Chapter 16. Chapter 16. Treasury Securities MarketsTreasury Securities Markets

Chapter 16. Chapter 16. Treasury Securities MarketsTreasury Securities Markets

• Treasury Securities

• Primary Market

• Secondary Market

• Stripped Treasuries

• Treasury Securities

• Primary Market

• Secondary Market

• Stripped Treasuries

I. Treasury SecuritiesI. Treasury SecuritiesI. Treasury SecuritiesI. Treasury Securities

• Treasury is largest debt issuer in world• large trading volume• high liquidity• zero default risk

• Treasury is largest debt issuer in world• large trading volume• high liquidity• zero default risk

currently issued securitiescurrently issued securitiescurrently issued securitiescurrently issued securities

• Tbills• zero coupon• 4, 13, 26 weeks

• Tnotes, Tbonds• coupon• 2, 5, 10 years• 30 yrs stopped in 11/2001

• Tbills• zero coupon• 4, 13, 26 weeks

• Tnotes, Tbonds• coupon• 2, 5, 10 years• 30 yrs stopped in 11/2001

TIPSTIPSTIPSTIPS

• inflation-indexed 10-year Tnote

• guarantee a real return if held until maturity• purchasing power of cash flows

held constant, not dollar value

• inflation-indexed 10-year Tnote

• guarantee a real return if held until maturity• purchasing power of cash flows

held constant, not dollar value

how do they work?how do they work?how do they work?how do they work?

• coupon rate set when issued• does NOT change

• face value adjusted annually • % increase in CPI• face value will not fall

• coupon rate set when issued• does NOT change

• face value adjusted annually • % increase in CPI• face value will not fall

exampleexampleexampleexample

• at issue: F = $10,000, coupon = 4%• payment = (.04)(.5)(10,000) = $200

• year 1: CPI 3%• new F = $10,000(1.03) = $10,300• payment = (.04)(.5)(10300) = $206

• at issue: F = $10,000, coupon = 4%• payment = (.04)(.5)(10,000) = $200

• year 1: CPI 3%• new F = $10,000(1.03) = $10,300• payment = (.04)(.5)(10300) = $206

• year 2: CPI = 2%• new F = $10,300(1.02) = $10,506• payment = (.04)(.5)(10506) = $210.12

• year 2: CPI = 2%• new F = $10,300(1.02) = $10,506• payment = (.04)(.5)(10506) = $210.12

advantage of TIPSadvantage of TIPSadvantage of TIPSadvantage of TIPS

• little inflation risk

• federal gov’t has incentive to keep inflation low

• little inflation risk

• federal gov’t has incentive to keep inflation low

disadvantagedisadvantagedisadvantagedisadvantage

• coupon rate is lower

• additions to face value taxed in the year they occur• but face value not received until

maturity

• coupon rate is lower

• additions to face value taxed in the year they occur• but face value not received until

maturity

II. Primary MarketII. Primary MarketII. Primary MarketII. Primary Market

• by auction• debt is issued by Treasury Dept.• auction ran by Federal Reserve

• by auction• debt is issued by Treasury Dept.• auction ran by Federal Reserve

auction frequencyauction frequencyauction frequencyauction frequency

• weekly• 4, 13, 26 week Tbills

• monthly• 2 year Tnotes

• quarterly• 5, 10 year Tnotes• 10 yr. TIPS

• weekly• 4, 13, 26 week Tbills

• monthly• 2 year Tnotes

• quarterly• 5, 10 year Tnotes• 10 yr. TIPS

types of bidstypes of bidstypes of bidstypes of bids

• $1000 minimum

• increments of $1000• $1000 minimum

• increments of $1000

competitive bidscompetitive bidscompetitive bidscompetitive bids

• bid by yield• lowest yields (highest price) are

successful

• quantity limited to 35% of offering for a single buyer

• only primary dealers submit competitive bids

• bid by yield• lowest yields (highest price) are

successful

• quantity limited to 35% of offering for a single buyer

• only primary dealers submit competitive bids

• primary dealers• large Treasury dealers• sufficient volume for Fed OMO• about 20 primary dealers

• primary dealers• large Treasury dealers• sufficient volume for Fed OMO• about 20 primary dealers

noncompetitive bidsnoncompetitive bidsnoncompetitive bidsnoncompetitive bids

• bid by quantity• $1 million limit for Tbills• $5 million limit for Tnotes, Tbonds

• agree to pay average yield of successful competitive bids

• anyone may submit a noncompetitive bid

• bid by quantity• $1 million limit for Tbills• $5 million limit for Tnotes, Tbonds

• agree to pay average yield of successful competitive bids

• anyone may submit a noncompetitive bid

tradeofftradeofftradeofftradeoff

• naming your reservation price (yield)• competitive bid

• vs.

• guarantee of success in filling bid• noncompetitive bid

• naming your reservation price (yield)• competitive bid

• vs.

• guarantee of success in filling bid• noncompetitive bid

awarding Treasuriesawarding Treasuriesawarding Treasuriesawarding Treasuries

• total amount auctioned

- Federal Reserve purchases

- noncompetitive bids

= amount for competitive bids

• total amount auctioned

- Federal Reserve purchases

- noncompetitive bids

= amount for competitive bids

• competitive bids awarded,• starting with lowest yield• & going up until all Treasuries are

awarded

• competitive bids awarded,• starting with lowest yield• & going up until all Treasuries are

awarded

• stop yield• highest yield of accepted competitive

bid• bidders at stop only get a fraction of

requested quantity

• tail

= stop yield - av. of successful yield bids• small tail means agreement about value

• stop yield• highest yield of accepted competitive

bid• bidders at stop only get a fraction of

requested quantity

• tail

= stop yield - av. of successful yield bids• small tail means agreement about value

• what do the bidders pay?• 1990s single price auction• all bidders pay price equivalent to

stop yield• no “winner’s curse”

-- low yield bidder would pay highest price relative to others

• what do the bidders pay?• 1990s single price auction• all bidders pay price equivalent to

stop yield• no “winner’s curse”

-- low yield bidder would pay highest price relative to others

ExampleExampleExampleExample

• 26 week Tbills, 3/18/02

• total $17 billion

• noncompetitive bids = $1.5 billion

• Federal Reserve = $5 billion

• competitive bids = $38 billion

• how to award competitive bids?

• 26 week Tbills, 3/18/02

• total $17 billion

• noncompetitive bids = $1.5 billion

• Federal Reserve = $5 billion

• competitive bids = $38 billion

• how to award competitive bids?

• $10.5 billion for competitive bids

• suppose bids are:• $10.5 billion for competitive bids

• suppose bids are:

$ 5 billion 1.78%

$ 23 billion over 1.87%

$ 3 billion 1.8%$ 2 billion 1.85%

$ 5 billion 1.87%

$10 billionaccepted in full

stop yield

unsuccessful

• stop yield = 1.87%• bidders at stop yield got 10% of

quantity requested

(.5 million left /5 million requested)

• stop yield = 1.87%• bidders at stop yield got 10% of

quantity requested

(.5 million left /5 million requested)

1991 auction scandal1991 auction scandal1991 auction scandal1991 auction scandal

• Salomon Bros.• submitted fraudulent bids to

exceed quantity limits

• results• single price auction• switch from sealed written bids to

open computerized process

• Salomon Bros.• submitted fraudulent bids to

exceed quantity limits

• results• single price auction• switch from sealed written bids to

open computerized process

III. Secondary MarketIII. Secondary MarketIII. Secondary MarketIII. Secondary Market

• OTC market• dealers w/ bid-ask prices

• “on-the-run” Treasuries• closer to auction date• more liquid

• “off-the-run” Treasuries• farther from auction date• less liquid

• OTC market• dealers w/ bid-ask prices

• “on-the-run” Treasuries• closer to auction date• more liquid

• “off-the-run” Treasuries• farther from auction date• less liquid

• “wi” market• when issued• Treasuries bought/sold prior to

auction date

• “wi” market• when issued• Treasuries bought/sold prior to

auction date

Price quotation in Treasury marketPrice quotation in Treasury marketPrice quotation in Treasury marketPrice quotation in Treasury market

• Tbills• quoted by “discount yield”

• Tbills• quoted by “discount yield”

discount yield = F - P

Fx

360d

discount yield = F - P

Fx

360d

YTM = F - P

Px

365d

YTM > discount yield

exampleexampleexampleexample

• F = $100,000

• 90 days

• discount yield = 5.25%

• what is Tbill price?

• F = $100,000

• 90 days

• discount yield = 5.25%

• what is Tbill price?

.0525 = 100,000 - P

100,000x

36090

100,000 - P.0525 (100,000) =

4

P = $98,687.50

• what is yield to maturity?• what is yield to maturity?

YTM = 100,000 - 98687.5

98687.5x

36590

YTM = 5.39%

• Tnotes and Tbonds• quoted by price• per $100 of face value• up to 1/32 of $1

• Tnotes and Tbonds• quoted by price• per $100 of face value• up to 1/32 of $1

exampleexampleexampleexample

• F = $100,000

• ask price 117:19

• what is price?• $117 19/32 per $100

-- 19/32 = .59375• P = $117,593.75

• F = $100,000

• ask price 117:19

• what is price?• $117 19/32 per $100

-- 19/32 = .59375• P = $117,593.75

RegulationRegulationRegulationRegulation

• exempt from most SEC regulation in debt markets

• no reporting of trades

• no display of bid/ask quotes for public• reported among primary dealers

• exempt from most SEC regulation in debt markets

• no reporting of trades

• no display of bid/ask quotes for public• reported among primary dealers

IV. Stripped TreasuriesIV. Stripped TreasuriesIV. Stripped TreasuriesIV. Stripped Treasuries

• Treasury does NOT issue zero coupon Tnotes or Tbonds

• 1982 firms created own synthetic zero coupon Treasuries• trademarked securities

• Treasury does NOT issue zero coupon Tnotes or Tbonds

• 1982 firms created own synthetic zero coupon Treasuries• trademarked securities

how did it work?how did it work?how did it work?how did it work?

• firms issued own zero coupon debt• backed by Treasury cash flows

• Merrill Lynch--TIGRs

• Salomon Bros. -- CATS

• firms issued own zero coupon debt• backed by Treasury cash flows

• Merrill Lynch--TIGRs

• Salomon Bros. -- CATS

• trademarked securities have some default risk• not direct obligations of U.S.

• trademarked securities not intertradeable• TIGRs were different from CATS

• trademarked securities have some default risk• not direct obligations of U.S.

• trademarked securities not intertradeable• TIGRs were different from CATS

problemsproblemsproblemsproblems

Treasury STRIPS (1985)Treasury STRIPS (1985)Treasury STRIPS (1985)Treasury STRIPS (1985)

• standardized the market

• certain Tnotes, Tbonds eligible for stripping• STRIPS direct obligation of U.S.• STRIPS are intertradeable

• standardized the market

• certain Tnotes, Tbonds eligible for stripping• STRIPS direct obligation of U.S.• STRIPS are intertradeable