Chapter 6

Treasury and Agency Securities

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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

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Treasury Securities
The U.S. Treasury securities market is the most active and liquid in the world for two reasons: i. volume (in terms of dollars outstanding, for both total debt and single issue size) ii. liquidity The Department of the Treasury is the largest single issuer of debt in the world. Therefore the dealer spread between bid and ask price is considerably narrower for Treasuries than in other sectors of the bond market.
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Types of Treasury Securities

The Treasury issues both marketable and nonmarketable securities. Non marketable securities are held by governments, both U.S. (principally the Social Security Administration) and foreign. Marketable Treasury securities include fixed-principal and inflation-indexed securities. The Treasury issues three basic types of fixedprincipal securities, differentiated by maturity at time of issue: Treasury bills, Treasury notes, and Treasury bonds.
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Types of Treasury Securities (continued)

Treasury bills are issued at a discount from their maturity value; the interest the investor earns is the difference between the maturity value and the purchase price. Initial maturity is less than one year. All other Treasury securities are coupon securities and pay interest semiannually. They are issued approximately at par and, for fixed-principal securities, mature at par.

Treasury notes mature in 1-10 years from issue; Treasury bonds mature more than 10 years from issue.
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Types of Treasury Securities (continued)

Non-fixed principal or Treasury inflation protected securities (TIPS) were first issued on January 29, 1997.

The Treasury makes an adjustment for inflation semiannually by adjusting the principal value which is due at maturity. This is called the inflation-adjusted principal. While the coupon rate does not change, the dollar amount of the coupon payment changes as the principal value is adjusted for inflation.
At maturity the investor receives the greater of the inflation adjusted principal or par.

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TIPs example
If a TIP has a coupon of 2% and a $10,000 principal at issue, the coupon payment is .02*10,000 = $200/year .

Assume inflation in the first year is 4% (or 2% every 6 mos).

First interest payment = coupon /2 x inflation adjusted principal = $200 /2 x ($10,000 * 1.02) = $100 x ($10,200) = $102 At the end of the first year, the inflation adjusted principal is $ 10,200 x 1.02 = $10,404

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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).

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.

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Treasury Securities Sales (continued)

Treasury securities priced competitively are sold initially through sealed-bid auctions. The Treasury Department announces each auction several days in advance in a Treasury Department press release or press conference. The announcement provides details of the offering: the offering amount, the term and type of security being offered, and describes some of the auction rules and procedures. Treasury auctions are open to all buyers, both institutional and retail.

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Treasury Securities Sales (continued)

The Treasury auctions Treasury bills with maturities of 4 weeks, 13 weeks (3 months), and 26 weeks (6 months); Treasury notes with maturities of 2, 5, and 10 years; and Treasury bonds with maturities of 20 and 30 years on a regular cycle. The Treasury suspended the issuance of 30 year bonds from October 2001 until February 2006. 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.

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Treasury Securities Sales Process

Auction bidders submit either noncompetitive bids (smaller buyers: < $1 MM for bills, < $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, then begins to accept the competitive bids, starting with the lowest yield bid (which has the highest price).

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Treasury Securities Sales Process (continued)

The highest yield (i.e., lowest price) the Treasury accepts is called the stop-out yield. Bidders who bid the stop-out yield are awarded a pro rata amount of their bids. Bidders who bid lower yields (higher prices) receive the entire amount for which they bid, but at the stop-out yield. The Treasury announces the auction results within an hour including the quantity of noncompetitive bids, the medianyield bid, and the ratio of the total amount for which bids were received to the amount awarded. That ratio is (virtually) always >100%; a ratio <100% has extremely serious market and policy consequences.

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Treasury Securities Markets

Treasury securities secondary market trading occurs in an over-the-counter market in which U.S. government securities dealers offer continuous bid and ask prices on outstanding Treasuries. Treasury trades settle the business day after the transaction (next day settlement). The three primary trading locations are New York, London, and Tokyo, so there is virtual 24-hour trading of Treasury securities.

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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. Older securities are called off-the-run issues. 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.

Treasury securities trade prior to the time they are issued by the Treasury on a when-issued (WI) basis. When-issued trading for both bills and coupon securities extends from the day the auction is announced until the issue day.

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Treasury Securities Pricing

The pricing convention for quoting bids and offers is different for Treasury bills and Treasury coupon securities.

Treasury bill bids and offers are quoted on a bank discount basis, 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), D = dollar discount (which is equal to the difference between the face value and the price), F = face value t = number of days remaining to maturity.

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Treasury Securities Pricing (continued)

Treasury bill example using yield on a bank discount basis: A Treasury bill has 100 days to maturity, a face value of $100,000, and sells for $99,100; it has a dollar discount from its face value of D = F P = $100,000 $99,100 = $900. Given D = $900, F = $100,000 and t = 100, the quoted yield on the Treasury bill would be :

D 360 $900 360 Yd 3.24% F t $100,000 100

Treasury bill yields are quoted on the face value, not the price, using a 360 day year.

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Treasury Securities Pricing (continued)

Treasury bill yields are the only yields quoted on face value, not price; all other security yields are quoted on price. Treasury bills and other securities issued with maturities < 1 year use a 360 day year; Treasury securities issued with maturities > 1 year use a 365 day year. 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. 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.
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Treasury Securities Pricing (continued)

Prices of Treasury coupon securities are quoted in points where one point equals 1% of par. The points are split into units of 32nds, so that a price of 96-14, for example, refers to a price of 96 and 14/32nds, or 96.4375 per 100 of par value. The 32nds are themselves often split by the addition of a plus sign or a minus, which represents 1/64th more or less; a third number after the dash indicates the number of 256ths included in the price. The yield to maturity is typically reported alongside the price.

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Treasury Securities Pricing (continued)

Examples of converting a quote to a price per $100 of par value: No. of 32nds No. of 64ths No. of 256ths Price per $100 par

Quote

91-19+ 107-222
109-066

19 22
6

1 0
0

0 2
6

91.609375 107.6953125
109.2109375

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Treasury Securities Pricing (continued)

When an investor purchases a bond between coupon payments, 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. (Note: this is true for all fixed income securities, not just Treasuries, as long as the issuer is not in default.) To calculate accrued interest, 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.
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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, settlement date, and date of previous coupon payment. The trade date is the date on which the transaction is executed. The settlement date is the date a transaction is completed; for Treasury securities, settlement is the next business day after the trade date. Interest accrues on a Treasury coupon security from (and including) the date of the previous coupon payment up to but excluding the settlement date.

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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, beginning in 1982. All Treasury notes and bonds (fixed-principal and inflationindexed) are eligible for stripping. Zero-coupon Treasury securities created under the STRIPS program (all but the earliest such securities) are direct obligations of the U.S. government.

A stripped security is separated into its component parts: each interest payment and its principal payment at maturity.
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Stripped Treasury Securities (continued)

STRIPS are identified by source of the cash flow, either the coupon (ci, called coupon strips), the principal from a Treasury bond (bp), or the principal from a Treasury note (np, both called principal strips). Coupon strips and principal strips are indentified separately because they are taxed differently by non-U.S. entities. All zero coupon securities are taxed each year on accrued, though not paid, interest, resulting in negative cash flow until maturity. Investors can reconstitute a stripped Treasury by purchasing all the coupon strips and the principal strip of the underlying Treasury. 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.
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Federal Agency Securities

Federal agencies are chartered by Congress; existing federal agencies provide funding support for the housing and agricultural sectors of the U.S. economy, and specific U.S. government projects. These government-chartered entities issue debt instruments which are traded in the federal agency securities market.

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Federal Agency Securities (continued)

Federal agency debt issued by these issuers carries government guarantees: Tennessee Valley Authority (TVA), Federal Home Loan Banks, Federal Farm Credit Bank, Farm Credit Financial Assistance Corporation, Resolution Trust Corporation (only its bonds remain) Some issuers are government-sponsored enterprises (GSEs), 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.S. government in September 2008, so their debt is government guaranteed.

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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

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