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Chapter 6

Treasury and Agency Securities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

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Learning Objectives
Understanding
• • • • • the different types of securities the Treasury issues the operation of the primary market for Treasury securities the role of government dealers and government brokers the secondary market for Treasury securities how Treasury securities are quoted in the secondary market • the zero-coupon Treasury securities market • the major issuers in the federal agency securities market • the functions of government-sponsored enterprises that issue securities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

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liquidity The Department of the Treasury is the largest single issuer of debt in the world. volume (in terms of dollars outstanding. Therefore the dealer spread between bid and ask price is considerably narrower for Treasuries than in other sectors of the bond market. for both total debt and single issue size) ii. Copyright © 2010 Pearson Education.Treasury Securities The U.S. Publishing as Prentice Hall 6-3 . Inc. Treasury securities market is the most active and liquid in the world for two reasons: i.

Marketable Treasury securities include fixed-principal and inflation-indexed securities. Copyright © 2010 Pearson Education. and Treasury bonds. Non marketable securities are held by governments. The Treasury issues three basic types of fixedprincipal securities. differentiated by maturity at time of issue: Treasury bills. (principally the Social Security Administration) and foreign. Publishing as Prentice Hall 6-4 .S. Inc.Types of Treasury Securities The Treasury issues both marketable and nonmarketable securities. both U. Treasury notes.

mature at par. Treasury notes mature in 1-10 years from issue. They are issued approximately at par and. All other Treasury securities are coupon securities and pay interest semiannually. Publishing as Prentice Hall 6-5 . Treasury bonds mature more than 10 years from issue.Types of Treasury Securities (continued) Treasury bills are issued at a discount from their maturity value. Copyright © 2010 Pearson Education. for fixed-principal securities. the interest the investor earns is the difference between the maturity value and the purchase price. Initial maturity is less than one year. Inc.

the dollar amount of the coupon payment changes as the principal value is adjusted for inflation. This is called the inflation-adjusted principal. While the coupon rate does not change. At maturity the investor receives the greater of the inflation adjusted principal or par. 1997. Copyright © 2010 Pearson Education.Types of Treasury Securities (continued) Non-fixed principal or Treasury inflation protected securities (TIPS) were first issued on January 29. Publishing as Prentice Hall 6-6 . The Treasury makes an adjustment for inflation semiannually by adjusting the principal value which is due at maturity. Inc.

02 = $10.200) = $102 At the end of the first year. the inflation adjusted principal is $ 10.000 = $200/year .200 x 1.000 principal at issue. Assume inflation in the first year is 4% (or 2% every 6 mos).404 Copyright © 2010 Pearson Education. Publishing as Prentice Hall 6-7 . First interest payment = coupon /2 x inflation adjusted principal = $200 /2 x ($10.000 * 1.TIPs example If a TIP has a coupon of 2% and a $10. Inc.02) = $100 x ($10.02*10. the coupon payment is .

The Treasury Secretary determines whether an issue will be sold on an interest-bearing or discount basis and may establish that the price will be set on a competitive (auction) or other basis. Publishing as Prentice Hall 6-8 . Copyright © 2010 Pearson Education.Treasury Securities Sales The Public Debt Act of 1942 grants the Department of the Treasury considerable discretion in deciding on the terms for a marketable security. though Congress sets the total amount of Treasury debt which may be outstanding (the debt ceiling). Inc.

and describes some of the auction rules and procedures. Publishing as Prentice Hall 6-9 . The announcement provides details of the offering: the offering amount. Inc. the term and type of security being offered. Copyright © 2010 Pearson Education.Treasury Securities Sales (continued) Treasury securities priced competitively are sold initially through sealed-bid auctions. Treasury auctions are open to all buyers. The Treasury Department announces each auction several days in advance in a Treasury Department press release or press conference. both institutional and retail.

Publishing as Prentice Hall 6-10 .Treasury Securities Sales (continued) The Treasury auctions Treasury bills with maturities of 4 weeks. and 10 years. Copyright © 2010 Pearson Education. 5. At irregular intervals the Treasury issues cash management bills with maturities ranging from a few days to about six months. the Treasury does not issue Treasury bonds on a regular basis. The Treasury suspended the issuance of 30 year bonds from October 2001 until February 2006. and 26 weeks (6 months). Inc. Treasury notes with maturities of 2. 13 weeks (3 months). and Treasury bonds with maturities of 20 and 30 years on a regular cycle.

Copyright © 2010 Pearson Education. Publishing as Prentice Hall 6-11 . starting with the lowest yield bid (which has the highest price). < $5 MM for coupon securities) which specify only the quantity sought or competitive bids which specify both the quantity sought and the yield at which the bidder is willing to purchase the security. Treasury first sets aside enough of the securities being auctioned to satisfy the noncompetitive bids.Treasury Securities Sales Process Auction bidders submit either noncompetitive bids (smaller buyers: < $1 MM for bills. then begins to accept the competitive bids. Inc.

Treasury Securities Sales Process (continued) The highest yield (i. lowest price) the Treasury accepts is called the stop-out yield.e. Copyright © 2010 Pearson Education. the medianyield bid.. Bidders who bid lower yields (higher prices) receive the entire amount for which they bid. That ratio is (virtually) always >100%. The Treasury announces the auction results within an hour including the quantity of noncompetitive bids. a ratio <100% has extremely serious market and policy consequences. Publishing as Prentice Hall 6-12 . but at the stop-out yield. Inc. and the ratio of the total amount for which bids were received to the amount awarded. Bidders who bid the stop-out yield are awarded a pro rata amount of their bids.

and Tokyo. Copyright © 2010 Pearson Education. Publishing as Prentice Hall 6-13 .Treasury Securities Markets Treasury securities secondary market trading occurs in an over-the-counter market in which U. Inc. Treasury trades settle the business day after the transaction (next day settlement).S. government securities dealers offer continuous bid and ask prices on outstanding Treasuries. so there is virtual 24-hour trading of Treasury securities. London. The three primary trading locations are New York.

When-issued trading for both bills and coupon securities extends from the day the auction is announced until the issue day. Treasury securities trade prior to the time they are issued by the Treasury on a when-issued (WI) basis. Off-the-run issues with approximately the same remaining maturity (but a longer maturity at issue) as an on-the-run issue often trade at a discount to the on-the run issues. Publishing as Prentice Hall 6-14 . Older securities are called off-the-run issues. Inc.Treasury Securities Markets (continued) The most recently auctioned issue of any maturity is referred to as the on-the-run issue or the current issue. Copyright © 2010 Pearson Education.

F = face value t = number of days remaining to maturity.Treasury Securities Pricing The pricing convention for quoting bids and offers is different for Treasury bills and Treasury coupon securities. Inc. Copyright © 2010 Pearson Education. Publishing as Prentice Hall 6-15 . D = dollar discount (which is equal to the difference between the face value and the price). not on a price basis. The yield on a bank discount basis is computed as follows: D  360  Yd    F t  Yd = annualized yield on a bank discount basis (expressed as a decimal). Treasury bill bids and offers are quoted on a bank discount basis.

a face value of $100.000 – $99. Publishing as Prentice Hall 6-16 .000 and t = 100. the quoted yield on the Treasury bill would be : D  360  $900  360  Yd       3.24% F  t  $100. it has a dollar discount from its face value of D = F – P = $100. and sells for $99. Inc. Given D = $900.000  100  Treasury bill yields are quoted on the face value. F = $100. using a 360 day year.100 = $900. not the price. Copyright © 2010 Pearson Education.Treasury Securities Pricing (continued) Treasury bill example using yield on a bank discount basis: A Treasury bill has 100 days to maturity.100.000.

Comparing Treasury bills to Treasury notes and bonds (or any other security issued with a maturity > 1 year) requires using the bond equivalent yield to adjust 360 day year yields to 365 day year yields. all other security yields are quoted on price.Treasury Securities Pricing (continued) Treasury bill yields are the only yields quoted on face value. Treasury bills and other securities issued with maturities < 1 year use a 360 day year. not price. Inc. Copyright © 2010 Pearson Education. Publishing as Prentice Hall 6-17 . Comparing Treasury bills to other securities issued with maturities < 1 year requires using the money market equivalent yield. which is calculated on the price instead of the face value of the Treasury bill. Treasury securities issued with maturities > 1 year use a 365 day year.

which represents 1/64th more or less.4375 per 100 of par value. or 96. The points are split into units of 32nds. The 32nds are themselves often split by the addition of a plus sign or a minus. Inc. refers to a price of 96 and 14/32nds. for example. a third number after the dash indicates the number of 256ths included in the price. Copyright © 2010 Pearson Education.Treasury Securities Pricing (continued) Prices of Treasury coupon securities are quoted in points where one point equals 1% of par. Publishing as Prentice Hall 6-18 . The yield to maturity is typically reported alongside the price. so that a price of 96-14.

609375 107.Treasury Securities Pricing (continued) Examples of converting a quote to a price per $100 of par value: No. of 256ths Price per $100 par Quote 91-19+ 107-222 109-066 19 22 6 1 0 0 0 2 6 91. of 64ths No. Inc.2109375 Copyright © 2010 Pearson Education.6953125 109. of 32nds No. Publishing as Prentice Hall 6-19 .

Publishing as Prentice Hall 6-20 . not just Treasuries. Copyright © 2010 Pearson Education.Treasury Securities Pricing (continued) When an investor purchases a bond between coupon payments. the buyer must know: • the number of days in the accrued interest period (the number of days interest which the seller earned before the sale) • the number of days in the coupon period • the dollar amount of the coupon payment. Inc.) To calculate accrued interest. (Note: this is true for all fixed income securities. as long as the issuer is not in default. the investor must compensate the seller of the bond for the coupon interest accrued from the time of the last coupon payment to the settlement date of the bond.

Inc. Publishing as Prentice Hall 6-21 . Interest accrues on a Treasury coupon security from (and including) the date of the previous coupon payment up to but excluding the settlement date. • The trade date is the date on which the transaction is executed. settlement is the next business day after the trade date.Treasury Securities Pricing (continued) Calculating the number of days in the accrued interest period and the number of days in the coupon period requires the trade date. for Treasury securities. settlement date. • The settlement date is the date a transaction is completed. and date of previous coupon payment. Copyright © 2010 Pearson Education.

Inc. Zero-coupon Treasury securities created under the STRIPS program (all but the earliest such securities) are direct obligations of the U. Copyright © 2010 Pearson Education. Publishing as Prentice Hall 6-22 . A stripped security is separated into its component parts: each interest payment and its principal payment at maturity. government. All Treasury notes and bonds (fixed-principal and inflationindexed) are eligible for stripping. beginning in 1982.S.Stripped Treasury Securities The Treasury does not issue zero-coupon notes or bonds. but the market demands zero-coupon instruments with no credit risk so the private sector created such securities.

both called principal strips). All zero coupon securities are taxed each year on accrued. Investors can reconstitute a stripped Treasury by purchasing all the coupon strips and the principal strip of the underlying Treasury. though not paid. either the coupon (ci. Copyright © 2010 Pearson Education.Stripped Treasury Securities (continued) STRIPS are identified by source of the cash flow. Publishing as Prentice Hall 6-23 . interest. Reconstitution is the means whereby investors can arbitrage the actual spot rate curve observed on zero-coupon Treasuries if it varies significantly from the theoretical spot rate curve. entities. Inc. called coupon strips). resulting in negative cash flow until maturity. or the principal from a Treasury note (np.S. Coupon strips and principal strips are indentified separately because they are taxed differently by non-U. the principal from a Treasury bond (bp).

government projects. existing federal agencies provide funding support for the housing and agricultural sectors of the U.S. Inc.S. Copyright © 2010 Pearson Education. and specific U.Federal Agency Securities Federal agencies are chartered by Congress. economy. Publishing as Prentice Hall 6-24 . These government-chartered entities issue debt instruments which are traded in the federal agency securities market.

S. Farm Credit Financial Assistance Corporation. Publishing as Prentice Hall 6-25 . Copyright © 2010 Pearson Education.Federal Agency Securities (continued) Federal agency debt issued by these issuers carries government guarantees: Tennessee Valley Authority (TVA). Federal Home Loan Banks. not federal agencies: • • • Federal National Mortgage Association (Fannie Mae) Federal Home Loan Mortgage Corporation (Freddie Mac) Federal Agricultural Mortgage Corporation (Farmer Mac) The first two entities in the above list were placed in conservatorship by the U. Inc. government in September 2008. Federal Farm Credit Bank. so their debt is government guaranteed. Resolution Trust Corporation (only its bonds remain) Some issuers are government-sponsored enterprises (GSEs).

in any form or by any means.All rights reserved. Publishing as Prentice Hall 6-26 . or otherwise. mechanical. Printed in the United States of America. without the prior written permission of the publisher. electronic. No part of this publication may be reproduced. photocopying. or transmitted. recording. stored in a retrieval system. Inc. Copyright © 2010 Pearson Education.