Chapter 6

Treasury Securities Markets

Treasury Securities

Backed by full faith and credit of U.S. government

Zero default risk Largest volume of any security issuer in the

world Most liquid securities Benchmark for other bond markets

Fixed Principal Treasuries

T-bills Maturity <1 year Trade on a discount basis (no coupon)

Notes 2-10 year maturity Coupon payment semiannual Issued at par

Bonds (same as notes > 10 year maturity)

Treasury Inflation Protected Securities (TIPS) First issued in 1997 Issued at 5, 10, and 30 years maturities Principal is adjusted to reflect inflation Coupon is a measure of the “real” rate Return on TIPS = real rate + actual inflation Return on Treasuries = real rate + expected inflation Provides a measure of the real rate and inflation

expectations

TIP principal adjustment

Principal is adjusted semiannually Inflation is measured using CPI-U Example –

Original principal = $100,000 coupon = 3.5% Inflation = 3% annually (1.5% semi-annually) Principal 6 mths = 100,000 *1.015 = 101,500 New coupon = .035 * 101,500*.5 = 1776.25 Both principal and coupon are inflation adjusted

TIPS in practice

Each new issue is given a reference CPI Index ratio

Calculated on each settlement date Current CPI/reference CPI

New principal = original principal * index ratio Coupon = coupon rate * new principal

Treasury Auctions

All new issue Treasuries use an auction 4, 13, and 26 week t-bills Cash management bills 2, 3, 5, and 10 year Treasury notes 30 year Treasury bonds

Stopped issuing in 2001 Resumed last year semiannual auctions

5, 10, and 30 year TIPS

Auction process

Treasury announces auction Bids are obtained

Competitive bids Non-competitive bids

Non competitive bids deducted from total Competitive bids arrayed

Lowest yield (high price) to highest yield (low price) Treasuries issued to best bids All “winners" receive the clearing bid yield/price Non-competitive also receive this yield/price

Auction process

The auction is called a Dutch Auction Auctions were multi price (English) until the

1990s Why did the Treasury switch?

Secondary market

Continuous, over-the-counter, market Dealer market

New York Tokyo London

Dealer’s provide bid and ask quotes “Next day” settlement

On-the run issues

The most recently auctioned security is “on-the run”

All other issues are “off-the-run” On-the-run issues are most liquid When issued (wi) market

On-the-run trades between auction announcement and auction

Inter dealer brokers

Dealer to dealer trades go through brokers Trading is generally electronic Dealer bids and offers are confidential Low-cost and efficient method to clear dealer

trades

T-bill price quotes

T-bills use bank discount method

T-bill Example

T-bill with a face value of $100,000, price of $99,100, and 100 days to maturity has a yield of:

Yd = 900/100,000 * 360/100 = 3.24%

This yield is not comparable to other Treasuries

Quotes on Treasury Coupon Securities Quotes are often in 32nds 91-19 = 91 19/32 = 91.59375 91-19+ = 91 + 19/32 + 1/64 = 91.609375 109-066 = 109 + 6/32 + 6/256 = 109.2109375

Accrued interest

Example

50 days in accrued interest period 183 days in coupon period Annual interest is $8 per $100 face value

Calculating dates

Need to know Trade date Settlement date Previous coupon date

Treasuries use actual/actual day count convention

Count days to get periods of interest Settlement date is not included in count

Treasury strips

Treasury only issues coupon securities There is a high demand for risk free zero-

coupon bonds Dealers strip coupons and principal and

create zero coupon treasuries Rely on price arbitrage to make money This process is managed by the Treasury

Strip example

A dealer buys $500,00,000 of 5% ten year Treasuries for stripping 20 cash flows of $12.5 million every 6 months One cash flow of $500 million in ten years Why?

Each cash flow creates a separate strip The 12.5 million are coupon strips The $500 million is a principal strip