Last month, a surprised

Treasury Department

got slapped in the face.

Historically, when the Treasury sold a full complement of bonds and notes at its quarterly refunding, agencies and high-rated corporate issuers got out of the way, letting the government sell these benchmark securities to investors hungry for a new liquid offering.

Not this time.

Merrill Lynch

waded in with a $2 billion offering, and Quebec sold $1 billion in bonds as well. With investors sated by the corporate supply, traders were weighed down with the bulk of Treasury supply, which contributed in part to the massive February selloff that's spilled over to this month.

This activity helps to emphasize the diminishing importance of Treasury bonds in the context of the fixed-income market. Treasury securities remain an effective way to gauge sentiment as it pertains to inflation and the economy. But the decline in supply has forced investors to find other tools to determine value in other fixed-income sectors, and it has also resulted in rebalancing the entire fixed-income spectrum away from the Treasury market.

"The Treasury market has become increasingly irrelevant for the better part of the last year and a half," says Michael Shamosh, market strategist at

Tucker Anthony

.

Now What?

Last year, the Treasury eliminated the 30-year Treasury bond from one of its quarterly auctions. This year, it may do the same thing, making long-bond sales a semiannual affair. This comes after eliminating three different maturities and scaling back the five-year auction as well.

The government's decreasing need for debt coincides with increasing sales of debt from agencies and corporations. The divergence means determining the value of a new corporate or agency issue isn't as simple as comparing it with a similarly dated Treasury security. Treasuries made up 30.8% of a total $11.2 billion in debt securities in 1996, according to the

Bond Market Association

. This year, it's $3.3 billion of $12.8 billion, or 26%.

"It's clearly reducing liquidity in the area of the marketplace, which calls into question whether it should be a benchmark," says William Sullivan, money-market economist at

Morgan Stanley Dean Witter

. "But all interest rates flow from the Treasury yield curve. You have to respect the Treasury yield curve as a benchmark or reference yield for another borrowing category. Yes, there may be less liquidity, but that may be reflected in how the issue is priced."

But the government's lack of demand for debt is resulting in heavy pressure on current, or on-the-run, Treasury bonds, many of which are trading at "special" rates in the repurchasing market. Even with the

Long Term Capital Management

fiasco now four months behind the market, corporate and agency spreads still have not returned to the levels witnessed at this time last year.

High-yield spreads are still around 540 basis points wider than the 10-year Treasury, compared with 350 basis points a year ago, according to

Bear Stearns

. Investment-grade bonds are still 130 basis points wider than the average Treasury bond, compared with 110 basis points one year ago.

"It is true they are not near those tight

levels of two years ago," says Victor Thompson, principal and head of fixed income at

State Street Global Advisors

. "We question whether that will happen at all, given Treasuries are trading so technically. Meaning, there is a scarcity value to Treasuries now that makes comparisons to the past not as relevant."

Corporate issuers, meanwhile, continue to sell more debt due to attractive interest rates. Almost $650 billion in corporate investment-grade debt was sold last year, according to

Securities Data

. The issuers, seeking to make up against less volatile, more stable instruments, are pricing their new deals against the yield of off-the-run issues. These issues are in greater supply than current bonds because they don't attract the same level of interest as current Treasury bonds and are therefore easier to hedge when pricing a corporate issue. The November 2027 30-year bond, just over a year older than the current bond, was still yielding 20 basis points more than the current bond. The August 2007 10-year note is yielding 17 more basis points than the current 10-year bond.

"You have seen corporate issuers shifting to some different sectors and using more seasoned paper to price their issuance off of," says Mike Cloherty, senior market economist at

Credit Suisse First Boston

. The agency sector, for instance, is occupying a greater percentage of the fixed-income world and therefore is more important as a benchmark.

Lehman Acknowledges Change

Lehman Brothers

recognized this shift by introducing another fixed-income index, the

Lehman U.S. Universal Index

, which adds in more non-U.S. debt and counts U.S. Treasury bonds as 33% of its index. This compares with the

Lehman Aggregate Index

, of which Treasury bonds make up 38% of the index (State Street's Thompson served as an adviser in developing this index).

Meanwhile, agencies such as

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

began benchmark-type programs last year to drum up more interest from foreign investors, who are more comfortable buying varied types of debt if there is a liquid, noncallable issue to track performance with.

"In any other market the sovereign is still far and away the dominant issuer," says Thompson. "Here agencies are the larger piece of the market now -- 39% of the market is related to the activity of the agencies."

The result is that the 30-year bond and other maturities will remain significant when used to determine market sentiment. The yield curve is still an important measure of inflation, economic and monetary policy expectations. But with Treasury securities no longer the dominant force in the fixed-income market, the usefulness of Treasury bonds as a comparative tool against other fixed-income sectors, as well their place within the entire fixed-income spectrum, has declined. And if the

Congressional Budget Office's

estimates are correct and the debt held by the public also declines, the influence of Treasuries will decrease even more.