Background Note on the Treasury Bill Program

1. Introduction

This year, the average outstanding stock of treasury bills has been about $85 billion, about half of where it was (almost $165 billion) five years ago. The turnover ratio (the trading volume to the outstanding stock of bills) has declined by even more, to less than half the rate of five years ago. As part of this year's market consultations on debt strategy, the Bank and Finance would like views on the liquidity of the treasury bill market and whether changes should be considered to the structure of the program.

This is the third time in just over three years that the issue of restructuring the bill program has come up. In September 1997, auctions were switched from every week to every second week. And in early 1999, an extensive review of possible further restructuring took place. Market consultations at that time produced the following feedback:

• according to most dealers, the Canadian bill market was working relatively well, but the status quo could be sustained only if gross issues at the biweekly auctions did not drop below $6 billion
• meanwhile, many accounts felt that liquidity was starting to deteriorate; they were more concerned with the total stock of bills outstanding than with the amounts issued at each biweekly auction
• there was a clear preference, if possible, to keep all three tranches; if one tranche were dropped, there was no consensus among dealers or accounts as to whether it should be the 6-month bill or the 12-month bill

A combination of this feedback and revised assumptions about the government's fiscal outlook led to the decision not to proceed with any changes at that time.

Is this conclusion still appropriate? In other words, is the status quo still acceptable? In answering, assume that the outstanding stock of bills will remain in the $75-$95 billion range over a two-year planning horizon.

2. Pros and cons of the previous restructuring options

In March/April 1999, the Bank and Finance presented five main options to market participants. Three options kept all three tranches but issued 6- and 12-month bills at every second biweekly auction (i.e., approximately once a month), rather than at every auction. The other two options discontinued either the 6- or 12-month bill. In all options, 3-month bills would continue to be issued at every biweekly auction.

2.1 Continuing to issue all three tranches:

In one of the 3-tranche variations, 6- and 12-month bills were issued together at every second auction, while in a second variation, 6- and 12-month bills were issued separately at alternate biweekly auctions. The first variation produced large swings from one auction to the next in the total amount of bills being issued, but it resulted in a smooth pattern of maturities. The second variation produced a smooth pattern of new issues, but resulted in large swings from one auction to the next in the amounts that were maturing. The third 1999 variation of monthly 6- and 12-month issues had 6-month bills bearing an initial term-to-maturity of 168 days, which would produce smooth patterns of both issues and maturities. 1

Needless to say, large variations from one biweekly auction to the next in new issues or maturities would result in large swings in the federal government's cash balances. This would necessitate either that the government carry larger average cash balances or make much more extensive use of cash management bills.

It is also important to question how much potential improvement in market liquidity might be provided by any biweekly three-tranche option, since the same amounts of each tranche would ultimately be auctioned. The only difference is that the tranche sizes of each monthly auction of 6- and 12-month bills would be double those of the status quo since they are offered only once a month instead of being issued and reopened at successive biweekly auctions.

2.2 Issuing only two tranches:

The other two 1999 options assumed that one of the two longer-dated tranches would be dropped to enable larger amounts of the two remaining tranches to be auctioned. Following are some of the factors that could be relevant in choosing which bill to drop under these options:

External environment
Since the last round of consultations, U.S. auctions of 12-month bills have been cut from once a month to once a quarter, and it is anticipated that they will be dropped completely in 2001. Canada could therefore: (i) follow the U.S. and drop the 12-month bill, or (ii) keep the 12-month bill in order to fill a particular market niche for foreign investors (specifically, new one-year securities issued by a North American sovereign).

Gap in the yield curve
Dropping one of the two longer bills would create a gap in the yield curve that may be filled by non-government securities or by other Government of Canada securities as they move down the curve towards maturity. Thus, the place of 6-month bills could be taken by 12-month bills that are rolling down the curve, while the place of discontinued 12-month bills could be taken by previously issued 2-year bonds. Dropping the 12-month bill would mean no Government of Canada bill product with more than 6 months to maturity. Moreover, non-government substitutes for discontinued bills may be less likely at 12 months than at 6 months.

Tender amounts
Dropping the 12-month bill and issuing only 3- and 6-month bills would produce a larger increase in biweekly auction sizes than would dropping the 6-month bill and issuing only 3- and 12-month bills, because the stock of bills will turn over more quickly. In other words, biweekly maturities and gross new issues would both be higher if a two-tranche bill program comprises 3- and 6-month maturities.

3. Characteristics of several possible restructuring options

The following two tables compare the status quo with five possible alternatives. Three of these alternatives were presented for consideration in March/April 1999. The two new alternatives have auctions either every third or fourth week rather than every second week. The main impediment to options with less frequent auctions is that the initial term to maturity of the 3-month bill would have to change from the current 98 days (14 weeks) to either 84 or 105 days (12 or 15 weeks) for a 3-week auction cycle, or to either 84 or 112 days (12 or 16 weeks) for a 4-week cycle. 2

Other restructuring options in addition to these five might also be considered. Implications for liquidity and for issue and maturity patterns would be important criteria in choosing among them.

Note that all but one restructuring alternative would involve a transition period during which there will be mismatches between the amounts of newly issued and maturing bills. Only the M-6-12 option (monthly issues of 6- and 12-month bills) avoids this problem, while the largest transitional difficulties arise with the 3-week auction cycle. The mismatches between new issues and maturities would result in greater volatility from week to week in the government's cash balances, and would necessitate some combination of larger average balances and greater use of cash management bills. The length of the transition period is the same for all options—one year—until all bills issued under the previous structure have matured.