Some Technical Details (and Math!) About Premium Bonds

by Neil H. Buchanan and Michael C. Dorf

In our latest Verdict column on . . . wait for it . . . wait for it . . . the debt ceiling (duh!), we offer the Biden administration a novel approach. Although we remain very dubious about the legality of platinum coins, exotic bonds, and other allegedly magical means to avoid a trilemma when the debt ceiling hits, we accept the point that one of these gimmicks might appeal to a court asked to invalidate whatever the administration might do to mitigate the damage of a debt ceiling impasse without unconstitutionally usurping legislative power by refusing to pay the nation’s bills.

In a previous essay here on the blog, we explained that we don’t just think that the platinum coin gimmick fails as a matter of statutory interpretation; we worry that if the administration were to attempt it, that would crowd out the better course of simply issuing debt-ceiling-violating bonds as the “least unconstitutional option” (LUO). As we wrote: “the administration will have only one shot at mitigating the damage if Congress doesn't raise the debt ceiling before the witching hour. Using that one shot on the platinum coin gambit when it would be so much simpler and more credible to issue debt in the usual course would be profoundly unwise.”

But maybe the administration can, as we say in the new Verdict column, have its cake and eat it too by rolling all of the various proposals into its one shot. The Treasury could issue what we call “fallback bonds,” which specify that if they are held invalid they will be replaced by other kinds of bonds, which in turn could be replaced by platinum coins if the first fallback option is also held invalid, and so on. Interested readers should consult the Verdict column.

In this accompanying essay, we offer two kinds of technical details that the Verdict column omits in the interest of space: (1) some math; and (2) further parsing of the debt ceiling statute as it applies to premium (i.e., very high interest) bonds.

1. Calculating the Interest Rate

Premium bonds pay a higher-than-market interest rate. Their proponents argue that by selling such bonds, the government could evade the debt ceiling because only the face value of such bonds counts against it. The core point is easy enough to see. If prevailing interest rates on a 3-month bond are 5% (which is roughly true now), by definition, you would pay $100 for a $100 bond paying 5%. At the end of the three months, you would receive back $101.25, which is your principal ($100) plus 1.25% (a quarter of the 5% interest rate you would receive in a year because three months is a quarter of a year. Note that we are simplifying here by not worrying about compound interest within the year).

Now suppose that the government wants to issue bonds with a low face value but still sell them for $100. It could do that by offering an interest rate premium. In the Verdict column we choose a very low face value of $1 because we imagine that the government wants to give itself as much leeway as possible to avoid bumping up against the debt ceiling. If only $1 counts against the debt ceiling, then each time the government retires a $100 face value bond and sells a $1 bond, it gains $99 of leeway against the debt ceiling. So, what interest rate must be offered on a $1 bond for it to be worth and thus sold for $100?

The key is that to duplicate the operation of a conventional $100 bond, the investor must receive $101.25 at the end of three months. To receive back $101.25 on a nominal investment of $1 means the investor makes $100.25 in interest (added to the $1 of principal to get $101.25). $100.25 in interest on $1 is an interest rate of 10,025 percent, but that’s in just three months. The annualized interest rate is four times as large, or 40,100 percent.

Needless to say, that’s a ridiculously high interest rate. It would be possible to bring the rate down by issuing bonds with higher face values, but that would provide less leeway against the debt ceiling. Another way to bring down the rate would be to sell bonds with longer terms: a year, ten years, or even thirty years. But that would have a legal and political cost. Any bonds issued during a debt ceiling crisis will have a cloud over them, so it’s sensible for Treasury to issue only short-term bonds that will be taken out of the market of their own accord rather than lingering after the crisis ends.

In any event, we chose the $1 face value bond simply for illustrative purposes. Our main point is that to sell a bond with any substantially lower face value than the price, the government needs to offer a rate of interest that would make even the most aggressive loan shark blush. (For example, suppose the government sold bonds with a face value of $80 for $100. Depending on the flow of tax revenues, that might not suffice to provide the necessary leeway under the debt ceiling, but we put that worry aside. Even so, the interest rate the government would need to pay on such a 3-month bond to be able to sell it for $100 is 106.25%. We leave that math as an exercise for the reader.)

2. Parsing the Debt Ceiling Statute as it Applies to Premium Bonds 

In our Verdict column last week on exotic bonds, we parsed the debt ceiling statute to conclude that the “face value” of such bonds is the price for which they are sold, not whatever nominal dollar value the Treasury places on them. We used as our primary illustration so-called consol bonds that pay only interest, not principal, and have an infinite term. Thus, they could be said to have a face value of zero. However, we noted that because subsection (c) of the debt ceiling statute defines face value for such bonds as sales price, the gambit fails.

An astute reader emailed us to suggest that whatever the merits of our statutory parsing with respect to consol bonds, premium bonds (like the $1 bond that pays 40,100 percent interest) still don’t count against the debt ceiling. Here we’ll make the best version of the reader’s textual argument, which we think is pretty good.

The actual debt ceiling itself is found in 31 U.S.C. § 3101(b). It counts “the face amount” of various obligations. If that were the only provision, then a $1 bond sold for $100 with a 40,100 percent interest rate would count for only $1 against the debt ceiling. However, both subsections (a) and (c) contain further language defining “face amount” as what the bonds are actually worth or sold for, not simply what appears on the face. (Yes, it’s annoying that the statute uses the term “face amount” to mean something totally different from what that phrase ordinarily means, but that’s not so unusual in technical statutes. Anyway, that’s not the current point).

It can plausibly be argued that neither (a) nor (c) applies to premium bonds, because both (a) and (c) by their terms define the term “face amount” for bonds “issued on a discount basis.” But premium bonds are not issued on a discount basis. That is, the rate of interest is not discounted from prevailing rates; it’s (way) higher. And if neither the definition of face amount offered in (a) nor (c) applies to premium bonds, then the natural reading of “face amount” applies and (b) counts only that $1 for the premium bond sold for $100. QED.

Is that persuasive? Purely as a matter of literal text, yes, at least so long as “discount basis” means what we say it means, as noted below. And we now think that’s enough of a reason to include premium bonds as one of the options rolled into our fallback bond proposal. However, as we argue in the new Verdict column, we’re still quite dubious that this is the best interpretation of the debt ceiling statute for the same core reason that we’re dubious about the platinum coin proposal. It’s just not plausible to think that the debt ceiling is so easily evaded, given the principle that Congress does not hide elephants in mouseholes. Moreover, if proponents of the premium bonds are correct, it’s not just a workaround for a debt ceiling crisis; it’s a means for an aggressive administration to fund the government entirely by issuing debt rather than collecting taxes. As we argued with respect to the platinum coins, that’s a bridge too far.

Hold on. How would a court that agrees with us that premium bonds can’t so easily evade the debt ceiling parse the text? The simplest answer would be to say that premium bonds are “issued on a discount basis,” but that the discount rate is negative. That’s textually awkward but not crazy. 

Or at least it might not be. The most common Treasury securities that are issued on a discount basis are short-term “T-bills,” which are sold simply with the promise of a certain dollar amount to be paid on a specific date. If prevailing interest rates are, say, 5 percent, then a promise by the Treasury to pay $100 one year from now would be worth $95.24 ($100 discounted to present value by dividing it by 1 plus the interest rate, or 100/(1.05) – we warned that this would be a bit technical!) Selling T-bills at a discount means that the fair-market value is below the face value, because the stated interest rate on the T-bills is effectively zero. But if Treasury issues premium bonds that have printed on them a face value and a final payoff, we have said that the interest rate is (as noted above) in the thousands. Why does that matter? Because bonds with interest rates above the prevailing rate are said to be issued “at a premium,” not at a discount.

Now, a court could follow simple mathematical logic and agree with the statement above that “premium” and “negative discount” are the same things. Again, maybe. But statutory definitions often do not follow math conventions, and a court could just as plausibly say that Congress would not include the words “issued on a discount basis” if it really meant to say “issued on a discount or premium basis, because … come on, the only difference is a negative sign.” That interpretation would create the classic problem of surplusage.

Even so, we might as well hope that some court would say that the statutory text takes premium bonds outside of the meaning of the debt ceiling statute. There is a reason that law students are taught to offer arguments in the alternative. 

Bottom line: although we think the debt ceiling statute is terrible on policy grounds, we don’t think that ordinary principles of statutory interpretation would lead to the conclusion that it is best read to allow its complete evasion by gimmicks like exotic bonds or platinum coins. However, in the interest of throwing everything at the wall in the hope that something sticks, we are not opposed to including gimmicks based on formalistic statutory interpretations within the list of options in a fallback bond.