Chapter 19

1. Chapter 19 Government Bonds

2. Government Bond Basics • In 2007, the gross public debt of the U.S. government was more than $5 trillion, making it the largest single borrower in the world. • The U.S. Treasury finances government debt by issuing marketable as well as non-marketable securities. • Municipal government debt is also a large debt market. • > 85,000 U.S. state and local governments. • Together, they contribute about $2 trillion of outstanding debt.

3. Government Bond Basics • Marketable • Can be traded among investors • U.S. T-bills, T-notes, and T-bonds • Non-marketable • Must be redeemed by the issuer • U.S. Savings Bonds • Government Account Series • State and Local Government Series

4. U.S. Treasury Bills • T-Bills = Short-term obligations • Maturing in 6 months or less • Originally issued with maturities of 4, 13, or 26 weeks • Sold at a discount from par • Discount represents the imputed interest • Smallest denomination = $1,000

5. U.S. Treasury Notes • Treasury Notes = Medium-term obligations • Original maturities of 10 years or less, but > 1 year • Normally issued with maturities of 2, 5, or 10 years • Pay semiannual coupons • Face values as low as $1,000

6. U.S. Treasury Bonds • Long-term obligations • Coupon rate set at issue based on prevailing market interest rates. • Coupon rate constant over life of security • Semiannual coupon payments

7. Treasury STRIPS • Separate Trading of Registered Interest and Principal of Securities • Derived from: • Treasury notes w/original maturity = 10 years • Treasury bonds w/original maturity = 30 years • Divided into: • Coupon strips • Principal strips • STRIPS = Zero-coupon bonds; “zeroes” • STRIPS price = PV(a single cash flow)

8. Calculating a STRIPS Price What is the price of a STRIPS maturing in 15 years with a face value of $100,000 and a yield to maturity of 6.5%? =PRICE(“07/01/2008”,”07/01/2023”,0,0.065,100,2,3) N=30; I/Y=3.25; PMT=0; FV=100,000 CPT PV = $38,308.7684

9. Calculating YTM on a STRIPS What is the yield to maturity of a STRIPS maturing in 12 years with a face value of $20,000 and a price of $11,000? =YIELD(“07/01/2008”,”07/01/2020”,0,55,100,2,3) N=24; PV=-11,000; PMT=0; FV=20,000 CPT I/Y = 0.0252 x 2 = 5.04%

10. Zero Coupon Bond Prices by Yield to Maturity and Maturity

11. Zero Coupon Bond Prices

12. WSJ Prices for Treasury Bonds, Notes and Bills

13. Treasury Bond and Note Prices • When a callable T-bond has a price above par, the reported yield is a yield to call (YTC). Since 1985 however, the Treasury has issued only non-callable bonds. • Because T-bonds and notes pay semiannual coupons, bond yields are stated on a semiannual basis. • The relationship between the price of a note or bond and its YTM was discussed in a previous Chapter (Bond Prices and Yields).

14. T-Bond and T-Note Prices Quoted on a % of par basis Fractions of a percent stated in 32nds “104:20” = 104 + 20/32 % = 104.625% Bonds callable within last 5 years of life (“C”) Since 1985 – no callable bonds issued Semiannual coupons

15. Treasury Note Quotes

16. Treasury Bond Prices and YTMfor Different Maturities

17. Inflation-Indexed Treasury Securities • In recent years, the U.S. Treasury has issued securities that guarantee a fixed rate of return in excess of realized inflation rates. • These inflation-indexed U.S. Treasury securities: • Pay a fixed coupon rate on their current principal, and • Adjust their principal semiannually according to the most recent inflation rate

18. Inflation-Indexed Treasury Securities

19. Treasury Inflation-Protected Securities (TIPS) • Inflation-Indexed Treasury Securities • Fixed coupon paid on current principal • Principal adjusted for inflation semiannually

20. TIPS Price Quotes

21. U.S. Treasury General Auction Pattern • The Federal Reserve Bank conducts regularly scheduled auctions for T-bills, notes, and bonds. • 4-week, 13-week, and 26-week T-bills are auctioned weekly • 2-year T-notes are auctioned monthly • 5-year and 10-year T-bonds auctions occur about four times per year for each maturity • Since 1998, all U.S. Treasury auctions = single-price auctions in which all accepted bids pay the stop-out bid.

22. U.S. Treasury Auctions • Conducted by Federal Reserve Bank • Non-competitive bids • Quantity only • Open to individual investors • Bids accepted automatically • Bidders pay the stop-out bid • Competitive bids • Price and quantity • Open only to Treasury securities dealers • Accept those ≥ Stop-out bid

23. U.S. Treasury Auctions • All noncompetitive bids are accepted automatically and are subtracted from the total issue amount. • Then, a stop-out bid is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount. • Since 1998, all U.S. Treasury auctions have been single-price auctions in which all accepted bids pay the stop-out bid.

24. Treasury Bill Auction Example The Fed has announced an offering of Treasury bills with a face value of $20 billion. The response is $2 billion of noncompetitive bids and the competitive bids shown above. Which bids are accepted and at what price? How much money is raised by the offering?

25. Treasury Bill Auction Example “stop-out bid” Offering = $20b - $2b noncompetitive bids = $18b Bidders A-D quantities sum to $18 billion A, B, C, D and the noncompetitive bids are accepted The Price paid by all accepted bidders is $9,500 The offering will raise $9,500/$10,000 x $40b = $38 billion.

26. Series EE U.S. Savings Bonds • Face values $25 - $10,000 • Original price = ½ face value • 20 year maturity • Monthly interest accruals to redemption value • Fixed interest rates set May 1 & November 1 • Must hold 1 year • Penalty if held < 5 years

27. Series I U.S. Savings Bonds • Designed to provide a guaranteed real rate of return • Face values $50 - $10,000 • Original price = face value • Interest • Fixed-rate constant over life of bond • Variable semiannual inflation rate • Earn interest for up to 30 years • Monthly interest accruals to redemption value • Fixed interest rate and inflation adjustment set May 1 and November 1 • Musthold 1 year; Penalty if held < 5 years

28. Federal Government Agency Securities • Most U.S. government agencies consolidate their borrowing through the Federal Financing Bank, which obtains funds directly from the U.S. Treasury • Some agencies authorized to issue securities directly to the public: • The World Bank • Tennessee Valley Authority • Credit quality ≈ U.S. Treasury issues • Higher yields than Treasuries • Less liquid market

29. Federal Government Agency Securities

30. Municipal Bond (“Munis”) • Intermediate- to long-term interest-bearing obligations • Issues by state and local governments, or agencies of those governments • “Tax-exempt market” • Coupon interest usually exempt from federal income tax • Insured

31. Municipal Bond Insurance • Insured municipal bonds • Secured by the issuer’s resources • Also backed by an insurance policy written by a commercial insurance company • With bond insurance: • Credit quality of the bond issue additionally determined by the financial strength of the insurance company

32. Municipal Bond Features • Typically callable • Semiannual coupons • Par value denomination of $5,000 • Prices stated as a percentage of par value • Commonly issued with serial maturity structure • May be putable, have variable interest rates, or both • Variable-rate demand obligation, VRDO • May be strippable • Muni-strips

33. Municipal Bond Quotes

34. Municipal Bonds

35. Types of Municipal Bonds • Revenue Bonds • Secured by proceeds from projects financed • Credit quality =f (ability of project to generate income) • General Obligation Bonds • Secured by general taxing power of municipality • “Full faith and credit bonds” • Hybrid Bonds • Revenue bond secured by specific project cash flows • “Moral obligation bond”

36. Municipal Bond Credit Ratings

37. Municipal Bond Credit Ratings

38. Municipal Bond Insurance • Insured municipal bonds, besides being secured by the issuer’s resources, are also backed by an insurance policy written by a commercial insurance company. • With bond insurance, the credit quality of the bond issue is additionally determined by the financial strength of the insurance company.

39. Equivalent Tax Yield What is the tax equivalent yield for an investor in a 28% marginal tax bracket considering a municipal bond with a tax-exempt yield of 7.5%?

40. Equivalent Taxable Yield Suppose you are trying to decide whether to buy: A corporate bond paying an annual coupon interest of 8%, or A municipal bond paying an annual coupon interest of 5%

41. Equivalent Taxable Yield How do you decide? If a tax-exempt retirement account, the corporate bond is preferred If not tax-exempt, decide on an after-tax basis Calculate an equivalent taxable yield or anafter-tax yield

42. Example: Equivalent Taxable Yield • Suppose you are in the 35% marginal tax bracket: Choose the corporate bond (8% > 7.69%) • Suppose you are in the 40% marginal tax bracket: Choose the municipalbond (5% > 4.8%)

43. Critical Marginal Tax Rate What marginal tax rate would make you indifferent between purchasing the two bonds? Calculate the critical marginal tax rate:

44. Taxable Municipal Bonds • Tax Reform Act of 1986 • Imposed restrictions on the types of municipal bonds that qualify for federal tax exemption of interest payments • Act expanded the definition of private activity bonds, which are taxable municipal bonds used to finance facilities used by private businesses. • Yields often similar to the yields on corporate bonds

45. Useful Websites • www.treasurydirect.gov (lots of information on Treasuries) • www.investinginbonds.com (information on bonds, bonds, bonds) • www.ustreas.gov (visit the U.S. Treasury) • www.savingsbonds.com (for the latest on Savings Bonds) • www.sifma.org (Securities Industry and Financial Markets Association) • www.municipalbonds.com (check out munis) • www.firstmiami.com (First Miami - muni bonds purchasable on-line) • www.muniauction.com (Muni Bond Auction on-line)