Economics Update (April-June 1996)

New Model Identifies Optimal Conditions For Calling U.S. Treasury Bonds

Until 1984, the U.S. Treasury typically issued its long-term bonds in callable form. A number of these securities, totaling $93.8 billion in face value, remain outstanding. After a call protection period, usually until five years prior to maturity, the Treasury can call the bonds but must give prior notification of intent to call. Robert R. Bliss, a senior economist at the Atlanta Fed, and Ehud I. Ronn, a professor of finance at the University of Texas at Austin, have developed a decision rule for determining when it is optimal to call such bonds.

The model Bliss and Ronn developed, which is explained in an article in the Atlanta Fed's November/December edition of Economic Review, specifies conditions under which the Treasury should call outstanding callable bonds in the future. The model differs from previous models in that it takes into account the requirement of prior notification of intent to call a bond. The model is also applicable to agency, corporate, and municipal callable bonds.

The decision of whether to call a bond is based on the current levels of interest rates and their volatility. According to Bliss and Ronn, two conditions must exist for a call to be optimal for the Treasury: (1) interest rates must be sufficiently low (relative to the bond's coupon) and (2) the potential benefits of waiting—on the chance of even lower interest rates—should be insufficient to compensate for the costs of continuing to pay the higher coupon rate for another six months. The authors use a numerical example to demonstrate their application.

Bliss and Ronn conclude that, at least in recent years, the Treasury has called bonds optimally.

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