A number of people have asked about the government's special auction of 10-year Treasuries today in response to thin bond trading.

I've written in the last few weeks how the bond market has become more illiquid and that this could persist for some time. While improving a bit, liquidity may never fully recover to what it was prior to September -- just as 1998's events caused a permanent reduction in the amount of trading capital that was allocated to fixed income.

Today's action was taken in response to the tightness of the repurchase agreement, or repo, market. Repo is the first cousin of fed funds, and is how dealers and banks finance a significant portion of their Treasury (and to a lesser extent, agency and mortgage) holdings.

Treasury repo normally trades five to 15 basis points below the fed funds rate. This is because repo is a secured loan, whereas fed funds is unsecured. A typical transaction may involve a money fund loaning money to a broker for a day. In return, the broker agrees to pay the fund the repo rate for the day, and delivers Treasuries to the fund as collateral in case the broker defaults. When the repo matures, the dealer pays the interest and returns the money, while the fund returns the collateral. For legal reasons, this is technically structured as a sale by the broker of Treasuries with a subsequent repurchase, giving the market its name. Practitioners are known in the trade as "repo geeks."

There are two types of repo: General and specified. General repo means the lender is indifferent to which Treasury issue is received as collateral. All that matters is that there is enough of it, typically 102% of the face amount. Specified repo is where the lender needs to receive a specific bond, typically the most recently issued two-year, five-year, 10-year or 30-year maturity. These "on-the-run" issues typically have significantly more liquidity (and trade at a lower yield) than the older "off-the-run" issues and so are important to a variety of trading and hedging strategies.

Often times, especially heading into an auction, specified issues are in such demand that they trade on "special" in the repo market. When an issue goes on special, it can be repoed at rates far lower than for general collateral (often hundreds of basis points below) and sometimes at zero. This situation has worsened in the last few years because the surplus

has shrunk the size of individual Treasury auctions.

The tremendous flight to quality bid and operational difficulties of the last few weeks have tightened the situation to the point where issues on special are not only trading at zero, dealers are having a hard time finding enough of them to deliver.

The Treasury's sudden move to auction more of the 10-year today was an attempt to ameliorate those conditions, and I think it was a good thing to do. I don't think today's auction changes the big picture, because everyone knows that there will be increased issuance of Treasuries as a result of September. The only questions are when, how much, in what form and whether demand will be strong enough to offset this issuance to prevent a crowding out of corporate borrowing. I've noted that, given my overweight in long Treasuries, I'm no longer a buyer after the run we've had, but if you were considering getting in, then today's drop in prices in response to the auction gives you a better entry point.

While I applaud the Treasury's effort to ease the situation, its execution has caused some of my contacts to scratch their heads a bit. Treasury auction cycles have historically had a long lead time so people can adjust their positions in advance. Given the uniqueness of the times, I cannot criticize the Treasury's implementation of its strategy, as I know it had to choose between impacting market prices or suffering fails over a long weekend. But I would hope that the department gives as much notice as possible about future auctions so as not to deter traders from taking positions. The department noted it may hold a similar auction of five-years next week, and I think this advance warning can help traders plan accordingly and keep the market moving.

Brian Reynolds is a Chartered Financial Analyst who spent more than 16 years as a fixed-income portfolio manager and economist at David L. Babson & Co. in Cambridge, Mass. He currently writes and lectures about investment issues and trades for his own account. At the time of publication, he had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell. He welcomes feedback at

Brian Reynolds.