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

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

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

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

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

exampleexample 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 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

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

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

disadvantagedisadvantage coupon rate is lower additions to face value taxed in the year they occur but face value not received until maturity coupon rate is lower additions to face value taxed in the year they occur but face value not received until maturity

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

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

types of bids $1000 minimum increments of $1000 $1000 minimum increments of $1000

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 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

primary dealers large Treasury dealers sufficient volume for Fed OMO about 20 primary dealers primary dealers large Treasury dealers sufficient volume for Fed OMO about 20 primary dealers

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 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

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

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

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

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 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

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 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

ExampleExample 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? 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?

$10.5 billion for competitive bids suppose bids are: $10.5 billion for competitive bids suppose bids are: $ 5 billion1.78% $ 23 billionover1.87% $ 3 billion1.8% $ 2 billion1.85% $ 5 billion1.87% $10 billion accepted in full stop yield unsuccessful

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

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

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 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

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

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

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

exampleexample F = $100, days discount yield = 5.25% what is Tbill price? F = $100, days discount yield = 5.25% what is Tbill price?

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

what is yield to maturity? YTM = 100, x YTM = 5.39%

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

exampleexample F = $100,000 ask price 117:19 what is price? $117 19/32 per $ /32 = P = $117, F = $100,000 ask price 117:19 what is price? $117 19/32 per $ /32 = P = $117,593.75

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

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

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

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

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