The Roles of Treasury Securities

 Two factors account for the prominent role of U.S. Treasury securities: i. volume (in terms of dollars outstanding) ii. liquidit y Chap ter 6  The Department of the Treasury is the largest single issuer of debt in the world. Treasury and Agency  The large volume of total debt and the large size make the Treasury market the most active and hence the most liquid Securities Markets market in the world.  The bid-ask spread is considerably narrower than in other sectfthbdkttors of the market.

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Types of Treasury Securities Treasury Bills, Notes and Bonds  The Treasury issues both marketable and non-marketable securities.  marketable: heavily traded in secondary markets • T-bills, T-notes and T-bonds issued by the U.S.  nonmarktblketable: h hldbold by government -managedfd fun d and can ’tb’t be Treasury to finance the national debt and other transferred federal government expenditures  Our focus here is on marketable securities. • Backed by the full faith and credit of the U.S.  Marketable Treasury securities are categorized as government and are default risk free  fixed-principal securities • T-bills  inflation-indexed securities. – Maturities up to one year  Fixed-income principal securities include: – No payment i. Treasury bills – Mature at par value ii. Treasury notes – Sold on discount basis iii. Treasury bonds – Return to the investor is the difference between the maturity value and the purchase price 6-3 6-4 Treasury I nfl ati on P rot ecti on S ecuriti es Treasury Bills, Notes and Bonds (TIPS) • T-notes and T-bonds • Design to protect the inflation risk – Coupon issues – Issued since 1997 – Notes: 1-10 years • The principal is adjusted according to the – Bonds: 10 +-30 years CPI-U (Consumer Price Index for all Urban – Sold by auction by the Federal Reserve banks • issued at approximately par and matured at par value. Consumers – Pay relatively low rates of (yields to – Inflation-adjusted principal maturity) – Principal is adjusted periodical (semiannual) by – Given their longer maturity, not entirely risk free multiplying the inflation rate due to interest rate fluctuations – Example: – Pay coupon interest semiannually period 1: 100,000×(1+1.5%)=101,500 6-5 6-6 period 2: 101,500×(1+1%)=102,515

The Treasury Auction Process Treasury I nfl ati on P rot ecti on S ecuriti es (TIPS)  The Public Debt Act of 1942 grants the Department of thidbldiiididihhe Treasury considerable discretion in deciding on the • The coupon rate on an issue is set at a fixed rate terms for a marketable security. – Each coupon payment is the fixed coupon rate multiplied by the inflation-adjusted principal  An issue may be sold on an –Example:  interest-bearing or discount basis period 1 : 1 .75% ×101500101,500=1 177625,776.25  competitive or other basis, period 2: 1.75%× (102,515)=1,794.01  Congress imposes a restriction on the total amount of • The inflation rate used to adjust the principal is . – The ratio of the CPI-U (reference CPI) for the settlement bdbonds outstan ding date to the CPI-U for the issue date – There is three-month lagged for CPI -U • The May 1 reference CPI is the CPI-U reported in February

6-8 6-7 The Primary Market in Treasury The Primary Market in Treasury Securities Securities

• Treasury securities are sold in the primary • Auction process market through sealed-bid auctions – investors submit applications for either competitive or – Bills with maturities of 4, 13, 26 and 52 weeks are noncompetitive bid offered on a regular cycle • competitive bids specify both yield and quantity wish to buy – Cash management bills on a irregular interval • noncompetitive bids specify only quantity only – noncompetitive bid will be accepted anyway – Notes and bonds issues are not on regular cycles • maximum 5 million for each noncompetitive bidder • Reopening – Firs t de duc ting the to ta l noncompe titive t en ders from the – Offer additional amount of outstanding securities total securities being auctioned, remainder is the amount for competitive bid • Debt buyback program – competitive bid will be accepted from the lowest yield – The Treasury redeems outstanding unmatured (highest price) up, until the total amount of issues is fulfill Treasury securities by purchasing them in the secondktthhdary market through reverse auctions 6-9 6-10

Secondary Market The Primary Market in Treasury  The secondary market for Treasury securities is an over- Securities the-counter market where a ggproup of U.S. government securities dealers offer continuous bid and ask prices on • Auction process outstanding Treasuries. – The highest yield accepted is referred to as the  There is virtual 24-hour trading of Treasury securities. stop-out yield (or high yield)  The three primary trading locations are New York, – All successf ul bidd ers are award ed at th e st op-out LdLondon, and dTk Tokyo. yield  The normal settlement period for Treasury securities is the • Single-price auctions (Dutch auction) business day after the transaction day (next (“next day ” – The Treasury adjust the coupon rate and the price settlement). so that the yield offered on the security is approximately equal to the stop-out yield • The securities are sold near the par value 6-12 6-11 Secondaryy( Market (continued ) Treasury Securities (continued)  The most recently auctioned issue is referred to as the on-the-run  Government dealers trade with the investing public and issue or the current issue. with other dealer firms.  Securities that are replaced by the on-the-run issue are called off-  through intermediaries known as interdealer brokers. the-run issues.  Dealers leave firm bids and offers with interdealer brokers  There may be more than one off-the-run issue with approximately the same remaining maturity as the on-the-run issue. whdilho display the hi gh est bid and l owest off er in a  Treasury securities are traded prior to the time they are issued computer network tied to each trading desk and displayed  when-issued market , or wi market . on a monitor .  When-issued trading for both bills and coupon securities extends  Dealers use interdealer brokers because of the speed and from the day the auction is announced until the issue day. efficiencyyp with which trades can be accomplished.

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Price quotes for Treasury bills Price quotes for Treasury bills

• T-bill is quoted on a bank discount basis • Given the bank discount yield, calculate the bill = D × 360 Yd price F t = × × t = × × 100 = D Yd F 0.0324 100,000 900 –Yd: bank discount yield 360 360 – D: dollar discount (= face value – bill price) – F: face value price = F - D = 100,000 - 900 = 99,100 – t: number of days remaining to maturity • Example – A treasury bill with 100 days to maturity, a face value of $100, 000, and selli ng f or $99 ,100 , th e b ank di scount yi eld i s D = 100,000 - 99100 = 900 = 900 × 360 = Yd 3.24% 100,000 100 6-15 6-16 Bond Equivalent and CD PiPrice quot es f or T reasury coupon Equivalent Yield securities

• Problem for the quoted yield on a bank discount basis • T-bonds and T-notes are quoted on a price – RtReturn measure is b ased on a f ace-valilue invest ment tth rather bibasis than on the actual dollar amount invested – Yield is annualized according to a 360-day rather than a 365- – One point equals 1% of par day year – Prices below 1 points is shown in 32nds • Two alternative yields are often used – Example: – Bond equivalent yield • 96-14 = 96+14/32 = 96.4375 per 100 of par value D 365 900 365 BEY = × = × = 3.31% = 0.964375 × par value purchase price t 99100 100 – CD equivalent yield (also called equivalent yield) 360Y 360(0.0324 ) CD equivalent yield = d = = 0.327 360 - t(Y d ) 360 - 100(0.0324 ) 6-17 6-18

Quotes on Treasury Coupon Securities (continued) Accrued Interest  The 32nds are themselves often sppylit by the addition of a plus sign or a number. • The portion of the coupon payment accrued between the last coupppyon payment and the settlement day . No. of No. of No. of Price per – normally, settlement takes place 1 to 2 days after a trade Quote date. 32nds 64ths 256ths $100 par • At settlement, the buyer must pay the seller the purchase price of the T-note or T-bond plus accrued 91-19+ 19 1 0 91.609375 interest. • : without accrued interest 107-222 22 0 2 107.6953125 • Dirty/full price: clean price + accrued interest

109-066 6 0 6 109.2109375

6-19 6-20 Why Clean Price? Accrued Interest Calculation

int actual number of days since last coupon payment accrued interest = × 2 actual number of days in coupon period

Actual number of days in coupon period Actual number of days since last coupon payment

Last Coupon Bond Settlement Next Coupon Payment Date Payment

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Day Count Conventions: Actual/Actual Day Count Convention • The first “actual” refers to the actual number of The number of days in the accrued interest days in a month. period and the coupon period may not be simppyly the actual number of calendar da ys • The second refers to the actual number of days between two dates. in a year. For Treasury coupon securities , the day • ElFExample: For coupon-biTbearing Treasury count convention used is to determine the securities, the number of days between June 17, actualbl number ofdf days b etween two d ates. 1992, and October 1, 1992, is 106. This is referred to as the actual/actual day 13 days (June), 31 days (July), 31 days (August), 30 days count convention. 6-23 (September), and 1 day (October). Stripped Treasury Securities Day Count Conventions:30/360  The Treasury does not issue zero-coupon notes or bonds. • Each month has 30 days and each year 360 days.  Demand for zero-coupon instruments with no credit • The numb er of d ays b etween J une 17 , 1992 , an d risk, October 1, 1992, is 104.  Private sector has created such securities. – Trademark products • Treasury Income Growth Receipts (TIGRs) – 13 days (June), 30 days (July), 30 days (August), • Merrill Lynch in 1982 30 days (September), and 1 day (October) .  Profit pppotential for a dealer who strips lies in arbitrage resulting from the mispricing of the • In general, the number of days from date1 to security. date2 is  The process of separating the interest on a bond from the underlyygping princi pal is called couppppgon stripping. 360 × (y2 − y1) + 30 × (m2 − m1) + (d2 − d1) 6-26 Where Date1 ≡ (y1,m1, d1) Date ≡ (y2,m2, d2)

1.Purchase Treasury bonds and deposit them in a bank custody account 2 Issue receipppts representin g an ownership in each Stripped Treasury Securities coupon payment on the underlying Treasury bond 3. Issue a receipt representing an ownership of the underlying Treasury bond’s principal  Zero-coupon Treasury securities were first created in August 1982 by dealer firms. Original bond  The problem with these securities: 50 50 50 1050  identified with particular dealers  therefore reduced liquidity.  involved legal and insurance costs  At 1985, Separate Trading of Registered Interest and Stripped zero-coupon bonds 1000 Principal of Securities (STRIPS) program 50  All Treasury notes and bonds (fixed-principal and inflation- indexed) are eligible for stripping. 50  The zero -coupon Treasury securities created under the STRIPS 50 program are direct obligations of the U.S. government.

50 6-28 6-27 Confusion of “Stripped Treasury” Stripped Treasury Securities

 Today, a stripped Treasury typically means a STRIPS  On dealer quote sheets and vendor screens STRIPS are prodtduct. identifi ed b y wh eth er th e cash fl ow i s creat ed f rom  However, because there are trademark products and  coupon (called ci), othfher types of pre-STRIPS zero-coupon products still  principal from a Treasury bond (called bp), outstanding, an investor should clarify what product  or principal from a Treasury note (called np). is the subject of the discussion .  Strippps created from the coupon are called coupppon strips and those from the principal are called principal strips.  Distinction is between coupppppon strips and principal strips is due to the tax treatment by non-U.S. entities  See next slide

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Tax Treatment Reconstructing a Bond by STRIPs

A disadvantage of stripped Treasury • Are the sum of the sale price of the components of STRIPs equal to the price of the original Treasury securities: security?  accrued interest is taxed each year even though – Reconstitution interest is not paid. • Buying a series of zero coupon bond and synthesizing o negative cash flow because tax payments on the cash flows of a Treasury security interest earned but not received in cash – The process of coupon stripping and reconstituting o For foreiggyn buyers in some countries prevents the actual spot rate curve observed on zero-coupon TifTreasuries from dtideparting o interest from principal strips are treated as significantly from the theoretical spot rate curve cappgital gain o lower tax 6-31 6-32 Stripped Treasury Securities Federal Agency Securities

– In reality, the sum of the sale price of the • To provide funding for certain sectors of the economy components of STRIPs is often greater than the – have a difficult time raising funds fair of the original Treasury security – such as agriculture, housing, small businesses, and college students • Investors are willing to pay a small premium because the idiidlindividual payment s can b e used did in durati on mat thiching • Beginning in 1916, the U.S. federal government created special strategies or cash matching strategies that limit the agencies to make direct or guarantee private loans to investor’s risk these “disadvantaged” borrowers • FitFor instance, ma itiiintaining a gi ven d urati tiithon with coupon • The agency market has soared in recent years, with the volume paying bonds requires periodic bond trading which of outstanding securities climbing from about $2 billion during generates transaction costs and perhaps tax the 1950s to almost $2 trillion today consequences. Use of STRIPs avoids these costs • Agency securities are generally short to medium term in – This provides the motivation for creating STRIPs maturity (running out to about 10 years)

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Federal Agency Securities Types of Federal Credit Agencies

• The most active buyers of agency securities include • Government owned corporation banks, state and local governments , government – Legally a part of the government structure, and their borrowing and lending activities are included in the federal trust funds, and the Federal Reserve System budget • The Federal Reserve is authorized to conduct open – Export-Import Bank (EXIM) market operations in agency debts – Farmers Home Administration (FMHA) • Major securities dealers who handle U.S. government – Government National Mortgage Association (Ginnie Mae) – Federal Deposit Insurance Corporation (FDIC) securities also generally trade in agency issues – Tennessee Valley Authority (TVA) • The major issuer of Federal agency securities • Provide flood control, navigation, and agriculture and industrial dldevelopment • The largest public power system in the U.S. • Finance its capital requirements through internally generated funds and by issuing debt • TVA debt is not guaranteed by the U.S. government 6-35 6-36 Types of Federal Credit Agencies

• Government-sponsored enterprises (GSEs) – Federally chartered but privately owned. Their borrowing and lending activities are not reflected in the federal government’s budget. – To reduce the cost of capital for certain borrowing sectors • Farmers, homeowners, and students – Issue securities directly to the marketplace –Examples: • Federal National Mortgage Association (Fannei Mae) • Federal Home Mortgggage Corp p( (Freddie Mac) • Federal Agricultural Mortgage Comporation • Federal Farm Credit Bank System (FFCB) • Federal Home Loan Bank System

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