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Chapter 2

Chapter 2. BOND ISSUERS. The United States Treasury. The U.S. Treasury performs primarily the following functions. Collects taxes. Pays the bills of the government. There is a deficit if taxes are less than payments. There is a surplus if taxes are greater than payments.

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Chapter 2

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  1. Chapter 2 BOND ISSUERS

  2. The United States Treasury • The U.S. Treasury performs primarily the following functions. • Collects taxes. • Pays the bills of the government. • There is a deficit if taxes are less than payments. There is a surplus if taxes are greater than payments.

  3. Several Things Noteworthy about U.S. Treasury Debt • The total debt is huge, in the vicinity of 14 trillion dollars. • The Treasury has a very large number of debt issues. • Individual debt issues are extremely large in size and therefore highly liquid. Liquid securities can be bought and sold rapidly without affecting the price.

  4. LINKS TO TREASURY WEBSITE • http://www.treasurydirect.gov/govt/reports/pd/mspd/mspd.htm • INTEREST ON NATIONAL DEBT • http://www.treasurydirect.gov/govt/charts/charts_expense.htm

  5. FISCAL YEAR DEFICIT

  6. FUTURE CHALLENGES

  7. The Treasury Must Raise Very Large Amounts of Money. • One reason for the large dollar volume of securities that must be sold is the need to replace maturing securities by new issues. • The Treasury must finance deficits.

  8. Marketable Debt vs. Nonmarketable • Basically the Treasury sells two types of debt. Marketable debt is sold to the public and can be resold to other buyers. This is approximately half of the debt. • Nonmarketable debt cannot be resold. It is composed of two major components. Savings bonds. Government retirement accounts.

  9. Three Types of Marketable Debt • Treasury bills. Maturities of one year less. No coupons. • Treasury notes. Original maturities of up to 10 years. Semi-annual coupons. • Treasury bonds. Original maturities of 30 years. Semi-annual coupons. The most recently issued Treasury bond is usually called the long bond.

  10. T-Bills 0 91 days Bills -P +PAR -99.50 +100

  11. Notes and Bonds 0 1 2 . . . n -P +c +c . . . +c +PAR -100 +6 +6 . . . +6 +100

  12. DEBT DISTRIBUTION • http://www.treasurydirect.gov/govt/charts/principal/principal_debt.htm

  13. Maturity of Debt InterestRates 14% Bonds 58% Notes 28% Bills Most common pattern is upward slope Maturity Spreads out maturities

  14. InterestRates Bills only Maturity Bills only would alter shape

  15. Auction Procedures • The Treasury announces auctions to the public. It states the total amount of a particular issue that it would like to sell and then solicits bids. • There are two types of bids.

  16. Types of Bids • Noncompetitive bids are for par values < $5 million. These bidders agree to pay the price of the average winning competitive bid. • Competitive bidders specify a par value and a price. Typically competitive bids are submitted by bond dealers who resell these bonds to the public.

  17. Price Supply Accept Reject Competitive Bids Demand 12 Total supply = $15b Noncompetitive = $ 3b Competitive bids = $12b Price/$ PAR PAR CUM .99 4 4 .98 4 8 .97 4 12 .96 4 Accept Reject

  18. Impact of Single-price Auction upon Demand Curve Price Supply curve Accepted bids Rejected bids Price in single-price auction Lowest accepted discriminatory bid Amount of bonds

  19. Flat Auction Demand Curve – No Winners’ Curse Price/$ Supply $

  20. Announcement Date, Auction Date, and Issue Date Time Announcementdate Auctiondate Issuedate

  21. Treasury Inflation Protected Securities (TIPS) c = Stated coupon Par = Original par value j = Inflation rate in period j 0 1 2 3 1 2 3 Time 1 par value: Par(1 + 1) Time 1 coupon: c(Par)(1 + 1) Time 2 par value: Par(1 + 1) (1 + 2) Time 2 coupon: c(Par)(1 + 1)(1 + 2) Time j par value: Par(1 + 1) … (1 + j) Time j coupon: c(Par)(1 + 1) … (1 + j)

  22. Municipal Bonds • Bonds issued by state and local governments. • General obligation bonds. Backed by the full taxing authority of the municipality. • Revenue bonds. Backed by the revenues from a particular project. Much higher default rate.

  23. In recent years, a large proportion of revenue bonds have been insured against defaults by private insurance companies.

  24. Yields on Municipal Bonds • Suppose that the interest rate on a default free taxable bond is y and that the tax rate for the marginal bond buyer is t. • Then the yield to maturity for a default free municipal bond would be y(1 – t). • However, the yield for a municipal bond is also affected by two other factors.

  25. Municipal Bond Yield Factors • Default risk. • Lower liquidity. • Suppose that the default risk adds a premium of d and liquidity risk adds a premium of l. Then, the yield to maturity for a municipal bond equals y(1 – t) + d + l.

  26. Benefits and Costs of Municipal Bonds • The yield to maturity for a municipal bond is less than the yield for a taxable bond that is otherwise identical. This represents a subsidy to the borrowing municipality. • The tax free status of municipal bonds represents a subsidy to buyers, that is, individuals in high tax brackets – wealthy individuals.

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