[LETTERHEAD OF THE BOND MARKET ASSOCIATION]
Via Electronic Mail and
Federal Express
February 6, 1998
Mr. Kerry Lanham, Acting Director
Department of the Treasury
Bureau of the Public Debt
Government Securities Regulation Staff
999 E Street N.W., Room 515
Washington, D.C. 20239-0001
Re: Proposed Amendment (Fungible Interest Components of Inflation
-Indexed Securities)
Dear Mr. Lanham:
The Bond Market Association (the "Association")/1/ appreciates the
opportunity to comment on the proposed rule amendments/2/ issued by
the Department of the Treasury ("Treasury") relating to fungible
interest components of inflation-indexed securities under the
Uniform Offering Circular for the Sale and Issue of Marketable Book-
Entry Treasury Bills, Notes and Bonds/3/ (the "Uniform Offering
Circular"). As you are aware, the Association has submitted comment
letters/4/ in connection with Treasury's previous proposals regarding
inflation-indexed securities and continues to have an active interest
in the refinement of Treasury's rules with respect to this new class
of securities.
/1/ The Bond Market Association (formerly known as "PSA The Bond
Market Trade Association " or "PSA") is the bond market trade
association, representing securities firms and banks that underwrite,
trade and sell debt securities, both domestically and internationally.
Its members include all of the primary dealers recognized by the
Federal Reserve Bank of New York, as well as other government
securities dealers. More information about the Association can be
found at its Internet website http://www.bondmarkets.com./2/ 62 FR
64528 (December 8, 1997).
/3/ 31 CFR Part 356.
/4/ Letters dated July 12, 1996 and November 6, 1996 to Kenneth
Papaj, Director, Government Securities Regulation Staff, Bureau of
the Public Debt, from Edwin F. Payne, Chairman, PSA Government and
Federal Agency Division.
In sum, the Association supports Treasury's efforts to make the
interest components of inflation-indexed securities fungible./5/
Association members generally believe that the fungibility of interest
components is an important step in making the underlying inflation-
indexed securities market more liquid. Association members appreciate
Treasury's foresight and commitment to establishing the mechanism
necessary for making interest components of inflation-indexed
securities fungible, particularly in advance of any noteworthy
increase in inflation. Notwithstanding the foregoing, most market
participants continue to be very concerned with the significant
modifications needed for their operational systems to accommodate
the trading and maintenance of the adjusted value of stripped
interest components to the penny./6/
/5/ Association members recognize that although inflation-indexed
securities are currently eligible for Treasury's Separate Trading
of Registered Interest and Principal Securities ("STRIPS") program,
the stripped components are not fungible. It is our understanding
that this is true even if the interest components have the same
maturity date because the inflation adjustment to the principal
component is based on the CPI reference number for the issue date
of the security and securities with the same maturity date may have
different issue dates.
/6/ In addition, although the Association generally supports the
proposed initiative in its current form, some members are also
concerned about the ability of investors to comprehend the proposed
STRIPS methodology given its complexity. In light of this concern,
the Association encourages Treasury to carefully evaluate the benefits
of fungibility, using the proposed methodology, against the potential
cost to market participants arising from its complexity and the
system related demands (independent of the "pennies" issue
identified above). Unfortunately, the Association is not in a
position at this time to comment on what effect these costs will
have on the market for inflation-indexed STRIPS.
The Association's comments are divided into two parts. Part I
elaborates upon the significant operational system changes most
market participants expect will be needed in order to maintain
and trade the adjusted value of the interest components of inflation-
indexed securities to the penny. As one solution to this issue,
Association members recommend that Treasury consider truncating
the pennies from the adjusted values for stripped interest components.
Part II describes Association members' view supporting the
establishment of a conversion factor if the Consumer Price Index
("CPI")/7/ is rebased and agree that the availability of such
conversion factor will increase fungibility. Association members
believe, though, that better liquidity can be achieved if conversions
are done on a voluntary basis, and if there is a conversion factor
available for converting securities issued under the old base
reference period to the new base reference period and vice versa.
/7/ The index for measuring the inflation rate for the securities
will be the non-seasonally adjusted U.S. City Average All Items
Consumer Price Index for All Urban Consumers.
I. Operational and Other Concerns
Under the proposal, the adjusted value of the interest components
stripped from inflation-indexed securities would have to be calculated,
transferred and maintained to the penny (e.g. $10, 802.47). Most
Association members currently do not have the operational capability
to maintain or trade par values or adjusted values of a security in
pennies./8/ As a result, these Association members consistently agree
that, if the proposal is adopted in its current form, significant
changes would need to be made to their internal trading, trade
processing, settlement and accounting systems. Association members
believe, realistically, that it will require approximately six to
nine months to both make and test the appropriate system changes
before they can begin trading the new stripped securities. In
addition, the same members have expressed concerns about whether
adequate internal resources can be dedicated to the project since
currently many are making operational system adjustments to prepare
for the Year 2000, the European Monetary Unit and the GCF Repo product
of the Government Securities Clearing Corporation ("GSCC").
/8/ Based on an informal survey conducted by the Association, an
extremely limited number of market participants seem to have the
ability, or with minimal effort will have the ability, to trade
securities maintained to the penny.
The Association has come to understand that other industry
participants would need to make significant modifications to their
computer systems to enable them to handle securities denominated
to the penny. In order to make these securities eligible for trade
comparison and netting services, registered clearing corporations,
such as GSCC, would have to reconfigure multiple components of their
systems. GSCC estimates that it would require four to six months
to develop, test and implement modifications to its systems once final
specifications regarding the introduction of fungible interest
components of inflation-indexed securities are established by
Treasury. In addition, one of the two major clearing banks that
needs to acquire the ability to clear a security carried to the
penny has indicated that significant program changes and a quality
assurance effort would be required. GSCC and this clearing bank are
concerned whether they will have adequate resources to give a high
priority to these modifications in light of the other important
industry initiatives described earlier in this letter.
Association members suggest that the significant cost associated with
modifying operational systems to accommodate maintaining and trading
the adjusted value to the penny could be avoided by incorporating one
modification in the present proposal-truncating the pennies from
the adjusted value. Treasury's proposal provided the example of an
inflation-indexed security submitted for stripping with a 10-year
maturity, a par amount of $1 million, a coupon rate of 3.5% and an
issue-date reference CPI of 162.00000. The adjusted value for each
interest component was calculated as $1 million x (0.035/2) x
(100/162), or $10,802.47. Using the truncation methodology we
suggest, the adjusted value of each stripped interest component
would equal $10,802.47, but a par value equaling $10,802 would
actually be issued. In other words, the dealer would forego
receiving $0.47 per interest component or a maximum aggregate
of $9.40 (20 interest components x $0.47) per $1 million stripped.
All such penny truncations would accrue to the benefit of
Treasury, and dealers would treat the forgone value as a variable
cost associated with participating in the stripping business.
Generally, for a 10-year issue, the adjusted value of pennies
truncated would be expected to average $0.50 per maturity date per
$1 million of inflation-indexed securities stripped or a total of
$10 for all 20 interest components, with a market value significantly
less than $10 per $1 million. The truncation would discourage the
stripping of trivial amounts. In the example above, 1,000
transactions of $1,000 would create costs of $0.80 x 20 x 1,000 or
$16,000 per $1 million compared to $9.40 ($0.47 x 20) per $1 million
for one transaction. In addition, the associated transfer fee imposed
by the Federal Reserve Bank of New York would be higher for 1,000
transactions.
The Association believes as part of this suggestion that, during
the reconstitution process, it would be necessary for Treasury to
accept interest components in the same truncated denominations that
were previously issued to market participants during the stripping
process. For example, the $10,802 par value in the case above would
be an acceptable STRIPS component -- even though, the adjusted value
credited will be equivalent to $10,802.47 in the reconstituted note,
and the interest payment on the securities would be calculated as
stated in Treasury's proposal and paid to the penny. Should Treasury
require pennies for reconstituting the securities, the initial
investor to strip the issue would find himself/herself unable to
reconstitute them if no other inflation-indexed securities were
stripped with the same interest payment dates. In fact, it would
be impossible to extinguish all outstanding STRIPS unless the
truncated adjusted value of the STRIPS received is acceptable for
reconstituting. Stripping and reconstituting in like amounts,
would appear to be revenue neutral. The truncated pennies Treasury
kept during stripping would be returned during the reconstitution
process.
The Association believes that truncating pennies from the adjusted
value furthers Treasury's goal of making the securities attractive
to a broader investor base and developing a liquid market. Moreover,
stripped interest components would be eligible for netting by clearing
corporations and clearance by both major clearing banks. Therefore
Association members suggest Treasury consider making this modification.
Association members recognize that theoretically a dealer could profit
from stripping a large par amount in one transaction and subsequently
reconstituting that same par amount using multiple transactions.
Using the same example above, if a dealer strips $1 million, thereby
walking away from $9.40 of adjusted value of interest components, and
later decides to reconstitute 1,000 $1,000 lots so as to receive
$10.80 for every $10 submitted, the dealer will have an adjusted value
benefit of $15,990.60 ($16,000-$9.40). This benefit, however, is
only theoretical, because it does not factor the transaction costs
associated with reconstitution. The Federal Reserve Bank of New
York's existing transfer fee of $2.25 per CUSIP number submitted
for reconstituting a security, whereby the principal and each interest
component is counted, makes it less costly to submit larger amounts
for reconstituting (in the example, 21 CUSIPS x $2.25 or $47.25 for
one transaction versus $47,250 for 1,000 transactions). If Treasury
decides that the transfer fees fail to offer enough protection from
potential abuse, Treasury could consider requiring a $1 million
minimum par amount of notes and bonds for stripping and reconstituting.
Market participants agree with Treasury's assessment that the
differences in payment amount between a stripped interest component
and an interest payment of a fully-constituted security are very small
and revenue neutral. Therefore, market participants support
Treasury's proposal not to change its current rounding conventions
to eliminate these differences.
II. Rebasing the CPI
Association members consistently believe that if the base reference
period for the CPI is changed from 1982-1984 ("the old period") to
1993-1995 ("the new period"), the benefits of increased fungibility
will justify the cost of creating a conversion factor between
securities originally issued with different reference CPI periods,
the cost of making any necessary system changes and the possibility
of creating additional small payment discrepancies./9/ Association
members recommend, though, that the conversion be done on a voluntary
basis because the conversion undoubtedly will create pennies.
Since, as described above, most dealers' systems would be unable to
accommodate pennies, the pennies would have to be truncated in the
same fashion as described in Part I when inflation-indexed securities
are stripped. However, unlike a fully constituted security being
submitted for stripping, most outstanding stripped interest
components will be held by investors rather than dealers. Therefore,
any truncating would be at the cost of an investor (assuming
dealers would not be willing to absorb this cost for the benefit
of an investor). By making conversion voluntary, investors will
be permitted to decide for themselves whether the benefits outweigh
the associated costs of conversion. Association members also
recommend that an additional conversion factor be created that will
allow interest components of inflation-indexed securities based on
the new period to be converted to the old period. Association
members believe that this additional convertibility and the voluntary
conversion feature will further increase the marketability of the
stripped interest components.
/9/ As the Association mentioned in its comment letter to Treasury
dated July 12, 1996, the likelihood that redefinition of the CPI
may occur during the life of a 10-year or 30-year inflation-indexed
note or bond is a real and serious concern to potential investors.
The Association agrees with Treasury's observation that interest
components stripped from inflation-indexed securities issued under
different indices with fundamentally different methodologies would
not be fungible.
The Association appreciates the opportunity to comment on the proposed
amendment and looks forward to continuing the exchange of ideas
between Treasury and market participants. Any questions may be
directed to the undersigned at 212-440-9431 or Paul Saltzman,
Senior Vice President and General Counsel at 212-440-9459.
Sincerely yours,
/s/ Paula H. Simpkins
Paula H. Simpkins
Vice President and Assistant General Counsel
cc: Members of the IIS STRIPS Task Force
Members of the Primary Dealers Executive Committee
Members of the Primary Dealers Committee
Michael D. McCarthy, Jr., Goldman, Sachs & Co.
Mark B.Werner, J.P. Morgan Securities Inc.
Susan M. Estes, Morgan Stanley & Co., Inc.
Selected Staff, The Bond Market Association