Chapter 16. Treasury Securities Markets

1. Chapter 16. Treasury Securities Markets • Treasury Securities • Primary Market • Secondary Market • Stripped Treasuries

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

3. currently issued securities • Tbills • zero coupon • 4, 13, 26 weeks • Tnotes, Tbonds • coupon • 2, 5, 10 years • 30 yrs stopped in 11/2001

4. TIPS • inflation-indexed 10-year Tnote • guarantee a real return if held until maturity • purchasing power of cash flows held constant, not dollar value

5. how do they work? • coupon rate set when issued • does NOT change • face value adjusted annually • % increase in CPI • face value will not fall

6. example • 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

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

8. advantage of TIPS • little inflation risk • federal gov’t has incentive to keep inflation low

9. disadvantage • coupon rate is lower • additions to face value taxed in the year they occur • but face value not received until maturity

10. II. Primary Market • by auction • debt is issued by Treasury Dept. • auction ran by Federal Reserve

11. auction frequency • weekly • 4, 13, 26 week Tbills • monthly • 2 year Tnotes • quarterly • 5, 10 year Tnotes • 10 yr. TIPS

12. types of bids • $1000 minimum • increments of $1000

13. 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

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

15. noncompetitive 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

16. tradeoff • naming your reservation price (yield) • competitive bid • vs. • guarantee of success in filling bid • noncompetitive bid

17. awarding Treasuries • total amount auctioned - Federal Reserve purchases - noncompetitive bids = amount for competitive bids

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

19. 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

20. 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

21. Example • 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?

22. $10 billion accepted in full stop yield • $10.5 billion for competitive bids • suppose bids are: $ 5 billion 1.78% $ 3 billion 1.8% $ 2 billion 1.85% $ 5 billion 1.87% $ 23 billion over 1.87% unsuccessful

23. stop yield = 1.87% • bidders at stop yield got 10% of quantity requested (.5 million left /5 million requested)

24. 1991 auction scandal • Salomon Bros. • submitted fraudulent bids to exceed quantity limits • results • single price auction • switch from sealed written bids to open computerized process

25. III. 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

26. “wi” market • when issued • Treasuries bought/sold prior to auction date

27. F - P 360 x F d Price quotation in Treasury market • Tbills • quoted by “discount yield” discount yield =

28. F - P 360 x F d F - P 365 x P d discount yield = YTM = YTM > discount yield

29. example • F = $100,000 • 90 days • discount yield = 5.25% • what is Tbill price?

30. 100,000 - P 360 x 90 100,000 .0525 (100,000) = 4 .0525 = 100,000 - P P = $98,687.50

31. 365 100,000 - 98687.5 x 90 98687.5 • what is yield to maturity? YTM = YTM = 5.39%

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

33. example • F = $100,000 • ask price 117:19 • what is price? • $117 19/32 per $100 -- 19/32 = .59375 • P = $117,593.75

34. Regulation • exempt from most SEC regulation in debt markets • no reporting of trades • no display of bid/ask quotes for public • reported among primary dealers

35. IV. Stripped Treasuries • Treasury does NOT issue zero coupon Tnotes or Tbonds • 1982 firms created own synthetic zero coupon Treasuries • trademarked securities

36. how did it work? • firms issued own zero coupon debt • backed by Treasury cash flows • Merrill Lynch--TIGRs • Salomon Bros. -- CATS

37. problems • trademarked securities have some default risk • not direct obligations of U.S. • trademarked securities not intertradeable • TIGRs were different from CATS

38. Treasury STRIPS (1985) • standardized the market • certain Tnotes, Tbonds eligible for stripping • STRIPS direct obligation of U.S. • STRIPS are intertradeable