2-1 Chapter 2 BOND ISSUERS

2-2 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.

2-3 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.

2-4 LINKS TO TREASURY WEBSITE  orts/pd/mspd/mspd.htm orts/pd/mspd/mspd.htm  INTEREST ON NATIONAL DEBT  rts/charts_expense.htm rts/charts_expense.htm

2-5 FISCAL YEAR DEFICIT

2-6 FUTURE CHALLENGES

2-7 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.

2-8 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.

2-9 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.

days -P+PAR Bills T-Bills

2-11 n c +PAR-P+c c Notes and Bonds

2-12 DEBT DISTRIBUTION  rts/principal/principal_debt.htm rts/principal/principal_debt.htm

2-13 Maturity of Debt Spreads out maturities Interest Rates Most common pattern is upward slope 28% Bills Maturity 58% Notes 14% Bonds

2-14 Bills only would alter shape Interest Rates Bills only Maturity

2-15 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.

2-16 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.

2-17 Price Accept 12 Reject Competitive Bids Demand Supply Total supply= $15b Noncompetitive= $ 3b Competitive bids= $12b Price/$ PARPARCUM Accept Reject

2-18 Impact of Single-price Auction upon Demand Curve Amount of bonds Price Price in single-price auction Lowest accepted discriminatory bid Supply curve Accepted bidsRejected bids

2-19 Flat Auction Demand Curve – No Winners’ Curse Price/$ $ Supply

2-20 Announcement Date, Auction Date, and Issue Date Announcement date Auction date Issue date Time

2-21 Treasury Inflation Protected Securities (TIPS) c = Stated coupon Par = Original par value  j = Inflation rate in period j 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 ) 11 22 33 0123

2-22 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.

2-23  In recent years, a large proportion of revenue bonds have been insured against defaults by private insurance companies.

2-24 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.

2-25 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.

2-26

2-27 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.