Academic journal article Federal Reserve Bank of New York Economic Policy Review

An Examination of Treasury Term Investment Interest Rates

Academic journal article Federal Reserve Bank of New York Economic Policy Review

An Examination of Treasury Term Investment Interest Rates

Article excerpt

* The U.S. Treasury, through its Term Investment Option (TIO) program, lends excess cash balances to banks at interest rates determined by single-rate auctions.

* An important issue in TIO auctions is whether the Treasury receives a market rate of return on TIO funds.

* An analysis of the spread between rates on TIO auctions and rates on mortgage-backed-security (MBS) repos suggests that for small auction sizes, TIO rates are comparable to market rates, except on offerings with term lengths of fewer than five days.

* The study also finds that a more compressed auction schedule, in which the Treasury announces and auctions TIO funds on the same day, does not adversely affect TIO rates; thus, banks appear to be indifferent to more advance notice of auctions.

1. Introduction

The Term Investment Option (TIO) program is a cash management tool of the U.S. Treasury Department. Through TIO, which is part of the broader Treasury Tax and Loan (TT&L) program, the Treasury lends funds to depository institutions for a set number of days. The rate that the Treasury receives is determined via a single-rate auction format.

An important issue in TIO auctions is whether the interest rates received by the Treasury are comparable to market rates. In this article, we compare TIO rates with rates on mortgage-backed-security (MBS) repurchase (repo) agreements. MBS repo rates are the closest benchmark for TIO rates in several respects: depository institutions can obtain funds using both types of transactions, the transactions are collateralized, and the eligible collateral is similar. We study the 166 auctions held from November 2003, when TIO first became an official Treasury cash management facility, to February 2006. (1)

TIO auctions can shed light on bidding behavior in general, because they vary along more dimensions than traditional Treasury debt auctions. For example, TIO auctions are not held on a regular basis and their size and term length vary. Typical Treasury debt auctions, by comparison, are held on a regular schedule, (2) and the amount auctioned is usually the only variable.

A key finding of our work is that for small auction sizes, TIO interest rates are fairly comparable to MBS repo rates for term lengths of five days or more. However, shorter term lengths result in the Treasury receiving lower TIO rates relative to market rates. We also observe a negative relationship between the size of an auction and the spread between the TIO rate and the MBS repo rate. Finally, a more compressed auction schedule, in which the Treasury announces and auctions TIO funds on the same day, does not adversely affect TIO rates. This finding suggests that banks are indifferent to more advance notice of TIO auctions.

Our study proceeds as follows. In Section 2, we provide background information on the TT&L program, term investments, and repo transactions. Our data and our regression framework are presented in Section 3, while regression results can be found in Section 4. In Section 5, we draw conclusions.

2. Background

2.1 The Treasury Tax and Loan Program

Treasury funds are held either at Federal Reserve Banks (the Fed balance) or private depository institutions in what is known as the Treasury Tax and Loan program (see Garbade, Partlan, and Santoro [2004] for a discussion of recent innovations in Treasury cash management). The Fed balance does not earn explicit interest, (3) while balances held at private depository institutions, which can be withdrawn on demand, earn the TT&L rate, which is the weekly average overnight federal funds rate less 25 basis points. (4) Depository institutions specify the maximum TT&L balances they are willing to hold, and the balances must be collateralized. If balances exceed the lesser of the specified limit or the collateral value of assets pledged by the institution, the excess is transferred to a Treasury account at the Federal Reserve Bank of St. …

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