The U.S. Treasury Buyback Auctions: The Cost of Retiring Illiquid Bonds

We study an important recent series of buyback auctions conducted by the U.S. Treasury in retiring $67.5 billion of its illiquid off-the-run debt. The Treasury was successful in buying back large amounts of illiquid debt while suffering only a small market-impact cost. The Treasury included the most-illiquid bonds more frequently in the auctions, but tended to buy back the least-illiquid of these bonds. Although the Treasury had the option to cherry pick from among the bonds offered, we find that the Treasury was actually penalized for being spread too thinly in the buybacks. ONE OF THE MOST DRAMATIC RECENT EVENTS in the Treasury bond market was the surprise announcement in January 2000 of the Treasury’s first buyback program for its long-term debt in 70 years.1 Through this program, the Treasury retired $67.5 billion of its debt in 45 separate buyback operations. The introduction of this program was in response to the budget surpluses of the late 1990s as well as to the Treasury’s goal of replacing older off-the-run debt with lower-coupon on-the-run debt. Market participants supported the buyback program enthusiastically and individual buybacks were invariably oversubscribed by wide margins. The buyback auctions differed from the standard Treasury auctions used to issue bills and bonds in several important ways. Foremost among these was that the bonds involved were older and less-liquid issues, contrasting sharply with the usual Treasury issuance auction for highly liquid on-the-run bills and bonds. Thus, the Treasury faced the risk of suffering huge market-impact costs in buying back such massive amounts of its illiquid debt. To address this problem, the Treasury designed a unique structure for the buyback auction that gave the Treasury a number of options that could be used to mitigate the ∗Han is with the McCombs School of Business at the University of Texas at Austin. Longstaff is with the UCLA Anderson School and the National Bureau of Economic Research. Merrill is with the Marriott School of Management at Brigham Young University and is a Fellow of the Wharton Financial Institutions Center. We are grateful for valuable comments and assistance from Tony Bernardo, Sushil Bikhchandani, David Hirshleifer, Andrew Karolyi, Val Lambson, Grant McQueen, Brett Myers, Kjell Nyborg, and Ross Valkanov. We are particularly grateful for the very helpful comments of Rob Stambaugh (the editor) and an anonymous referee. All errors are our responsibility. 1 On the day after the announcement, long-term Treasury markets had their largest single-day rally since Black Monday, October 19, 1987. The 30-year Treasury bond rallied by five points ($5 per $100 notional amount) and dropped 32 basis points in yield.