Treasury Securities

1. Treasury Securities Fixed Income Society

2. What is a Treasury? • U.S. Treasury Securities-such as bills, notes and bonds- are debt obligations of the U.S. government • When a Treasury Security is bought, the investor lends money to the government for a specified period of time • Considered “risk-free” investments because the are the safest of all investments • Viewed in the market as having no “credit risk” • This means it is almost 100% certain that the investor’s principal and interest will be paid on time • Because of the high degree of safety, interest rates are generally lower than other traded debt

3. Market Size and Liquidity • Amount of marketable U.S. Treasury securities is about $11 trillion • Average daily trading volume in 2007 = $561.8 billion • Treasuries are considered on of the most liquid debt markets in the entire world • This means the pricing, executing and settling a trade is very inexpensive and efficient due to tight bid/ask spreads

4. Who buys U.S. Treasuries? • 5% held by state and local governments • 7% held by individuals • 7% held by public and private pension funds • 9% held by banks and mutual funds • 15% held by category of “other investors” • 47% held by foreign investors • Today, the largest purchaser of American debt is China

5. Role of Treasury Securitiesin a Portfolio • Primary advantage – SAFETY! • Invest in Treasuries to preserve and increase capital and to receive a dependable income stream • Pay lower interest rates than other taxable fixed-income investments • Investors take this as a trade-off for a secure investment • In a portfolio, treasuries represent money investors want to keep safe from risk

6. Benefits in the Portfolio • 1) Predictability • Treasury has not issued a “callable” securities since 1985 • Call provision-permit issuer to pay off the bond in full before the scheduled maturity • This happens when interest rates decline (issuer will refinance debt to obtain lower interest rate) • This forces investors to pay more for the same interest rate • 2) Availability with a wide range of maturity dates • Allows investors to structure a portfolio to specific time horizons • 3) Interest payments exempt from state and local income taxes • 4) High level of liquidity • The spreads between bid/ask prices are much tighter than other securities

7. Market Risk • Affected by interest-rate risk and inflation risk • Underlying value of the bond itself may change depending on direction of interest rates • If interest rates rise, the value of the issued security will fall, since bonds paying higher rates will come into the market • If rates fall, the value of the older bond will rise in comparison with new issues

8. Differences Between Bills,Notes and Bonds • Bills • Short-term instruments with maturities of no more than one year • Fill investment needs similar to MM funds and savings accounts • Quick investments • Highly liquid market • Function like zero-coupon bonds • Notes • Intermediate to long-term investments • Typically mature in two, three, five and ten years • Used for such things as college tuitions • Bonds • Cover terms of more than ten years

9. Other Treasury Securities • TIPS-Treasury Inflation Protected Securities • CPI (Consumer Price Index) is the guide the value of the principal is adjusted to reflect the effects of inflation • Fixed interest rate paid semi-annually • If inflation has increased the value of the principal, the investor receives the higher value • If deflation decreases the value, the investor receives the original face amount of the security

10. TIP Example • Here’s an example of how inflation-indexed securities work. Let’s say you invested $1,000 in January on a new 10-year inflation-indexed note paying 3% interest. At mid-year, the Consumer Price Index indicates that inflation has been 1% during the first six months. Your principal is adjusted upward to $1,010 and your interest payment (one-half of 3%) is based on that figure. Your payment is $15.15. At the end of the year, the index indicates that inflation was 3%, which brings the value of your principal to $1,030. Your second interest payment is $15.45 ($1,030 times 3% divided by 2). • Because of the built-in inflation protection, these securities usually offer lower coupon rates than Treasuries of similar maturities without the feature.

11. Other Treas. Sec. Cont… • STRIPS-Separate Trading of Registered Interest and Principal (Zero-Coupon Securities) • Separates the principal and interest components (“Coupon Stripping”) • Coupon-the part of a bond certificate that denotes the amount of interest due, and on what date and where payment will be made • Traded as individual securities • Once a bond is stripped, investors can buy any or all of the available STRIPS • Savings Bonds • Price is half of the face amount (minimum investment is $25) • Series EE • Accrue interest according to a floating rate • Rate is adjusted twice a year • Investor does not receive maturity until the bond is cashed in • Guaranteed full maturity no longer than 17 years • Series I • Built-in inflation adjustment • Pay interest according to an earning rate that is partly fixed and partly inflation adjusted

12. Summary

13. Buying and Selling Treasuries • Bought and sold through investment professional, a commercial bank or a broker • “On the run” issues are traded on the primary market • “Off the run” issues are traded on the secondary market • Investor can trade directly from the Treasury • Treasury Direct and Sell Direct account needs to be set up (Fed. Res. Bank of Chicago sells the securities for the investor) • Can participate directly in Treasury auctions