptions caused by any future debt limit impasses.

A default would have devastating effects on U.S. and global economies  and the public. It is generally recognized that a default would prevent the  government from honoring all of its obligations to pay for such things as  program benefits; contractual services and supplies; employees’ salaries  and wages and retirement benefits; and principal on maturing securities.  Any disruption of these payments would have cascading effects on the  economy. A default would call into question the full faith and credit of the  U.S. government, and therefore immediately and significantly decrease  demand for Treasury securities. Those investors who did purchase  Treasury securities would demand a premium in the form of higher  interest rates, to compensate for this increased risk.

We have reported numerous times that the full faith and credit of the  United States must be preserved. We have recommended that Congress  consider alternative approaches to the current debt limit to avoid seriously  disrupting the Treasury market and increasing borrowing costs. Experts  have suggested replacing the debt limit with a fiscal rule imposed on  spending and revenue decisions. As previously reported, Congress could  consider this change as part of a broader plan to put the government on a  more sustainable fiscal path.

Some market participants we interviewed and surveyed expressed  concern that continued deterioration of the federal government’s fiscal  position could negatively affect the safety of Treasury securities. We have  reported that the federal government is on an unsustainable fiscal path.  Over the last 10 years, debt held by the public has more than doubled;  increasing from about $7 trillion in 2009 to $16 trillion in 2019. We, the  Office of Management and Budget, and the Congressional Budget Office  estimate that federal debt will continue to grow, surpassing its historical  high of 106 percent of gross domestic product within 13 to 20 years.  Congress and the administration face serious economic, security, and  social challenges that require difficult policy choices in the near term in  setting national priorities and charting a path forward for economic  growth. We have reported that a broad plan is also needed to put the  federal government on a sustainable long-term fiscal path and ensure that  the United States remains in a strong economic position to meet its  security and social needs, as well as to preserve the flexibility to address  unforeseen events.

In August 2011, one of the major credit rating agencies, Standard &  Poor’s, lowered its long-term sovereign credit rating on the U.S. from AAA  to AA+, citing the United States’ rising public debt burden and greater  policymaking uncertainty. The other major rating agencies have not  lowered their rating of U.S. debt but continually monitor fiscal conditions  and the political climate.

If market participants perceive that the deteriorating fiscal outlook of the  federal government could undermine the credit quality of Treasury  securities, some investors could seek out alternative investments or  demand a risk premium. This could further increase yields and therefore  costs to Treasury. In general, larger deficits are likely to increase the  yields on Treasury securities that are required by market participants, all  else equal.

U.S. Dollar’s Status as Reserve Currency

Market participants and subject matter experts we interviewed  emphasized the importance of the U.S. dollar’s status as the dominant  global reserve currency in supporting demand for Treasury securities. So  long as the U.S. dollar remains the dominant reserve currency worldwide,  Treasury securities are likely to remain in high demand by foreign central  banks and other investors.

However, events that undermine the liquidity, safety, or depth of the  Treasury market—such as debt limit impasses or concerns about fiscal  sustainability—could reduce the share of U.S. dollar assets in foreign  central bank reserves. Furthermore, reduced openness of the U.S.  economy in global trade or financial markets would reduce the  advantages of holding U.S. dollar reserves and could similarly precipitate  a shift away from the U.S. dollar toward other currencies. Such a shift  would likely reduce foreign official holdings of Treasury securities and  could potentially reduce demand from other sectors that use U.S. dollars  for global trade and other transactions. Consequently, Treasury’s cost to  borrow would likely increase.

Secondary market trading in Treasury securities is increasingly conducted  on electronic platforms. The resulting changes and innovations have led  to a number of benefits for market participants, but could also introduce  new risks. For example, the Treasury Market Practices Group reported in  2015 that electronic trading had arguably improved overall liquidity  through enhanced order flow and competition, reducing trading costs and  allowing market participants to more effectively manage risk.

Many market participants we surveyed agreed. For example, a market   participant we surveyed reported that increased electronification of the  Treasury market made it easier to price, trade, and settle holdings.  However, market participants we surveyed and interviewed also told us  that there is a potential risk of reduced liquidity and increased volatility in  the Treasury secondary market. Market participants attributed these  potential risks to a number of different factors related to the changing  structure of the market: (1) increased use of automated trading; (2)  increased role of principal trading firms; and (3) post-crisis financial  reforms.

Automated Trading  A subset of electronic trading that relies on  computer algorithms—advanced  mathematical models—to make decisions  about the timing, price, and quantity of the  market order.   High-frequency Trading   A subset of automated or algorithmic trading  in which the trading opportunities are  identified and acted upon algorithmically and  executed through technology at high speeds.

Market participants we surveyed and interviewed said that automated  trading—particularly high-frequency algorithmic trading (see sidebar)— may introduce operational risks that could interfere with market  functioning. Automated trading relies on speeds that are beyond manual  detection and intervention. Consequently, the Treasury Market Practices  Group pointed out that internal controls may not be sufficient to  counteract malfunctioning algorithms or algorithms reacting to inaccurate  or unexpected data. For example, a malfunctioning algorithm could  interfere with market functioning by creating sharp, short-lived spikes in  prices as a result of other algorithms responding to an initial incorrect  order. “Our Treasury trading desk is about 50  percent smaller than it was a decade ago,  and we now have nearly as many traders  devoted to algorithmic and electronic market- making as traditional market-making activity.”

Market participants also noted that this type of trading may lead to more  frequent episodes of volatility, making it more difficult to buy or sell  Treasury securities at predictable or stable prices, particularly during  periods of market stress. In one notable example, on October 15, 2014— in what has been referred to as a “flash rally”—the Treasury secondary  market experienced record-high trading volumes and significant intraday  volatility that could not be explained by external policy announcements or  other factors. A 2015 interagency report examining the events of that day  observed that as the speed of market activity increases, the Treasury  market could continue to experience more frequent variations in market  liquidity than in the past.

Increased Role of Principal Trading Firms  Advancements in technology, and the associated growth in high-speed  electronic trading, have contributed to a shift in the composition of the  types of firms actively trading and making markets in Treasury securities.  Market-makers serve a crucial role in financial markets by providing  liquidity to facilitate market efficiency and functioning (see sidebar). The  2015 interagency report examining the “flash rally” found that principal  trading firms—proprietary trading firms that almost exclusively use  automated trading strategies—conducted more than half of the trading  activity on certain electronic platforms on the days reviewed.

Market participants we spoke with expressed concern that some of the  principal trading firms might not continue to provide liquidity in times of  stress. According to the 2015 interagency report, principal trading firms  tend to buy and sell frequently in small amounts, rarely holding Treasury  securities beyond a day, and generally not trading on behalf of clients.

Additionally, the extent of these firms’ presence in the Treasury market  and the role they play is less well understood in part because they are not  required to report their Treasury holdings and other financial information  to the SEC that other financial institutions, such as broker-dealers and  investment companies, are required to report. These firms’ holdings of  Treasury securities are reflected in the Federal Reserve’s “household”  category; the largest category of Treasury securities holdings among all  domestic investors (excluding the Federal Reserve). As of June 2019,  “households” held roughly $2 trillion in Treasury securities, up from $565  billion at the beginning of 2009—a 249 percent increase.

According to Treasury, its 2018 market outreach revealed that data on the  size of trades (market volume) are not transparent, which may hinder  liquidity for certain securities. In September 2019, Treasury announced  that the Financial Industry Regulatory Authority, Inc. (FINRA) expects to  publicly release aggregate trading volume data for the Treasury  secondary market in 2020.

At the same time that the number of principal trading firms increased,  market participants we surveyed and interviewed told us that broker- dealers are holding a smaller inventory of Treasury securities, which they  attributed to certain post-crisis financial reforms that increased the cost of  holding a large inventory of securities, including Treasury securities, for  broker-dealers that are part of the larger banking institutions.

As discussed above, these reforms were introduced to promote a more  resilient financial sector. One set of reforms requires that large banking  institutions hold a certain amount of high-quality liquid assets, including  Treasury securities, to cover short-term cash needs. Another bank capital  regulation—the supplementary leverage ratio—requires an institution to  hold a supply of capital proportionate to total assets, which includes both  low-risk assets (e.g., Treasury securities) and higher-risk assets.  Because there are costs for holding capital, these institutions may prefer  to reduce the size of their Treasury securities portfolio for the purpose of  making markets and instead expand other lines of business that offer  higher returns for the same amount of capital under the supplementary  leverage ratio.

Broker-dealers have traditionally been the predominant market makers for  customers, including foreign central banks, mutual funds, hedge funds,  pension funds, and insurance companies; buying and selling Treasury  securities to meet customer trading needs, which could involve  maintaining a large balance sheet to be able to buy and sell in large  amounts and across days.

According to market participants, broker-dealers’ smaller balance sheets  have resulted in reduced liquidity for certain securities and could lead to  additional risks during periods of secondary market stress or volatility. A  well-functioning secondary market is important to Treasury in part  because rates in the secondary market ultimately affect Treasury’s  borrowing costs, as investors generally demand similar rates at auction to  those in the secondary market.

Market Outreach and Analysis Inform Treasury Debt Issuance Decisions but Policies Governing Key Inputs Could Be Strengthened

Treasury must regularly make important debt issuance decisions—such  as what type of Treasury security to issue and in what quantities—to  maintain broad-based demand and support its goal of borrowing at the  lowest cost over time. Treasury officials described the steps the Office of  Debt Management takes to make decisions about Treasury’s debt  issuance strategy (see fig. 9). Treasury officials told us that they rely on  three key inputs to help analyze financing options and inform these  decisions: (1) market outreach, (2) auction and market metrics, and (3)  analytical models.

This is consistent with World Bank-IMF guidelines for public debt  management. These guidelines highlight the importance of  communicating regularly with investors, monitoring market activity, and  having a strong analytical framework to inform decisions about the timing  and amount of each type of security to issue.

However, we found Treasury lacks policies governing some of these key  inputs. Specifically, Treasury’s draft policy for bilateral market outreach  does not include guidance on systematically selecting and documenting  these interactions. Furthermore, Treasury does not have a policy  governing important aspects of its analytical modeling, including requiring  that analyses are documented and that Treasury staff follow and  document appropriate quality assurance steps.

Treasury Conducts Market Outreach but Does Not Have a Policy for Bilateral Outreach

Primary Dealers  A group of banks and broker-dealers  designated by the Federal Reserve Bank of  New York (FRBNY) to serve as trading  counterparties to the FRBNY in the  implementation of monetary policy. They are  also required to participate in all Treasury  auctions. meets with half of them in person on a rotating basis to obtain  estimates on borrowing, issuance, and the federal budget deficit (see  sidebar).

Treasury also uses the survey and meetings to obtain input on a  variety of debt management discussion topics, posed in advance. For  example, in April 2018 Treasury officials asked the primary dealers to  comment on foreign private and official demand for Treasury  securities over the short to intermediate term.

Treasury Borrowing Advisory Committee  An advisory committee composed of 15  senior officials from broker-dealers, asset  managers, banks, and hedge funds.

Treasury Borrowing Advisory Committee (TBAC). Treasury and  TBAC meet quarterly as part of Treasury’s quarterly refunding  process (see sidebar). At these meetings, Treasury officials and the  committee members discuss economic forecasts, federal borrowing  needs, debt management issues, and market dynamics. For example,  in January 2019, Treasury asked TBAC to examine any products or  debt management practices that might expand the investor base for  Treasury securities, among other things.

TBAC also provides Treasury with technical assistance intended to  complement Treasury’s internal analyses. For example, in 2016,  TBAC members began work to develop a debt issuance model to help  guide the committee’s recommendations to Treasury about how to  finance the government’s borrowing needs. In November 2017, based  on the modeling framework as well as other factors, TBAC  recommended that Treasury increase issuance of 2-, 3-, and 5-year  notes to meet higher funding needs.

Bilateral market outreach. To reach a broader range of investors,  Treasury officials and staff also communicate directly—via email,  telephone, conferences, and in-person meetings—with other market  participants, such as foreign central banks, asset managers,  investment banks, life insurance companies, pension funds, hedge  funds, principal trading firms, and trading platforms. According to  Treasury, staff use this bilateral outreach to discuss new products or  distribution channels; assess investor needs; determine the drivers of  market demand; and guide market perception about Treasury policy.  Treasury officials said they select individuals for bilateral outreach  using a combination of qualitative and quantitative information, such  as data on specific investors’ participation in the Treasury market.  According to Treasury, the bilateral market outreach helps mitigate an  over-reliance on a subset of market participants that might not  represent the full spectrum of views of Treasury market investors.

However, we found that Treasury does not have an official policy to  ensure that its bilateral market outreach is conducted or documented in a  systematic manner. This is consistent with our reporting from 2010.

In May 2010, Treasury officials told us that one of Treasury’s priorities  was to improve investor outreach and collect information more  systematically. Treasury acquired a customer relationship management  tool, but Treasury officials said they only use it to store contact  information. Treasury also drafted a policy document in November 2017  for Office of Debt Management staff that specifies the nature, restrictions  on, and expectations for bilateral discussions with market contacts, but  the policy is not final. While Treasury’s 2017 draft policy includes some  guidance on documenting the bilateral outreach, Treasury officials told us  they did not systematically produce formal documentation of these  meetings.

Treasury officials said that one reason Treasury did not have formal  documentation of market outreach is because the staff who conduct the  outreach also make the policy recommendations. Treasury officials also  said direct outreach can sometimes cover market-sensitive information  and that confidentiality is important to ensure candid exchange of  information. However, the discreet nature of the outreach does not  preclude Treasury staff from taking steps to document summary level  information that would meet their needs and still maintain confidentiality.  For example, Treasury officials and staff are experienced at managing  market sensitive information for TBAC and primary dealers and  communicating appropriate information to the public.

While the level and nature of documentation can vary based on the  materiality to decision-making, documentation is a necessary part of an  effective internal control system. Documentation provides a means to  retain organizational knowledge and mitigate the risk of having that  knowledge limited to a few personnel. In 2017, Treasury conducted  market outreach—through the primary dealers, TBAC, and bilateral  discussions with market participants—about demand for a potential  Treasury ultra-long bond (50- or 100-year bonds). At that time, Treasury  decided not to proceed with introducing ultra-long bonds in part because  its analysis indicated that the bond would be too costly to issue relative to  other Treasury securities, such as the 30-year bond. In August 2019,  Treasury announced that it was conducting broad market outreach to  update its understanding of market demand for an ultra-long bond.

Federal standards for internal control direct agencies to design and  implement control activities—policies, procedures, and mechanisms—to  achieve program objectives and respond to risks. A policy governing the  selection of individuals for bilateral outreach could help Treasury ensure it  is systematically obtaining market views from investors across various  sectors. A policy for documenting bilateral outreach would also ensure  that the information that Treasury staff obtains is available to help inform  future deliberations. Treasury officials said that they are considering  updating and finalizing the 2017 draft outreach guidance based on our  review.

Treasury Uses Auction and Market Metrics to Analyze Issuance Decisions and Is Working to Develop Improved Data on the Secondary Market

In addition to market outreach, Treasury calculates and monitors metrics  that summarize important aspects of the debt portfolio, Treasury auctions,  and the secondary market. Treasury officials stated they monitor metrics  to understand changing market dynamics and highlighted some of the key  metrics they use to inform decisions (see table 2).

According to Treasury officials, the percent of debt maturing in a given  period is among the better indicators of rollover risk (see sidebar).

2.  market access risk—the operational risks  inherent in coming back to the market to  refinance the debt.

As of September 2019, more than half of the $16.3 trillion marketable  debt held by the public will mature in the next 3 years; about 27 percent  will mature in the next 12 months (see fig. 10). A significant share of that  maturing debt will need to be refinanced at prevailing interest rates.

Treasury publishes a number of key auction metrics that provide insight  into auction demand for Treasury securities as well as which sectors  purchase securities at auction (see table 3). Treasury also analyzes more  granular data on bidders that are not publicly available.

According to Treasury officials, one indicator of demand for Treasury  securities at auction is the bid-to-cover ratio. When the ratio is greater  than one, buyers submitted bids for more securities than were offered.  Figure 11 shows weighted average bid-to-cover ratios for the 4-week bill,  2-year note, and 10-year note from 2000 to 2019.

Treasury regularly engages with the Federal Reserve, SEC, and the U.S.  Commodity Futures Trading Commission regarding secondary market  activity, including significant price movements and their causes, trends in  market structure (such as changes in venues, participants, and trade  protocols), liquidity conditions, and market functioning. Treasury officials  reported that they routinely review data relevant to secondary market  activity (see table 4).

Figure 12 shows the average daily trading volumes between primary  dealers for Treasury bills; this is a measure of liquidity of the market.

In the past, Treasury has had limited data on transactions in the  secondary market. As a result, it has had limited real-time information on  secondary market trading activity, which, as discussed earlier, has  changed significantly in recent years, and has experienced abrupt  changes in liquidity conditions, such as the October 2014 “flash rally”  event.

In July 2017, Treasury and other agencies gained access to more  granular data on secondary market transactions as reported to the  Financial Industry Regulatory Authority, Inc. (FINRA) by its broker-dealer  members through the Trade Reporting and Compliance Engine (TRACE).  Currently, the TRACE data are available to Treasury, the SEC, the  Federal Reserve, and other official entities. According to Treasury  officials, analyzing the raw TRACE data can provide insight into pricing in  the market, patterns of trading activity, and the timing of trades. Treasury  officials stated no other data source offered such detailed and reasonably  comprehensive information on secondary market transactions in Treasury  securities.

However, there are limitations to the TRACE data, and Treasury is  continuing to work with FINRA and the SEC to improve the quality of the  data. Treasury has made policy recommendations supportive of  expanding the scope of TRACE data reporting. Treasury reported that in  April 2019, FINRA made enhancements to the Treasury transaction data  that are reported through TRACE. For example, FINRA now requires  more detailed transaction reporting to better understand the firms that are  trading with each other. These identifying data will be available only to  Treasury and regulators, such as the SEC and the Federal Reserve.  According to Treasury, this will provide them with a better understanding  of principal trading firm activity in the Treasury secondary market.

Treasury Uses Analytical Models to Illustrate Costs and Risks of Issuance Strategies, but Does Not Have a Quality Assurance Policy

Treasury’s analytical models are another source of information for the  department’s financing decisions, but Treasury lacks a policy governing  important aspects of these activities. According to Treasury officials, they  use a number of analytical approaches, from fully specified models to  simple illustrative analyses. Some models are more complex, combining  information on the debt portfolio along with assumptions about future  financing needs, economic conditions, and interest rates. Other models  perform relatively simple calculations based on market data. Treasury  officials told us they use these analyses to illustrate trade-offs, test  potential financing options, and understand long-term dynamics of the  Treasury market. These kinds of analytical tools can play an important  role in good debt management decisions.

According to Treasury officials, the bulk of modeling is completed by the  Office of Debt Management’s Quantitative Strategies Group. Treasury  officials told us that the group, which was formed in 2011, has two full- time-equivalent employees. Treasury officials provided examples of some  internal analysis and modeling they have used in the last few years.

Portfolio simulation models of the Treasury debt portfolio. These  simulations produce estimates of future costs and risks—among other  potential outputs—arising from the debt portfolio and potential  issuance strategies. For example, the simulation can produce a cost  metric that represents Treasury’s interest cost for a particular  issuance strategy.  In addition, the simulation can produce a risk  metric that represents the amount of debt maturing over various  periods (e.g., in 1 year, 3 years, 5 years) given a specific issuance  strategy. One use of such a model is to represent an issuance  strategy as one cost-risk choice among a range of options associated  with alternative issuance strategies (see fig. 13). As assumptions  about the economy or financial markets change, or as issue sizes or  maturities are adjusted, the cost and risk outcomes change.

In August 2018, Treasury officials stated that model output, along with  market outreach and analysis of historical auction data, supported  Treasury’s decision to increase issuance at all maturities with a focus  on the intermediate range of 2, 3, and 5years.

Stress testing to examine how the debt portfolio might perform  in challenging environments. For example, Treasury staff examined  projections of future borrowing needs and interest rates and analyzed  how a strategy might perform under different interest-rate  assumptions.

Calculations to estimate the yields on potential new securities.

For example, in 2017, Treasury used several analytical approaches to  create a range of potential prices for an ultra-long bond. One  approach estimated the additional yield for an ultra-long bond,  assuming it would be proportionate to the difference between 30-year  and 10-year bond yields.

Analytical models can improve decisions, but they also come with risks,  including possible adverse consequences of decisions based on models  that are incorrect or misused. These risks can be managed through  appropriate documentation and quality assurance. In our previous work,  we identified the elements of economic analyses that are relevant for  federal agency decision-making, including transparency and  documentation of the analyses for internal stakeholders.

Analyses should be transparent by describing and justifying the analytical  choices, assumptions, and data used. Transparency allows internal  stakeholders to understand the implications of these analytical choices  and their associated risks. Sufficient documentation ensures that  analytical choices, data, assumptions, limitations, and uncertainties are  clear and available to future model developers and users.  Documentation also provides a means to retain organizational knowledge  and mitigate the risk of having that knowledge limited to a few  personnel.

Documentation of quantitative analyses and models should be clearly  written, with a plain language summary and clearly labeled tables that  describe the data used and results, and a conclusion that is consistent  with these results. Documentation should also indicate that analyses  comply with a robust quality assurance process. The Federal Reserve  outlines a quality assurance process intended to verify that models are  performing in line with their design objectives and business uses and also  identifies potential limitations and assesses their possible impact.

The degree of quality assurance required should be commensurate with  the level of complexity, risk, and materiality to decision-making. Federal  standards for internal control also direct agencies to design and  implement control activities—such as documentation and quality  assurance—through policies to achieve program objectives and respond  to risks.

Treasury provided information on its analytical models which included  some key elements relevant to the documentation and transparency of  Treasury’s analyses, including:  Internal Treasury presentations that described the purpose, rationale,  and certain analytical choices and results for a portfolio simulation  model.

Internal presentations detailing results and some analytical choices  related to pricing estimates for an ultra-long bond.

A code repository that can facilitate replication of some models and  examples of code used to operate models.

While Treasury’s documentation of its analytical models contained useful  information for internal stakeholders, the documentation did not fully  characterize the analytical choices, data, assumptions, limitations, and  uncertainties associated with the analyses. For example:

Treasury’s internal presentations on its portfolio simulation models did  not fully justify analytical choices or describe the limitations of the  models.

Treasury’s internal presentations on pricing estimates for an ultra-long  bond contain estimates from six different analytical approaches  developed by Treasury but only detail a subset of the assumptions  needed to arrive at the estimates. For example, there is no description  of the precise structure of the approaches or the necessary sources of  uncertainty that would lead to the range of estimates that Treasury  presents for each approach.

Treasury officials did not have documentation indicating that analytical  models had been subject to quality assurance or that quality assurance  activities had been commensurate with the level of complexity, risk, and  materiality to decision-making.

These issues arise in part because Treasury does not have a policy  governing important aspects of the Office of Debt Management’s  analytical modeling activities, including requiring that analyses are  documented and that Treasury staff follow and document appropriate  quality assurance steps. Treasury officials told us that they take steps to  ensure that analytical work is appropriately reviewed. They stated that the  review process is based on the nature of the work, and according to  Treasury officials, quality assurance generally entails cross checks  among staff and review by office leadership. One model was also shared  with external contacts for feedback.

Treasury officials emphasized that models are only one input of many into  Treasury’s decision-making and explained that their practices are  sufficient for the more straightforward analyses that typically inform  decisions. However, the analyses that Treasury relies on—both relatively  straightforward and more complex—to inform important decisions should  be documented and subject to quality assurance to ensure that decision  makers receive quality information based on appropriate analytical  approaches. Treasury relies on a range of analytical methods, all of which  require some degree of technical expertise to develop, implement, and  evaluate, despite varying degrees of complexity.

A policy requiring appropriate documentation and quality assurance  would help Treasury ensure that analytical methods, data, assumptions,  limitations, and uncertainties are transparent, appropriate, and available  to future model developers and users.

U.S. Treasury securities play a vital role in U.S. and global financial  markets because of their deep and liquid market and because investors  are confident that debt backed by the full faith and credit of the U.S.  government will be honored. This combination of characteristics has  helped support reliable demand for Treasury securities through ever  changing market conditions, which, in turn, has helped minimize  Treasury’s borrowing costs. Changing investment needs across different  sectors and fluctuations in demand for Treasury securities are a normal  part of economic cycles.

Treasury and Congress need to be alert to risks that could compromise  these key characteristics to preserve Treasury securities’ unique  advantages. These risks include changing dynamics of the secondary  market, including new participants using high-frequency trading strategies  that could reduce liquidity, particularly in times of market stress.  Treasury’s recent efforts to coordinate with the SEC and FINRA to obtain  detailed information on the secondary Treasury market are an important  step.

In addition, as we have previously reported, Congress needs to consider  taking action to address the unsustainable long-term fiscal path as well as  alternative approaches to managing the debt limit that would ensure the  continued safety of U.S. Treasury securities.

Treasury has a critical role to play through its management of the federal  debt portfolio to support its goal to borrow at the lowest cost over time.  Treasury must promote strong demand for its securities from a diverse  group of investors while making debt issuance decisions that  appropriately balance risks and interest costs. Therefore, it is important  that Treasury make these decisions based on the best information  possible.

Consistent with good debt management practices, Treasury uses a range  of qualitative and quantitative inputs to inform its decision-making. It does  not, however, have policies governing important aspects of two of these  inputs: bilateral market outreach and analytical modeling. Until Treasury  has designed and implemented policies around these key activities, it  cannot be certain that needed information for debt issuance decisions is  available, complete, and appropriately reviewed. Moreover, without  appropriate documentation of important market outreach or analytical  models, Treasury risks losing critical organizational information as staff  leave the agency. Given the size and importance of the Treasury market,  ensuring the quality of information available to decision-makers is  essential to Treasury’s efforts to reduce risk and cost to taxpayers.

We are making the following two recommendations to Treasury.

The Secretary of the Treasury should finalize the Office of Debt  Management’s policy for conducting bilateral market outreach and ensure  it includes guidance on selecting market participants and documenting  and sharing relevant information throughout the office while safeguarding  the confidentiality of discussions. (Recommendation 1)

The Secretary of the Treasury should establish a policy for the  documentation and quality assurance of the Office of Debt Management’s  analytical models. At a minimum, this policy should require (1)  appropriate and sufficient documentation of analytical models, and (2)  documented quality assurance of analytical models commensurate with  the level of complexity, risk, and materiality to decision-making.  (Recommendation 2)

We provided a draft of this report to Treasury and the Federal Reserve for  review and comment. In its comments, reproduced in appendix III,  Treasury agreed with our recommendations and said it would work to  implement them over the coming months. Treasury and the Federal  Reserve also provided technical comments, which we incorporated as  appropriate.

We are sending copies of this report to the appropriate congressional  committees, the Secretary of the Treasury, the Federal Reserve, and  other interested parties. In addition, the report will be available at no  charge on the GAO website at http://www.gao.gov.

For questions about this report, please contact Tranchau (Kris) T. Nguyen  at (202) 512-6806 or nguyentt@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made key contributions to this report are  listed in appendix IV.

Appendix I: Survey Population and Sample Design

To address both of our objectives, we surveyed market participants  regarding (1) factors that affect demand for Treasury securities, (2)  experiences interacting with the Department of the Treasury (Treasury),  and (3) evolution of the Treasury market.

In March 2019, we administered an online survey to 109 institutions. We  selected the 10 largest institutions by total assets (or other equivalent  financial indicator) in nine sectors that hold Treasury securities and the 15  largest mutual funds and exchange-traded funds by total assets under  management (see table 5). We also sent the survey to four market  participants we interviewed in September that did not meet our top 10  criterion for its sector. The survey results are not generalizable to all  investors in Treasury securities.

To define the sectors for our sample, we reviewed data from the Federal  Reserve’s Financial Accounts of the United States, (table L.100 to L. 133,  first quarter 2018) to identify sectors holding Treasury securities. We  excluded some sectors due to challenges in contacting certain entities,  such as foreign monetary authorities, other foreign investors, and the  household sector. According to the Federal Reserve, the household  sector is a residual category and includes individuals holding Treasury  securities, hedge funds, and other institutions not required to report to  regulatory bodies. We excluded this sector due to the difficulty of  identifying, ranking, and contacting individual household investors and  other entities. We excluded Government Sponsored Enterprises because  these entities are unlikely to provide additional insights into the Treasury  market beyond our sample, which includes commercial banks. We  excluded federal government retirement funds because the Thrift Savings  Plan does not invest in marketable Treasury securities.

To identify the organizations within each sector that would receive our  web-based survey, we used rankings of the largest organizations in each  sector based on total assets or an equivalent financial indicator, such as  assets under management or direct premiums written, and selected the  10 largest in each sector. In the case of mutual funds and exchange  traded funds, we used information from the Investment Company Institute  on total assets under management in Treasury- and government-focused  funds to identify the largest 15 in that sector. For the broker-dealer sector,  we selected the 10 largest primary dealers.

Appendix II: Selected Results from Survey of Market Participants

As part of our survey of market participants, we asked respondents to  identify products or debt management practices that, if the Department of  the Treasury (Treasury) introduced, would increase the respondent’s  overall demand for Treasury securities. Results from our related survey  questions are presented below.

Survey Question: If Treasury were to make the following changes to its  offerings, would your overall demand for Treasury securities increase?  (see fig. 14).

Survey Question: If Treasury were to change its debt management  practices in the following ways, would your overall demand for Treasury  securities increase? (see fig. 15).

Appendix III: Comments from the Department of the Treasury

Appendix IV: GAO Contacts and Staff Acknowledgments

In addition to the contact named above, Thomas J. McCabe (Assistant  Director), Margaret M. Adams (Analyst-in-Charge), Abigail Brown,  Michael Hoffman, Loren Lipsey, Daniel Mahoney, Anna Beth Smith,  Andrew J. Stephens, Farrah Stone, and Wade Tanner made significant  contributions to this report. Robert Gebhart, Jerome Sandau, Peter  Verchinski, and Alicia White also contributed to this report.

The Congressional Budget Office projects that federal deficits will average $1.2 trillion per year through 2029—adding to the existing $16 trillion in public debt.

The Treasury Department will need to borrow from investors to finance the government. To ensure low borrowing costs, Treasury must maintain strong demand for Treasury securities (e.g., bonds) from diverse investors, such as foreign and domestic banks, money market funds, and retirement funds.

We examined factors that affect demand and how Treasury analyzes the market to inform its debt issuance strategy. We recommended improving Treasury’s policies on market research and analysis.