CHAPTER 6
TREASURY AND AGENCY SECURITIES MARKETS
CHAPTER SUMMARY
The second largest sector of the bond market (after the mortgage market) is the market for U.S. Treasury securities. The smallest sector is the U.S. government agency securities market. We discuss these two sectors together in this chapter. As explained in Chapter 11, a majority of the securities backed by a pool of mortgages are guaranteed by a federally sponsored agency of the U.S. government. These securities are classified as part of the mortgage-backed securities market rather than as U.S. government agency securities.
TREASURY S ECURITIES
Two factors account for the prominent role of U.S. Treasury securities: volume (in terms of dollars outstanding) and liquidity. The Department of the Treasury is the largest single issuer of debt in the world. The large volume of total debt and the large size of any single issue have contributed to making the Treasury market the most active and hence the most liquid market in the world. The dealer spread between bid and ask price is considerably narrower than in other sectors of the bond market.
T ypes of Treasury Securities
The Treasury issues marketable and nonmarketable securities. Our focus here is on marketable securities. Marketable Treasury securities are categorized as fixed-principal securities or inflation-indexed securities. Fixed-income principal securities include Treasury bills, Treasury notes, and Treasury bonds.
Treasury bills are issued at a discount to par value, have no coupon rate, and mature at par value. The current practice of the Treasury is to issue all securities with a maturity of one year or less as discount securities. As discount securities, Treasury bills do not pay coupon interest. Instead, Treasury bills are issued at a discount from their maturity value; the return to the investor is the difference between the maturity value and the purchase price.
All securities with initial maturities of two years or more are issued as coupon securities. Coupon securities are issued at approximately par and, in the case of fixed-principal securities, mature at par value. Treasury coupon securities issued with original maturities of more than one year and no more than 10 years are called Treasury notes. Treasury coupon securities with original maturities greater than 10 years are called Treasury bonds. Callable bonds have not been issued since 1984. On January 29, 1997, the U.S. Department of the Treasury issued for the first time Treasury securities that adjust for inflation. These securities are popularly referred to as Treasury inflation protection securities, or TIPS. The principal that the Treasury Department will base both the dollar amount of the coupon payment and the maturity value on is adjusted semiannually. This is called the inflation-adjusted principal.
T he Treasury Auction Process
The Public Debt Act of 1942 grants the Department of the Treasury considerable discretion in deciding on the terms for a marketable security. An issue may be sold on an interest-bearing or discount basis and may be sold on a competitive or other basis, at whatever prices the Secretary of the Treasury may establish.
Treasury securities are sold in the primary market through sealed-bid auctions. Each auction is announced several days in advance by means of a Treasury Department press release or press conference. The announcement provides details of the offering, including the offering amount and the term and type of security being offered, and describes some of the auction rules and procedures. Treasury auctions are open to all entities.
The Treasury auctions securities on a regular cycle: Treasury bills with maturities of 4 weeks, 13 weeks (3 months), and 26 weeks (6 months). At irregular intervals the Treasury issues cash management bills with maturities ranging from a few days to about six months. The Treasury auctions 2-, 5-, and 10-year Treasury notes. The Treasury does not issue Treasury bonds on a regular basis. The Treasury had issued 30-year Treasury bonds on a regular basis but suspended doing so in October 2001.
The auction for Treasury securities is conducted on a competitive bid basis. A noncompetitive bid is submitted by an entity that is willing to purchase the auctioned security at the yield that is determined by the auction process.
When a noncompetitive bid is submitted, the bidder only specifies the quantity sought. The quantity in a noncompetitive bid may not exceed $1 million for Treasury bills and $5 million for Treasury coupon securities. A competitive bid specifies both the quantity sought and the yield at which the bidder is willing to purchase the auctioned security.
The highest yield accepted by the Treasury is referred to as the stop-out yield (or high yield). Bidders whose bid is higher than the stop-out yield are not distributed any of the new issue (i.e., they are unsuccessful bidders). Bidders whose bid was the stop-out yield (i.e., the highest yield accepted by the Treasury) are awarded a proportionate amount for which they bid.
Within an hour of the auction deadline, the Treasury announces the auction results including the quantity of noncompetitive tenders, the median-yield bid, and the ratio of the total amount bid for by the public to the amount awarded to the public (called the bid-to-cover ratio). For notes and bonds, the announcement includes the coupon rate of the new security.
Secondary Market
The secondary market for Treasury securities is an over-the-counter market where a group of U.S. government securities dealers offer continuous bid and ask prices on outstanding Treasuries. There is virtual 24-hour trading of Treasury securities. The three primary trading locations are New York, London, and Tokyo. The normal settlement period for Treasury securities is the business day after the transaction day (“next day” settlement).
The most recently auctioned issue is referred to as the on-the-run issue or the current issue. Securities that are replaced by the on-the-run issue are called off-the-run issues. At a given point in time there may be more than one off-the-run issue with approximately the same remaining maturity as the on-the-run issue. Treasury securities are traded prior to the time they are issued by the Treasury. This component of the Treasury secondary market is called the when-issued market, or wi market. When-issued trading for both bills and coupon securities extends from the day the auction is announced until the issue day.
Government dealers trade with the investing public and with other dealer firms. When they trade with each other, it is through intermediaries known as interdealer brokers. Dealers leave firm bids and offers with interdealer brokers who display the highest bid and lowest offer in a computer network tied to each trading desk and displayed on a monitor. Dealers use interdealer brokers because of the speed and efficiency with which trades can be accomplished.
The convention for quoting bids and offers is different for Treasury bills and Treasury coupon securities. Bids and offers on Treasury bills are quoted in a special way. Unlike bonds that pay coupon interest, Treasury bill values are quoted on a bank discount basis, not on a price basis.
The quoted yield on a bank discount basis is not a meaningful measure of the return from holding a Treasury bill. There are two reasons for this. First, the measure is based on a face-value investment rather than on the actual dollar amount invested. Second, the yield is annualized according to a 360-day rather than a 365-day year, making it difficult to compare Treasury bill yields with Treasury notes and bonds, which pay interest on a 365-day basis.
The measure that seeks to make the Treasury bill quote comparable to Treasury notes and bonds is called the bond equivalent yield. The CD equivalent yield (also called the money market equivalent yield) makes the quoted yield on a Treasury bill more comparable to yield quotations on other money market instruments that pay interest on a 360-day basis. It does this by taking into consideration the price of the Treasury bill rather than its face value.
Treasury coupon securities are quoted in a different manner than Treasury bills—on a price basis 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 number. In addition to price, the yield to maturity is typically reported alongside the price.
When an investor purchases a bond between coupon payments, if the issuer is not in default, the investor must compensate the seller of the bond for the coupon interest earned from the time of the last coupon payment to the settlement date of the bond. This amount is called accrued interest. When calculating accrued interest, three pieces of information are needed: (i) the number of days in the accrued interest period, (ii) the number of days in the coupon period, and (iii) the dollar amount of the coupon payment. The number of days in the accrued interest period represents the number of days over which the investor has earned interest.
The calculation of the number of days in the accrued interest period and the number of days in the coupon period begins with the determination of three key dates: 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.
The number of days in the accrued interest period and the number of days in the coupon period may not be simply the actual number of calendar days between two dates. For Treasury coupon securities, the day count convention used is to determine the actual number of days between two dates. This is referred to as the actual/actual day count convention.
STRIPPED TREASURY SECURITI ES
The Treasury does not issue zero-coupon notes or bonds. However, because of the demand for zero-coupon instruments with no credit risk, the private sector has created such securities.
In August 1982, both Merrill Lynch and Salomon Brothers created synthetic zero-coupon Treasury receipts. Merrill Lynch marketed its Treasury receipts as Treasury Income Growth Receipts (TIGRs), and Salomon Brothers marketed its receipts as Certificates of Accrual on Treasury Securities (CATS). The procedure was to purchase Treasury bonds and deposit them in a bank custody account. The firms then issued receipts representing an ownership interest in each coupon payment on the underlying Treasury bond in the account and a receipt for ownership of the underlying Treasury bond’s maturity value. This process of separating each coupon payment, as well as the principal (called the corpus), and selling securities against them is referred to as coupon stripping.
Other investment banking firms followed suit by creating their own receipts. They all are referred to as trademark zero-coupon Treasury securities because they are associated with particular firms.
In February 1985, the Treasury announced its Separate Trading of Registered Interest and Principal of Securities (STRIPS) program to facilitate the stripping of designated Treasury securities. Today, all Treasury notes and bonds (fixed-principal and inflation indexed) are eligible for stripping. The zero-coupon Treasury securities created under the STRIPS program are direct obligations of the U.S. government. Moreover, the securities clear through the Federal Reserve’s book-entry system. Creation of the STRIPS program ended the origination of trademarks and generic receipts.
On dealer quote sheets and vendor screens STRIPS are identified by whether the cash flow is created from the coupon (denoted ci), principal from a Treasury bond (denoted bp), or principal from a Treasury note (denoted np). Strips created from the coupon are called coupon strips and strips created from the principal are called principal strips. The reason why a distinction is made between coupon strips and principal strips has to do with the tax treatment by non–U.S. entities, as discussed in the next section.
Tax Treatment
A disadvantage of a taxable entity investing in stripped Treasury securities is that accrued interest is taxed each year even though interest is not paid. Thus these instruments are negative cash flow instruments until the maturity date. They have negative cash flow because tax payments on interest earned but not received in cash must be made.
Reconstituting a Bond
R econstitution is the process of coupon stripping and reconstituting that will prevent the actual spot rate curve observed on zero-coupon Treasuries from departing significantly from the theoretical spot rate curve. As more stripping and reconstituting occurs, forces of demand and supply will cause rates to return to their theoretical spot rate levels.
FEDERAL AGENCY SECURITIES
Federal agency securities can be classified by the type of issuer: those issued by federally related institutions and those issued by government-sponsored enterprises.
Federally Related Institutions
Federally related institutions are arms of the federal government and generally do not issue securities directly in the marketplace. With the exception of securities of the TVA and the Private Export Funding Corporation, the securities are backed by the full faith and credit of the United States government. However, TVA securities are rated AAA by Moody’s and Standard and Poor’s. The rating is based on the TVA’s status as a wholly owned corporate agency of the U.S. government and the view of the rating agencies of the TVA’s financial strengths.
Government - Sponsored Enterprises
Government-sponsored enterprises (GSEs) are privately owned, publicly chartered entities. They were created by Congress to reduce the cost of capital for certain borrowing sectors of the economy deemed to be important enough to warrant assistance.
Today there are six GSEs that currently issue debentures: Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, Federal Agricultural Mortgage Corporation, Federal Farm Credit Bank System, Federal Home Loan Bank System, and Student Loan Marketing Association.
The interest earned on obligations of the Federal Home Loan Bank System, the Federal Farm Credit Bank System, and the Student Loan Marketing Association is exempt from state and local income taxes.
The price quotation conventions for GSE securities will vary between types of debt. Short-term GSE discount notes are quoted on a yield basis, the same as that for Treasury bills explained earlier in this chapter. The most liquid GSE issues are generally quoted on two primary bases: (i) a price basis, like Treasury securities, where the bid and ask price quotations are expressed as a percentage of par plus fractional 32nds of a point; (ii) a spread basis, as an indicated yield spread in basis points, off a choice of proxy curves or issue.