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ECONOMIC REVIEW Additional copies of the EC O N O M IC R E V IE W may be obtained from the Research Department, Federal Reserve Bank Cleveland, Ohio of Cleveland, 44101. P. Permission 0. Box 6387, is granted to reproduce any material in this publication providing credit is given. FE B R U A R Y 1972 F E D E R A L A G E N C Y ISSUES: N E WC O ME R S IN THE CAPI TAL M A R K E T James L. Koch an An increasingly im p o rta n t share o f the United States capital m arket is being claimed by long-term Federal Agency debt issues. A lthough Federal Agencies have been selling debt securities since 1919, the volume o f long-term issues had never been su fficie n t to support an active secondary market u n til the latter part o f the 1960's. Since 1969, long-term agency debt has shown an especially sharp increase. This article describes the characteristics o f Federal Agency long-term debt instrum ents and the procedures used to place them on the market. -1 The effect o f the increased volume o f these issues on the developm ent o f an active secondary m arket is then discussed. A lthough data on this m arket are lim ited, evidence is presented which suggests th a t an active and e ffic ie n t m arket fo r these IN T H IS ISSUE securities does exist. The final examines the im plication of section the o f the article proposed Federal Financing Bank fo r the agency market. 1 In this article, long-term issues are those maturing in five years or over. Short- and interm ediate-term issues are those maturing in less Federal Agency Issues: than one, and one-to-five years, respectively. For a discussion o f this Newcomers in the Capital M a r k e t............. classification, see "U . S. Government Bonds as Capital Market 3 Instrum ents," Econom ic Review, Federal Reserve Bank of Cleveland, August 1971, p. 4., Footnote 1. 3 ECONOMIC REVIEW T A B LE I Long-term Federal Agency Debt Outstanding December 31, 1971 Agency Type o f Debt Federal Land Banks Federal National Mortgage Association Bonds* Debentures Mortgage-backed bonds* Notes* Mortgage-backed bonds* Participation certificates Insured notes Participation certificates Bonds* Federal Home Loan Banks Federal Home Loan Mortgage Corporation Government National Mortgage Association Farmers Home A dm inistration E x p o rt-lm p o rt Bank Tennessee Valley A u th o rity U. S. Government Guarantee Number of Issues Volume (m il. o f $) 5 13 No No $ 1,107 3,198 1 4 Yes No 200 950 2 Yes 290 24 6 Yes Yes 2,780 1,350 1 7 Yes No 250 375 63 TOTAL $10,500 * Income fro m these issues is exempt from state and local income taxes. Sources: Salomon Brothers and First Boston Corporation denom inations C H A R A C T E R IS T IC S OF th a t range from $1,000 to A G E N C Y ISSUES $100,000 and, except fo r one current outstanding A summary o f the long-term debt issues that issue, are not each Federal Agency had outstanding at the end o f individual outstanding 1971 is presented in Table I. The listing indicates from $148 m illio n to $300 m illio n . Interest on the whether or not the issues are guaranteed by the bonds is paid semi-annually by any Federal Land Federal Government and, therefore, backed by its bank, Federal Reserve bank, or the U. S. Treasury. fu ll held The bonds are secured by farm mortgages held by particular importance when agency issues were the Land Banks. They are not guaranteed by the considered new instrum ents and investors were Federal uncertain about their default risk. The absence of security any h in t o f default, however, has allayed most of commercial this uncertainty and has made this d istinction less investments fo r Government tru st funds. fa ith and credit. This d istin ctio n meaningful. C urrently, characteristics such as issue callable. The size o f the five long-term issues ranges Government; however, they q u a lify as fo r FNMA U. banks S. Government and Debentures. are The deposits considered Federal at lawful National size, denom ination size, and tax status are more Mortgage Association (FN M A)debentures are the im portant factors affecting the m a rke ta b ility and direct obligations o f the Association and are issued tradeability o f agency issues. to FLB Bonds. The Federal Land Bank (FLB) finance its secondary market operations in Government-insured or guaranteed home bonds are the jo in t obligations o f the twelve mortgages. A lthough the to ta l am ount outstanding Federal may n o t exceed the volume o f mortgages and Land banks. The bonds are issued in FE B R U A R Y 1972 The PCs are not callable, are fu lly registered, United States Government obligations owned by are not backed by any have denominations th a t range from $5,000 to $1 specific collateral security or guaranteed by the m illio n , and pay interest tw ice annually. Payment Federal Government. The debentures are issued in o f interest and principal is guaranteed by G NM A, denominations ranging from $5,000 to $500,000, and the Treasury is authorized to purchase GNMA are n ot callable, and pay interest semi-annually at obligations to enable the agency to meet this any guarantee. the Association, they Federal Reserve bank or at the Treasury Department. Thirteen separate long-term issues are The purpose o f issuing the PCs was to reduce currently outstanding, ranging in size from $150 the m illio n to $350 m illion . borrow from FHLB Notes. Federal Home Loan Bank amounts the originating agencies had to the U. S. Treasury. They were a means o f reducing the size o f the Government's (FH LB) notes are issued to provide funds to the budget by placing this debt in to private hands. twelve regional Home Loan banks fo r lending to Sales o f member savings institutions. They are not callable, continued u n til August 1968. G N M A, as trustee, are issued in denominations ranging from $10,000 administers the trusts and collects the interest and to $1 m illio n , and pay interest semi-annually at principal from the trusts' assets. GNM A is also any Federal Reserve bank. These notes are the authorized jo in t and several obligations o f the Home Loan become due; however, current policy is to pay banks and are n ot guaranteed by the Federal them Government. Four long-term issues are currently long-term PCs are cu rre n tly outstanding, ranging in outstanding; three are $200 m illio n in size and one size from $25 m illio n to $500 m illio n . is $350 m illio n . PCs o ff to at began roll in November over existing m a tu rity . 1964 and PCs as they T w e n ty-fo u r issues of Mortgage-Backed Bonds. The mortgage-backed became the bonds issued by FNM A and the Federal Home trustee o f three trusts made up o f debt obligations Loan Mortgage Corporation (FH LM C ), a subsid owned by FN M A, the Veterans A d m in istra tio n , iary the guaranteed GNMA Small PCs. In 1964, FNM A Business A d m in istra tio n , and other of Federal by Home G NM A. Loan Bank, are also The agencies assemble agencies w ith in the Federal Government. FNM A VA-guaranteed and FHA-insured mortgages into then issued participation certificates (PCs), w hich trusts and issue bonds secured'by these mortgages. are bond-type instrum ents giving the owners a The bonds are issued in denom inations ranging beneficial interest in the trusts. When FNM A was from reorganized in 1968, the Government National semi-annually, and the bonds are not callable. The Mortgage Association (G NM A) was organized as a GNM A guarantee pledges the fu ll fa ith and credit corporate e n tity w ith in the U. S. Departm ent of o f the U. S. Government to payment o f interest $25,000 to $1 m illio n . Interest is paid Housing and Urban Development and given the and principal. FHLMC cu rre n tly has tw o long-term responsibility o f managing the trusts. In addition, issues outstanding o f $140 and $150 m illio n , while GNM A assumed ownership and control o f FNM A's FNM A has one long-term issue o f $200 m illio n . share o f the trusts' assets. FmHA Notes. The Farmers Home A dm inis 5 ECONOMIC REVIEW tra tio n (F m H A ), an agency w ith in the Departm ent w ith m aturities o f five years or greater outstanding of A griculture, extends real estate and housing at the end o f 1971. They are issued in m ultiples o f loans to farmers and other rural residents. It then $1,000 and are callable, usually after five or ten assembles these assets in to blocks w ith a face value years. In most respects, these bonds are more o f $500,000 or $1 m illio n and sells "insurance sim ilar to private u tility bonds than to Federal contracts” covering the assets to private investors. Agency issues. FHA Ownership o f the contracts is registered w ith the Debentures. The and issued denominational changes o f the contracts are not (FHA) perm itted. They are guaranteed by the Federal cannot be considered capital market instrum ents, Government, pay interest annually, are eligible although they are usually included in discussions collateral fo r Treasury Tax and Loan Accounts, of and are acceptable fo r discounting by member uniform in terms o f m a tu rity, yield, or denom i banks at the Federal Reserve Banks. nation and, therefore, are n o t easily traded on a Federal Reserve Bank of New Y o rk Prior to Fm H A's firs t public offering o f these by the Federal long-term debentures Housing A dm inistration are rather specialized Federal Agency instrum ents th a t securities. They are not secondary market. They are issued as paym ent to a contracts in February 1970, the agency raised mortgagee who funds through private placement o f its debt w ith mortgage th a t has gone in to default. FHA acquires individual investors. This practice was abandoned either the mortgage or the property fro m when the grow th in volume o f the agency's lending mortgagee and, in return, issues a debenture w ith operations face value, m a tu rity , and yield identical to those made private placement im practical. has purchased an FHA-insured the Fm H A issues are currently o u t of the mortgage contract. The mortgagee can then standing, ranging in size from $150 m illio n to either hold the debenture u n til it matures, sell it to $300 m illio n . another investor, or use it fo r payment o f FHA Six long-term Export-lmport Bank PCs. The E xp o rt-lm p o rt Bank cu rre n tly has outstanding one issue o f insurance premiums. FHA w ill accept the debentures at face value from holders o f insured PCs, which are participations in the mortgages fo r Bank's loans. These PCs were issued in denom i premiums. Thus, nations ranging fro m $5,000 to $1 m illio n , pay mortgage lenders who acquired the debentures interest semi-annually, and are not callable before when some o f th e ir mortgages went in to default or they mature in 1982. Since the Bank is w h o lly purchased them fo r use in paying FHA insurance owned by the U. S. Government, its obligations premiums. It appears th a t there is very little open are backed by the Government's fu ll fa ith and market trading o f these debentures. Consequently, credit. they are n o t included in the remainder o f this long-term payment the of holders FHA are insurance principally T V A Bonds. The Tennessee Valley A u th o rity discussion o f agency capital m arket instruments. (T V A ) has issued 25-year power bonds since 1959 U. S. Postal Service Bonds. The U. S. Postal the u tility to issue Service, the newest Federal Agency, made its firs t bonds and notes. The A u th o rity had seven issues public debt offe rin g in January 1972, when it sold when Congress authorized FE B R U A R Y 1972 $250 m illio n o f 6 7/8 percent 25-year bonds. The or the bonds are callable in ten years, are not guaranteed recommend changes in the tim in g , size, yield, or Federal Reserve Bank may request or by the Federal Government, and are exempted other terms o f the new issue. A fte r the final terms from state and local income and property taxes. have been established, the agency is ready to Principal buyers were pension funds, life insurance announce the sale o f the new issue. Members o f the selling group and the general companies, and individuals. public are advised o f the pending sale through an offering notice, which is issued by the fiscal agent P R IM A R Y M A R K E T FOR about one week p rio r to the offe rin g date. Selling A G E N C Y ISSUES Marketing group members then begin to accept tentative Procedures. Unlike the U. S. orders from investors. The evening before the Treasury, w hich markets its new securities through o ffering date, the fiscal agent advises the group direct subscriptions or refundings, the Federal members by telegram o f the offe rin g price or Agencies em ploy methods very sim ilar to those coupon rate fo r the issue. Subscription books are used by private corporations in placing new issues opened only on the o ffering date, and the selling on issues under group members phone or w ire th e ir subscriptions discussion, FN M A, FH LB , and FLB sell th e ir new to the fiscal agent. Each subscription generally issues through fiscal agents and a netw ork of equals the m axim um set by the fiscal agent fo r securities dealers and banks. New issues o f T V A , each member o f the group. Consequently, the Exim bank, issues are usually oversubscribed and the fiscal the market. Of Fm H A, the the Agency Postal Service and mortgage-backed bonds are sold though under w ritin g syndicates. agent must make allotm ents to the group members. A fte r these allotm ents are confirm ed, A fiscal agent serves as an agency's liason w ith the new securities can be traded in the secondary the financial co m m un ity. FN M A, FH LB, and FLB market on a "w hen issued” basis. New securities each employs its own agent who participates in all are dated and issued fro m one to tw o weeks after phases the offering date to perm it tim e fo r receiving of m arketing a new issue, fro m the determ ination o f the total size, m a tu rity, and price orders, making allotm ents, and through observing the market a ctivity after the delivering certificates. preparing and issue's sale. Each agent has an organized netw ork The selling group is expected to achieve wide of securities dealers and dealer banks throughout d is trib u tio n o f the securities and to place them the nation th a t form a selling group to market new w ith “ true investors," th a t is, investors interested agency securities to the public. When an agency in holding rather than trading the securities. One requires test o f the pricing o f a new issue is the issue's new funds, either to carry out its operating functions or to refund a maturing issue, performance in the secondary market im m ediately it consults w ith its fiscal agent, the U. S. Treasury, after the sale and its d is trib u tio n by the selling and the Federal Reserve Bank o f New Y ork about group. If the issue has been correctly priced and the terms o f the proposed new issue. The Treasury placed in the hands o f true investors, its price ECONOMIC REVIEW should behave favorably relative to other agency and then waited u n til 1970 to sell other long-term issues in the secondary market. Since agency issues issues. Generally, the agencies attem pted to match are usually quite easy to place, secondary market the m a tu rity o f th e ir debt to the m a tu rity o f their action is generally quite favorable. assets, and the three regular long-term borrowers Members o f the selling group receive comm is were those agencies th a t held long-term assets. principal W ithin the past tw o years, this pattern has been am ount on a short-term issue to approxim ately m odified somewhat. The increase in the number o f $3.50 on the longest m aturities. The rates are low agencies issuing long-term debt has been due partly relative of to the creation o f new programs in which agencies corporate and m unicipal bonds, b u t are acceptable acquire long-term assets, such as the mortgage- because agency issues are relatively easy to sell and backed bond programs o f FNM A and FHLM C, and the offerings are frequent and usually large in size. also fro m greater diversification in the borrow ing sions ranging from to When those $.50 per $1,000 earned by underw riters new securities are issued through an strategies o f FN M A, FH LB , and Fm H A. The three the latter agencies have borrowed in the capital market syndicate fu n ctio n as the selling group, w ith the quite frequently since 1970. FHLB began to sell underw riting syndicate, the members of leading members perform ing the duties o f a fiscal long-term agent. may be chosen through began making advances w ith m aturities o f up to bidding or negotiation. In general, ten years to th e ir member institu tio n s. FNM A underw riting syndicates are used fo r the sale of started to issue long-term securities in order to longer-term obtain a more orderly refunding schedule fo r its The syndicate com petitive issues, such as T V A power bonds, issues when the Home Loan Banks Fm H A insured notes, and the mortgage-backed rapidly bonds. The fiscal agents' selling groups had been Fm H A began the public sale o f its long-term debt geared because its lending activities had grown to the prim a rily fo r placing short- and interm ediate-term agency securities. Marketing Strategies. Successful marketing o f a growing outstanding debt. S im ilarly, p o in t where private loan sales were no longer possible. new debt issue requires the selection o f a m a tu rity The increased fle x ib ility in the debt manage and yield com bination th a t w ill be attractive to an ment policies o f these agencies has apparently adequate number o f investors. U n til the past tw o introduced some cyclical variation in the total years, most o f the agencies lim ited th e ir m a tu rity outstanding selections to suggests th a t, sectors, w ith the short- and only TVA, interm ediate-term Exim bank, and FLB long-term taken agency debt. collectively, Chart 1 the agencies marketed long-term issues on a fa irly regular basis selling long-term debt on a regular basis. FNM A when m arket conditions were favorable, as in sold long-term issues during the 1960-1962 period, 1971, but lim ite d th e ir offering to the short- and interm ediate-term 2 For a more detailed discussion o f fiscal agents see W illiam J. Branscom, "Federal Agency Obligations and the Commercial Bank P o rtfo lio ,” (a Stonier School of Banking Thesis, Rutgers U niversity, 1963), pp. 24-33. 8 m aturities when interest rates were relatively high, as in 1969. This pattern is very apparent in Table II, w hich lists the share o f total new agency issues accounted fo r by FE B R U A R Y 1972 CHA RT 1 L O N G -T E R M FED ERA L AGENCY ISSUES Outstanding Issues Maturing in 5 Years or More B illions o f dollars 12 10 8 6 4 2 End o f Year 0 1960 '65 '66 '67 '68 '69 '70 '71 Last entry: 1971 Sources: Salomon Brothers and Treasury B ulletin long-term issues during each o f the past twelve Although the tim e period surveyed here is too quarters along w ith a representative long-term short to form an estimate o f the share o f total new 1969 agency debt th a t w ill norm ally be long-term debt, in te re s t r a te f o r t h a t q u a r te r . T h r o u g h o u t when interest rates were rising steadily, sales o f it appears th a t a substantial volume o f such debt long-term issues were low ; during February and w ill continue to be sold each quarter as long as March market conditions are favorable. of 1970 when rates fe ll, sales jumped sharply; and during the second quarter o f 1970 Setting an appropriate interest rate is crucial to when rates moved upward, sales were low again. the successful m arketing o f a new issue. Agency During the remainder o f 1970 and throughout issues compare favorably w ith Treasury securities 1971, in regard to risk, but the fo rm e r are somewhat less market conditions improved, and the volume o f new issues remained relatively high. 3 o liq u id . Consequently, coupon rates on new agencies have been set below the yields on new Although some instrum ents—the o f these sales were issues o f new new Fm H A securities and mortgage- backed bonds—w hich generally carry long m aturities, it is also true th a t these securities had been issued earlier w ith interm ediate m aturities. The corporates w ith approxim ately the same issue date b u t above the yields on new Governments. W ithin the past tw o years, yields on new agency issues agencies did, therefore, adjust the m aturities o f these new instruments in response w ith m aturities around five years have generally to changing m arket conditions. been set between 20 to 75 basis points below the 9 ECONOMIC REVIEW T A B LE II agencies Long-term Debt Issued by Federal Agencies 1969-1971 conditions in the Treasury sector o f the capital Quarter Volum e (m il. o f $) 1969 I II III IV -0 $ 100 250 350 TOTAL 1971 I II III IV TOTAL 5.88% 5.92 6.14 6.53 -0 3.1% 6.3 7.0 700 4.7 1,200 350 1,150 1,540 17.5 7.2 20.9 40.2 4,240 20.2 1,824 1,150 1,900 2,450 45.4 27.0 32.5 37.8 7,324 35.7 TOTAL 1970 I II III IV Long-term Issues as Percent o f Total Issues market Average Yield on Long-term Government Bonds were than a better were the measure yields of on m arket seasoned Governments. This is probably due to the fa ct th a t the Treasury was not selling new bonds during this period. If the Treasury had been selling long-term bonds during the period fro m m id-1965 through mid-1971, the spread between yields on these issues and on new long-term agencies most like ly w ould have been w ith in the 12 to 77 basis p oint 6.56 6.82 6.65 6.27 range observed before and after the 1965-1971 period. Buyers of Agency Issues. In form ation on buyers o f long-term agency issues is lim ite d to the 5.82 5.88 5.75 5.62 Treasury's Survey o f Ownership o f GovernmentSponsored Agency Issues. This Survey is at best only suggestive because o f the large p o rtio n o f the Sources: Treasury B u lle tin and Federal Reserve Bulletin outstanding issues th a t are included in the “ all yield o f new five-year Aa u tility bonds, and yields ownership data suggest th a t the principal buyers o f on new ten-year agencies were from 30 to 100 long-term agencies are commercial banks, savings other investors" category (see Table III). These basis points below yields on new u tilitie s w ith institutions (m utual savings banks and savings and m aturities o f ten years and over. Yields on new loan associations), state and local governments, agencies have usually ranged from 25 to 75 basis insurance companies, and corporate pension funds. points above the yields set on new Treasury notes Data on commercial bank ownership is under and bonds. stated in the Survey because those agency issues It is interesting to note th a t during periods in purchased by banks fo r their tru st accounts are w hich the Federal Agencies marketed long-term included issues and the Treasury did not (1966-1970 and statement in the " o th e r” category. This under may be substantial, because the the firs t half o f 1971), yields on new agency issues attractive yields and safety o f long- term agencies were generally much closer to yields on new u tility make them ideal investments fo r tru st accounts. bonds Also included in the " o th e r" category are the than seasoned to secondary Governments of market similar yields on m a tu rity. holdings of Because new issue yields usually reflect current p ro fit m arket conditions more accurately than yields on dealers. seasoned issues, it appears th a t during the period from 1966 to m id-1971, new issue yields on 10 individuals, foreign investors, non organizations, and nonbank securities Significant by th e ir absence as buyers o f agency issues have been the Federal Government's tru st FE B R U A R Y 1972 TABLE III Principal Owners o f Long-term Federal Agency Issues June 30, 1971 M illions o f Dollars Insurance Companies Agency Federal Land Banks Bonds Federal National Mortgage Association Debentures Mortgage-backed bonds Federal Home Loan Mortgage Corporation Notes Mortgage-backed bonds Farmers Home A dm inistration Insured notes E x p o rt-lm p o rt Bank Participation certificates Tennessee Valley A u th o rity Bonds TOTAL State and Local Governments Pension Funds Corporate Pension Funds A ll Other Investors $78 $ 15 $26 $ 669 10 6 78 2 31 21 22 7 655 121 4 1 13 - 4 4 6 6 450 88 2 17 37 46 18 546 3 23 110 77 4 608 Total Commercial Banks Savings Institu tion s Life Fire, etc. $1,114 $ 195 $ 74 $10 $32 1,498 200 412 8 262 34 14 1 750 140 134 2 138 40 - 950 110 174 1,225 319 73 General Funds 525 2 33 16 4 1 133 9 325 $6,402 $1,182 $828 $46 $98 $319 $331 $98 $3,462 Ownership share 18.5% 12.9% 0.7% 1.5% 5.0% 5.2% 1.5% 54.1% Source: Treasury Bulletin funds and the Federal Reserve Banks. The trust therefore, the Federal Reserve w ill be an owner o f funds are major holders o f long-term Government long-term bonds, b u t even though almost all agency issues purchases in the secondary market. In contrast to are legal investments fo r these tru st funds, they the other owners, it w ill n o t be a buyer o f new hold no long-term agency issues other than some agency issues. agency securities, b u t w ill make its participation certificates.4 In System September 1971, the Federal Reserve began acquiring agency issues when it SEC O N D A R Y M A R K E T Participants in the secondary m arket fo r initiated d ire ct purchases o f these securities as part long-term agency issues contend th a t w ith in the of past three or fo u r years, this market has come into its open m arket operations. In the fu tu re , its own as a trading market and is no longer sim ply Participation certificates are not included in Table III because the Survey o f Ownership does not list them by an appendage to the Government bond market. individual issues. It is impossible, therefore, to estimate The market is, however, sim ilar in many respects the pattern o f ownership o f long-term PCs. The Federal to the m arket fo r seasoned Government bonds. Government tru st funds own $1.9 b illio n PCs, or about 16 percent o f the total outstanding. Some of these may be long-term PCs. Most dealers who make markets in Treasury issues also quote prices on agency issues. Bid and asked 11 ECONOMIC REVIEW prices are quoted in fractions o f 1/32 of a outstanding issues. A lthough the exact volume percentage p oin t, w ith published spreads ranging required to support an active trading market is not from tw o fu ll points on some issues to 12/32 o f a know n, m arket participants report th a t trading in po in t long-term on others. Trading in most long-term agencies began to increase m arkedly agencies is accomplished at a spread o f 16/32 o f a during the poin t and occasionally at a spread o f 4/32 o f a standing volume reached the $4 to $5 b illio n level. p o in t if the issue is relatively new and trading They also indicate th a t, due to the rapid grow th in actively. These spreads are comparable to those the volume o f outstanding issues in the past tw o encountered in the m arket fo r long-term Govern years, the long-term sector o f the agency m arket ments. currently has the necessary volume to support an The presence o f dealers w illin g to quote prices on long-term sufficient, agencies is a necessary, but not con dition fo r a highly developed 1967-1968 period when to ta l o u t active secondary market. Trading w ill remain lim ite d , however, if this volume is composed o f many small-sized individual secondary market. Other prerequisites are a large issues, or volume o f securities available fo r trading and the investors diffe re n tia te between the securities of participation o f active traders; th a t is, commercial the various agencies. A large volume o f relatively banks, large small issues is n o t conducive to active trading in the because the market fo r each issue w ould be quite securities. A mature secondary m arket is charac th in . For example, one o f the few Treasury bond insurance investors companies, m aintaining trading and other accounts if the m arket is segmented because terized by a high volume of trading, w ith a large issues not actively traded are the 4s o f 1988-1993; number o f investors adjusting th e ir positions in there response to relatively small movements in prices. A outstanding. W ith the exception o f this issue, the market is then said to enjoy the famous trio o f sizes o f regular Treasury bond issues range from depth, breadth, and resiliency. $806 m illio n to $4.6 b illio n . Prior to 1967, most This type o f m arket exists fo r most Treasury bonds and appears to be developing fo r most are o nly $246 m illio n o f these bonds long-term agency issues were relatively small—only tw o outstanding issues were larger than $150 long-term agency issues. It is d iffic u lt to docum ent m illio n and none were larger than $200 m illio n . In this developm ent because data on trading volume, contrast, dealer positions, investor participation, and price outstanding long-term issues totaled $200 m illio n changes or more, w ith tw enty-one equal to $250 m illio n or are inadequate. There is, however, a substantial am ount o f indirect evidence th a t most by the end of 1971, th irty -tw o larger. active The fact th a t these large issues are the debt o f secondary m arket trading are cu rre n tly available to seven separate agencies could lim it the tra d e a b ility the long-term sector o f the agency market. o f these securities if investors do not view the of the A ingredients fundam ental secondary m arket 12 th a t c o n trib u te requirem ent is an fo r adequate to an active volume of separate issues as a homogeneous group o f market instruments. However, m arket participants have FE B R U A R Y 1972 suggested that, except fo r the mortgage-backed bonds, Fm H A insured notes, and T V A long-term agency homogeneous issues trade group of as a assets. The regressions generally support the obser bonds, vations o f m arket participants th a t issue size is an relatively im p o rta n t determ inant o f an issue's performance The mortgage- in the secondary m arket and th a t the issuing backed bonds are still viewed as relatively new and agency is not. The co e fficie n t on the issue size are n ot traded as actively as regular agency issues. variable is negative in all equations, significant at Trading in these bonds w ill probably increase as the 95 percent confidence level in three o f the more reach the m arket and as more investors regressions, and significant at nearly this level in become fam ilia r w ith them. The Fm H A insured the other tw o. It appears, therefore, th a t yields on notes trade less actively because o f their large the smaller-sized issues are somewhat higher than m inim um denom inations and the fa ct th a t interest on is paid only once a year rather than semi-annually. necessary to compensate investors fo r the reduced T V A bonds are traded separately from the other m a rke ta b ility o f the smaller issues. agencies—as mentioned earlier, they trade like large issues. A pparently, The coefficients on higher yields are the dum m y variables corporate bonds rather than agency issues. Once indicate th a t, except fo r Fm H A, the issuing agency the has very little effect on market yields. The Fm H A initial placement of these bonds is accomplished, most dealers specializing in Govern coe fficie n t is positive and highly significant, m ent and Federal Agency issues drop o u t o f this indicating th a t the peculiar characteristics of these m arket, leaving the secondary trading to corporate issues keep th e ir m arket yields above yields on bond dealers. other agency issues o f sim ilar size and m a tu rity. A series o f regressions were run in order to test The remainder o f the agency coefficients are whether the remainder o f the long-term agency very small, w ith only GNMA fro m zero co e fficie n t issues can be regarded as a homogeneous set o f significantly assets, and w hether the size o f an agency issue regressions. The affects its market performance. Secondary m arket cients is th a t the market values comparable issues yields on long-term issues o f FNM A, FLB, FHLB, o f FN M A, FHLB, FLB, and T V A equally, but puts Fm H A, T V A , and the GNMA a small regressed against all five PCs. Yields on PCs are influence m arket yields: issue size, issuing agency other issues. This prem ium probably results from (represented by dum m y variables), m a tu rity , and the fa ct th a t PCs are guaranteed, w hile the other coupon Market yields were used as the agency issues (except fo r Fm HA notes) are not. dependent variable under the assumption th a t any Given the choice between buying a PC or another d istinction investors may make between individual agency issue o f equal yield and m a tu rity, many issues investors apparently choose the guaranteed asset, be reflected in th e ir th a t on in o f these c o e ffi approxim ately .10 o f a percentage p o in t below the w ill variables prem ium interpretation m ight rate. fo u r PCs were each d iffe re n t the prices and, therefore, in th e ir market yields. Details o f the thereby regressions are presented in Table IV . above, and yields somewhat below, those o f other keeping prices o f the PCs somewhat 13 ECONOMIC REVIEW TABLE IV Estimated Relationships Between Market Yields of Federal Agency Long-term Issues and Selected Variables Market Y ield = b 1 D 1 (F N M A ) + b2 ° 2 + b3 ° 3 + b4 ° 4 + b 5 ° 5 + b 6 ° 6 + b7 + b 8 + (G N M A ) (F L B ) (F H L B ) (F m H A ) (T V A ) Coupon M a tu rity Rate Date December 15, 1971 December 2 9 , December 31 , 1971 January 4, 19 72 Septem ber 15, 1971 (.4 8) -.0 9 5 (-2 .5 3 ) .0 4 8 (.9 4) -.0 9 8 (-2 .6 3 ) (- .0 4 7 (.9 3) Size Error .83 .14 9 .0 0 5 .387 -.0 0 2 .0 2 0 .0 0 5 -.0 0 0 4 (.0 6 ) (5 .0 2 ) (-.0 1 9 ) (.6 6 ) (7 .3 8 ) ( - 1 .5 9 ) -.0 9 8 -.0 7 7 -.0 2 5 .39 4 .037 ( 1 .2 2 ) -.0 0 0 5 ( - 2 .0 3 ) .84 .1 4 9 ( - 1 .0 4 ) -.1 0 8 ( - 1 .0 7 ) .00 5 (-2 .6 1 ) -.0 0 0 5 .84 .14 9 .84 .1 4 8 .92 .0 9 9 -.0 7 5 1 .0 2 (5 .4 4 ) 0 ) .3 9 2 -.1 1 6 .0 3 5 .0 0 5 ) (5 .4 3 ) ( - 1 .1 6 ) (1 .1 7 ) (8 .3 0 ) (- -.0 0 9 (-.10) .3 9 2 -.1 0 7 .03 3 (5 .4 8 ) (-1 .0 7 ) ( 1 .1 0 ) .00 5 (8 .3 5 ) (- -.0 1 9 ) (8 . 2 (-.2 2 .0 4 3 -.0 9 3 (-2 .5 2 ) -.0 6 0 (-.8 3 ) - .0 7 1 -.0 6 3 (-2 .6 4 ) -.1 8 4 -.0 0 6 .4 7 5 .09 4 .0 3 8 .00 4 ( - 3 .4 1 ) (-.0 8 ) (8 . 1 1 ) (1 .3 2 ) (1 .8 4 ) (7 .7 0 ) N O T E : Observations on m arket yields o f 58 long-term issues were taken from quotation sheets published by Salomon Brothers. Six dum m y variables (D-j through Dg) w ere used to take account o f the influence o f the six issuing agencies. The remaining variables were centered about th e ir sample means, w ith the intercept term o m itted fro m the equations. Estimates fo r the nine coefficients (b i through bg) are presented below the corresponding independent variables; t-values for each coefficient are in parentheses. The coefficients fo r the dum m y variables (coefficients b i through bg) measure the degree to which m arket yields on individual securities are influenced by the particular agency th at issued the security. Coefficients b 7 , bg, and bg measure the quantative im pact on m arket yield o f a one percentage p o int increase in coupon rate, an increase o f one m onth in term to m atu rity, and a $ 1 m illion increase in issue size. For exam ple, the December 29 , 1971 regression implies th a t on average, m arket yield w ould be " .3 9 4 — .0 4 8 = .3 4 6 " o f a percentage po int higher if the security were issued by F m H A than if it were issued by F N M A , w ould increase .0 0 5 o f a percentage po int w ith a one m onth increase in term to m atu rity, and w o uld decrease .0 0 0 5 o f a percentage point w ith each $ 1 m illion increase in issue size. Th e t-values are used to judge whether the influence of each o f the independent variables is statistically significant. In these regressions, a t-value above 2.01 2 .1 2 ) -.0 0 0 4 1 .8 8 ) -.0 0 0 4 (- 2 .2 1 ) indicates th at, if there is no association between m arket yield and the independent variable, th e p rob ab ility is less than 5 percent th a t a sample t-value this large w ould be obtained. Thus, in the December 2 9 , 1971 regression, variables D 2 , D 5 , m atu rity, and issue size are judged to be statistically significant at th e 5 percent level. Th e m ultiple R2 indicates th at from 8 3 percent to 9 2 percent o f the total variation in m arket yields was explained by the variables included in these regressions. The observations used in the first fo ur equations were taken w ithin a relatively short tim e period in order th at each sample w ould contain the same set o f long-term issues. It is possible, therefore, th at these results were influenced by th e selection o f th e sampling dates. Regression 5, which uses yields fo r Septem ber 15, 1971 and, therefore, has six fewer observations, is interesting in this respect. The results are similar except fo r the FLB co efficient, which is statistically significant. It is not know n, however, to w hat exten t the change in this coefficient is due to the d ifferen t tim e period, or to the changed sample (a $ 3 0 0 m illion FLB bond issue m arketed in October 1971 is no t in the Septem ber sample). Although Regression 5 introduces the possibility o f some variation in these coefficients over tim e , these results are not inconsistent w ith the impression gained from conversations w ith agency traders th at m arket participants view comparable issues o f F L B , F N M A , F H L B , and G N M A as a relatively homogeneous group o f investment assets. Sources: Salomon Brothers and Federal Reserve Bank o f Cleveland 14 Standard R -.0 9 7 (.8 7) ( - 1 .7 6 ) M ultip le ( - 1 .3 1 ) CO CM 1971 .0 2 4 b9 Issue F EB R U A R Y 1972 issues. 5 study o f the secondary market fo r agency issues.6 Also o f interest is the lack of significance o f the This study found a significant positive correlation T V A coefficient. A pparently, yields on the T V A between dealer transactions and the to ta l volume bonds are similar to those o f other agencies, even of securities outstanding and the volume o f new agency issues sold during a quarter. These results though T V A issues trade in a d iffe re n t market. These regression principal prerequisite results th a t the were obtained using quarterly averages o f all an active secondary outstanding issues as the independent variable and m arket—a sizable body o f homogeneous assets may not hold exactly fo r trading in securities available fo r fo r suggest the maturing in five years or more. However, even if long-term agency market. Whether these securities trading—currently exists in the relationship is o nly roughly sim ilar fo r the are in fact actively traded is d iffic u lt to determine. longer m aturities, the grow th in the volume o f Because dealers report th e ir trading volume in only long-term agencies outstanding and in gross new tw o m a tu rity categories—over one year or under issues since 1967 w ould be associated w ith rapid one year—it is impossible to measure d ire ctly the grow th in trading in this market. level of trading a ctiv ity in long-term issues. On the The grow th in dealer positions resulted from , basis o f indirect evidence, however, it appears th a t and a substantial am ount o f trading a c tiv ity is being a ctivity. The realized in this market. trading a c tivity and gross new issues to be the also con trib u te d to , the increased trading Peskin study found the level o f The average daily level o f dealer positions and major determinants o f dealer positions in agency transactions in agency issues maturing beyond one securities.7 However, the relationship between the year has increased dram atically since 1966 (see level o f trading and the level o f dealer positions Chart 2). Even though the over one-year totals are goes both ways, because the presence o f dealers probably heavily influenced by the behavior of m aintaining positions is essential to active trading the one-to-five year m aturities, this in any securities market. G row th in the size of growth suggests th a t trading a c tivity in long-term dealer positions is generally regarded as reflecting agencies has increased sharply in recent years. an Such an interpretation w ould be consistent w ith secondary market. trading in improvem ent in the performance of the dealers' comments concerning the apparent growth A d d itio n a l impetus to trading in agency issues in trading a c tiv ity and w ith the results o f a recent by private investors is expected to result from the 0 5 This result is somewhat surprising because it conflicts Janice Peskin, "Federal Agency Debt and Its Secondary M arke t," Treasury-Federal Reserve S tudy o f the U. S. w ith m arket participants' contention that the guarantee Government Securities Market, (Washington, D. C.: Board has no effect on an issue's m arket performance. However, o f Governors o f the Federal Reserve System, 1967), pp. 85-100. the size o f the PC co e fficie nt indicates th a t the magnitude o f the difference between PCs and other issues, w hile not negligible, is quite small. 1 Ibid., pp. 100-113. 15 ECONOMIC REVIEW C HART 2 SECONDARY M A R K E T A C T IV IT Y in L O N G -T E R M AGENCY ISSUES Selected Indicators Billions o f dollars * Excluding T V A issues. Last e n try: 4Q 1971 Sources: Salomon Brothers, Treasury B ulletin, and Federal Reserve Bank o f New Y o rk recent in itia tio n o f direct open m arket operations roughly 20 percent o f the System's purchases of in these issues by the Federal Reserve System. agencies have been long-term issues. These operations, which bring a large, active trader A by-product o f the System's new p olicy is th a t into this market, should improve the m arketability fu tu re long-term agency debt w ill probably be sold of all agency debt, including the long-term issues. in blocks o f $200 m illio n or larger. Guidelines Since these transactions began in September 1971, adopted by the Federal Reserve fo r its operations 16 FEB R U A R Y 1972 in agency issues lim it transactions in issues w ith securities m aturities o f more than five years to those w ith equivalent o f direct Treasury obligations. $200 m illio n or over outstanding. Because are Under expected this to be considered the new program, agencies such as e lig ib ility fo r System purchase w ill increase the Exim bank, m arketa bility o f an issue, the agencies w ill almost longer issue debt instrum ents to the public, but certainly as the w ould sell th e ir debt to the Bank. The Bank w ould issues. The then issue its own debt instrum ents to finance view m inim um the $200 m illio n size fo r th e ir level long-term FH A , T V A , and Fm H A w ould no results o f the m arket regressions described earlier these suggest th a t any increase in the m inim um size o f assistance programs fo r the financing o f public purchases. Federal housing currently financed through the sale o f tax-exem pt of the ir secondary market. public housing bonds, w ould be financed through Bank. Finally, redevelopment, credit long-term agency issues w ill also increase their the urban a d dition, tradeability and improve the overall performance F E D E R A L F IN A N C IN G BANK and In new w hich borrow ing are agencies The grow th o f the long-term agency market has currently being proposed, such as the Environ been especially rapid during the past tw o years, as mental Financing A u th o rity , the Urban Develop new instruments were introduced in to this m arket m ent Bank, the Rural Development Bank and and agencies to o k advantage of improved market others, w ould also obtain financing through the conditions to lengthen the average m a tu rity of Bank. their debt. Indications are that fo r the next few If legislation establishing the Bank is approved years this grow th w ill be maintained as the current by Congress, the Bank is expected to issue a large participants continue to tap the capital m arket and volume as new agencies, such as the U. S. Postal Service, Purchasing the public housing bonds alone w ill get their borrow ing programs underway. However, require over $2 b illio n per year. Added to this growth w ill accelerate sharply if the proposed volume w ould be the growing borrow ing needs o f Federal Financing Bank becomes a reality. As existing of debt securities agencies, such as of all Fm H A, maturities. the Postal proposed in a b ill cu rre n tly before Congress, the Service, T V A , etc., and the new agencies' initial Bank w ould centralize the m arketing o f securities and fo r many existing Federal Agencies and fo r a group o f proposed new agencies. The obligations o f all agencies except FN M A, FH LB , and the members of the Farm Credit ongoing borrowings. It is not surprising, therefore, th a t this new Bank is expected to be a very active borrower. The in tro d u ctio n o f the Financing Bank should A d m in istra tio n have a profound im pact on the Federal Agency w ould be eligible fo r purchase by the Financing sector of the capital market. Many o f the existing Bank. The Bank w ould purchase these issues w ith separate agency issues w ould be replaced w ith a funds raised through the sale o f its own debt. single issue o f unquestioned credit worthiness and Because the improved Financing Bank w ould have the a u th o rity to borrow fro m the U. S. Treasury, its m a rke ta b ility. In addition, the Bank w ould convert relatively illiq u id long-term debt, 17 ECONOMIC REVIEW such as the public housing bonds, in to marketable FN M A, FH LB , and FLB, w ill be sold and traded in instruments. Both o f these developments should a m arket as active and as e ffic ie n t as the m arket increase the volume o f secondary m arket a c tivity fo r in all long-term agency issues. It is conceivable th a t Federal w ith the establishment o f the Federal Financing relative obscurity as late as 1965 in to one o f the Bank, long-term agency issues, including those o f most prom inent o f the capital market instruments. 18 U. S. Government bonds. Agency issues w ill In th a t event, have grown from FEBR UAR Y 1972 RECENTLY PUBLISHED ECONOMIC COMMENTARIES OF T H E F E D E R A L R E S E R V E B A N K OF C L E V E L A N D "Business Economists Reexamine Outlook for 1972" January 17, 1972 "Changing Financial Structure of Agriculture in Ohio" January 31, 1972 "What is a DISC?" February 14, 1972 "The Prime Rate: To Float or Not To Float?" February 28, 1972 Econom ic Com m entary is currently published every other week and is available w ith o u t charge. Requests to be added to the mailing list or fo r additional copies o f any issue should be sent to the Research Departm ent, Federal Reserve Bank o f Cleveland, P. 0 . Box 6387, Cleveland, Ohio 44101. 19
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