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Why not lock in low interest rates?

The federal government has failed to take up an historic opportunity to lock in ultra-low interest rates on long-term Government of Canada bonds.

Normally -- as outlined in annual debt management reports -- the government follows a strategy which is intended to achieve two main goals: low overall debt servicing costs, and stable and predictable bond markets. Since the yield curve is normally upward-sloping -- i.e. long-term bonds carry higher rates of interest -- the government issues a mix of treasury bills (t-bills) and shorter- and longer-term bonds to balance the trade-off between cost and risk, and the projected mix for the coming year is announced in the debt management strategy section of the annual federal budget. Borrowing needs for the coming year essentially consist of financing most of the annual deficit, plus refinancing current debt as earlier bond issues mature.

The latest debt management report (for 2010-11) tells us that the term structure of federal market debt has remained broadly stable since early 2008, before the financial crisis. The share of treasury bills rose in 2009 as the government used this source to fund much of the sharp increase in the deficit, and it has since been run down by shifting from t-bills to shorter-term bonds.

But the share of long-term bonds has remained quite steady at about 40 per cent -- 20 per cent for 10-year bonds, and 20 per cent for very long-term bonds (30-year bonds and real return bonds.) (See Chart 2.) The average term to maturity is just under 6 years.

The debt management strategy in the last budget tells us that the government intends to continue reducing the overall share of t-bills over the coming year, but will maintain the share of long-term bonds over the next 10 years at about 40 per cent.

As one would expect as a result of very low interest rates in the wake of the financial crisis, the average cost of servicing federal market debt has fallen to a low of 2.8 per cent in 2010-11. But there would seem to be a strong case for shifting the term structure to long-term bonds.

As of today, interest rates on long-term federal government bonds are just above record lows -- 1.94 per cent for ten year bonds, 2.5 per cent for 30-year bonds, and 0.5 per cent on real return bonds (i.e. 2.5 per cent if inflation is 2 per cent.)

Obviously the government and the Bank of Canada should not cease issuing t-bills which are required to conduct monetary policy and to maintain a stable bond market, but there is surely an opportunity to lock in ultra-low interest rates for a very long period of time. Why are we not taking advantage of it?

This article was first posted on Progressive Economics Forum.

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