The Mother of All Bond Portfolios: Social Security Trust Fund

by: Bruce Krasting

The G20 will certainly discuss the matter of Reserve Currencies this week in London. There is a lot to discuss on this topic. As of January 09 the US Treasury reports foreign holders of US Treasury securities (excludes Agencies) of a total of $2.399 Trillion. The biggest holders of these securities include:

While those numbers in the aggregate are staggering, they are nothing compared to the biggest holder of Treasury Securities. As of January 2009 the Social Security Trust Fund (“SSTF”) held $2.419 Trillion of Treasury Obligations.

Fortunately for Mr. Geithner at Treasury and Mr. Bernanke at the Fed, the SSTF is a captive buyer of Government paper. Unlike the Chinese, the SSTF does not have the option of diversification. Also unlike the Chinese, they can't complain about the risks they are taking while investing such an enormous amount of money in the IOU's of America.

The SSTF provides a significant amount of information regarding their holdings on their web site. For those who love to analyze huge data bases this is a place to spend an afternoon. For those bond traders out there, the information contained in the various reports will surprise you. The SSTF publishes a blotter of all of its transactions. There are some links at the end the end of this article.

This observer has reviewed the information. It is difficult to draw definitive conclusions, there is just too much to look at. The following are observations based on a review of the data and related information.

• The mission of The SSTF is to invest all of its excess cash while at the same time maintaining sufficient liquidity to meet its monthly disbursements. The numbers are very big. The April 2009 SS checks will total $55 billion. The SSTF has a big 'cash management' job as their in/out flows are very seasonal.

• The investment activity of the SSTF is governed by a law enacted in 1960. At that time a 'formula' was established to determine the pricing of securities that would be purchased by the SSTF from Treasury. There are two forms of securities, One short term, the other long term. The short term is defined as a maturity of one year or less. All short term securities mature on the next June 30th. The long maturities range from 1-15 years.

• The 1960 law was a reasonable effort to establish rules for these purchases and sales. However it is archaic in 2009. It causes the SSTF to do all manner of things that would seem illogical. One consequence is that there are huge swings in the 'fair value' that is conveyed from the taxpayer to the SSTF each year.

• The pricing formula is simple. The average of all the Treasury coupons for the prior 30 days is established on each June 30th. The rate for all maturities is set at this one average rate. The following is a description and pricing of these new issues. The amounts are in billions.

When the yield curve for 1-15 year maturities is steep, the average pricing formula from 1960 produces a significant variance to the results that would have been achieve if 'market' rates had been applied to these investments. The consequence of the formula is to produce interest rates on short maturities much higher than the prevailing market rates. However, the formula also produces a lower than market rate for the all important 15th year maturity.

The ratio of 1-14 maturities to the 15th year is about 12 to 1. Therefore understating the yield on the 15th year portion significantly reduces the cost to Treasury overtime. The following are my calculations of the differences for selected years.

The large variance between the 1960 formula and the results that would have been achieved if market rates were applied sets up an interesting debate. The Grey Panthers want 'market rates' and anyone under 40 wants to keep the old formula. A curious juxtaposition of interests.

• In January of 09 the Fund bought a net of $18 billion of Treasury notes due in five months at a yield of 2 1/8 %. The market yield on that date for this would have been closer to 90 BP's. This one transaction represents a scalp of the Treasury for $90mm. One wonders if anyone is looking at this.

• In 2008 the SSTF bought and sold securities in excess of $2 Trillion. Approximately equal to their portfolio size. This is a surprisingly large number given they are executing the classic buy and hold strategy. A substantial portion of the buying/selling is a result of the requirements of the 1960 rules. The SSTF is stuck with rigid investment guidelines. The rules conflict with their requirement to have funds invested while at the same time managing the monthly cash outlays. This observer is convinced that there is a 'better way'. Cash management techniques have evolved a great deal in the past fifty years.

• There appears to be discretionary activity in managing the portfolio. Choices appear to made in some years and different ones in other years. It begs the question, Why?

In the second half of each year the SSTF redeems certain securities and replaces them with new securities. All of the securities that are bought and sold have maturities of the next June 30th. The result of this buying and selling is not clear. The value of the portfolio as of the next June 30th is not affected by this activity. However, this activity does have an affect on the reported year end number put out by the SSTF. In some years the fund sells high coupon notes and replaces them with low coupon notes. This produces a capital gain which would increase the YE number. In other years they do the reverse.

By my calculation the result of their activity in 08 was a gain of $197mm. Their activity in 07 produced a loss of $117mm. No doubt this is a random event that happens when running such a huge pile of money. They did however choose the bonds to be redeemed deliberately.

• The April 2009 cash outlay for SS will be $55.7 Billion. The average annual rate of increase in the last five years is 6%. That number jumped up in January of 2009 to a YoY increase of 9%. The jump in expenditures means about $150mm a month to the Fund. This sharp increase in 09 is a reflection of America's election cycle.

• The actuarial at the SSTF says that it is “80% probable that assets in the fund will begin to decline later than 2013”. This is not a date when SS is broke. That occurs far into the future. The 2013 date is however significant to the US Treasury. From that point onward the SSTF will not have excess cash to invest. This means that this constant buyer of US debt will go away. The fund currently holds $2.4 Trillion. This means that they have funded 1/3 of all the deficits since 1938. As a buyer of new Treasury issues they will be sorely missed.

The dynamics of the fund are driven by prevailing interest rates, economic activity and the rate of expenditures. In 2009 interest rates are low, economic activity is low and the expenditures are increasing on a cash basis by 9% annually. That 80% probability for 2013 is at risk. Either way 2013 is not very far away.

• The SSTF invests in a strip of Treasury maturities from 1 to 15 years. There is a ratio of the amount of intermediate maturity bonds and the final maturity of the bond. That ratio varies from year to year. In the 1990's that ratio averaged 14%. In 2000 it started to decline. In 2008 it stood at only 8%. This change in investment strategy would seem to be motivated to create duration. The significant change in this ratio suggests that 'human' choices are being made. While extending duration my be a wise choice it is still a choice. On Wall Street they call this a “rate bet”.

• The Fund produced this graph which shows the ratio of those employed and contributing to the fund versus the number who are receiving benefits. That number began a permanent decline in 2007. About the same time that everything else fell apart.

Links of interest:
Social Security trust funds investment holdings
Social Security trust funds investment transactions