Treasury and Agency Security Markets

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Treasury and Agency Security Markets

• FabozziChapter 6

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Treasury and Agency Sectors

• Treasury Securities
• Are debt instruments issued by the U.S.
  Department of the Treasury and are backed by the
  full faith and credit of the U.S. government--and
  thus are viewed as default risk-free
• The U.S. government is the largest single issuer
  of debt in the world.
• Treasury markets are one of the most liquid
  markets in the world.
• 2nd largest bond market sector (behind mortgage
  sector).
• Federal Agency Securities
• Debt instruments issued by federally related
  institutions and government sponsored enterprises
  (GSEs)

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Types of Treasury Securities

• Treasury bills
• Short-term debt issued at a discount to par value
  (no couponsentire return is paid at maturity).
• Original maturities of 4, 13, and 26 weeks.
• Treasury notes
• Coupon-bearing debt instrument issued with
  maturities greater than 1 year but no more than
  10 years.
• Treasury bonds
• Coupon-bearing debt instrument issued with
  maturities greater than 10 years.
• Treasury Inflation Protection Securities (TIPS)
• Debt securities whose payments are adjusted for
  inflation.
• Treasury securities are sold in minimum
  increments of 1,000.

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Treasury Bills

• T-bills are quoted in a special way
• Quotes are on a bank discount basis, not a price
  basis.

• F face value
• P market price
• t number of days until maturity
• Yd annualized yield quoted on a bank discount
  basis
• The quote you get from a dealer is Yd, not P.

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Example of Bank Discount Quote

• A 100,000 face value T-bill has 100 days until
  maturity and sells for 99,100.
• What is the bank discount quote?

(or 3.42)

• If you called for a quote on this T-bill, you
  would be given a quote of 3.24 ( discount from
  par).

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How to Find Price Given Yd

• If you got a quote of Yd, how do you find price?

• Solve for P

• Example A dealer gives you a quote of 3.68 on
  a 100,000 face value T-bill expiring in 90 days.
  What is the price of the T-bill?

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Bank Discount and Return

• Is the bank discount rate the rate of return on a
  T-bill?
• Nofor two reasons
• The bank discount rate is the annualized
  percentage difference between F and P using F as
  the base.
• It uses a 360 day year, not 365 as it should.
• The bank discount rate is not meaningful (or
  comparable to other securities) as a return.
• Two adjustments are often made to facilitate
  comparison
• Bond equivalent yieldmakes Yd comparable to
  non-discount bonds (this will give actual rate of
  return).
• CD equivalent yield makes Yd comparable to
  quotes on other money market instruments.

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Bank Discount Rate Adjustments

• Bond Equivalent Yield

• CD Equivalent Yield (see page 143)

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Quotes on Treasury Bonds and Notes

• T-notes and T-bonds use different conventions
  than those used for T-bills. Look at examples
• Example 1 A T-bond is quoted as 96-14
• The 96 is a percent of face value.
• The 14 is the number of 32nds added to 96.
• The quote would be 96 14/32, or 96.4375.
• Example 2 A bond is quoted as 96-14
• The means add 1/64th to 96-14
• The quote is 96 14/32 1/64 or 96.453125.
• Example 3 A bond is quoted as 96-142
• The 2 means add 2 256ths to 96-14
• The quote is 96 14/32 2/256 or 96.4453125

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More T-Note T-Bond Conventions

• Accrued interest
• When an investor purchases a bond between coupon
  payments, the buyer must compensate the seller
  for coupon interest earned since last coupon
  payment.
• Example
• There are 183 days between coupon payments and
  the annual coupon is 8 per 100 of Par Value.
  The last coupon was paid 50 days ago.
• If you buy this bond, how much accrued interest
  must you pay to the seller?

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Accrued Interest and Day Count Conventions

• Timeline of a T-bond transaction
• Trade date Date on which the transaction is
  executed.
• Settlement date Date on which the transaction
  is completed (payment made and ownership
  recorded).
• For T-bonds (and notes) settlement is the next
  business day after the trade date.
• To determine the number of days since last coupon
  payment
• Count the number of days from last coupon payment
  up to, but not including, settlement date.

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Day Count Example

• A T-bond paid its last coupon on May 15. The
  next coupon will be paid on November 15.
• If the security is purchased on September 9, and
  settled on September 10. How many days are used
  for accrued interest calculation?

• Note we counted May 15th, but we didnt count
  September 10th.

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Stripped Securities

• The Treasury does not issue zero-coupon bonds.
• However, there has been considerable demand for
  zero-coupon bonds with no credit risk.
• To meet demand, dealers in the private sector
  began stripping Treasury securities in 1982.
• In 1985, the U.S. Treasury began its STRIPS
  program to facilitate the stripping of U.S.
  Treasury securities
• Today, all T-notes and T-bonds are eligible for
  stripping.
• All zeros created under the STRIPS program are
  considered direct obligations of the U.S.
  government.
• Securities created under the STRIPS program are
  cleared through the Federal Reserves book-entry
  system.

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How A Bond is Stripped

• Suppose a dealer has 500,000,000 of a 10-year 5
  coupon Treasury note.
• This note has 21 cash flows
• Twenty 12,500,000 cash flows come from coupons.
• One 500,000,000 cash flow is from the repayment
  of principal (called the corpus).
• These cash flows can be sold off in 1,000 face
  value zero coupon bonds.
• Strip quotes are denoted as
• ci if created from coupons (called coupon
  strips)
• bp if created from bond principal, or np if
  created from note principal (called principal
  strips).

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Tax Treatment of Strips

• As zero-coupon instruments, strips pay no
  interest until maturity.
• However, the U.S. government taxes the implied
  gain (called accretion) as ordinary income every
  year.
• This creates a negative cash flow which reduces
  the attractiveness of these securities.

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Treasury Inflation Protection Securities (TIPS)

• In 1997 the Treasury began issuing bonds that
  adjust for inflation
• TIPS provide inflation protection for investors
  the higher the inflation rate, the higher the
  TIPS interest payments become.
• TIPS pay a fixed coupon rate
• The face value is adjusted based on the inflation
  rate (called inflation-adjusted principal)
• The face value is indexed to CPI for urban
  consumers (CPI-U), a price index for U.S. cities.

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TIPS Example

• Suppose the coupon rate on TIPS is 3.5 and the
  annual inflation rate is 3 (semiannual inflation
  rate 1.5).
• An investor purchases 100,000 (face value) of an
  issue on January 1.
• In June (when the coupon is paid), the face value
  is increased by the amount of the inflation, or
  101,500.
• The coupon will be 0.0175 ? 101,500 1,776.25
• Suppose for the next six months the annual
  inflation rate is 2. To find the next coupon
  (on December 31)
• Increase the face value by 1, to 102,515.
• Given the semi-annual coupon rate of 1.75, we
  get a coupon of 0.0175 ? 102,515 1,794.01
• Note The U.S. government now taxes the
  inflation adjustment of TIPS, making them less
  attractive since they are less useful as an
  inflation hedge.

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The Treasury Auction Process

• Treasury securities are sold in the primary
  market via sealed-bid auctions

Quarterly Auctions occur in February, May,
August, and November
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The Treasury Auction Process

• The Treasury auction determines the yield at
  which an issue will be sold.
• Two types of bids are submitted, competitive and
  noncompetitive.
• Competitive bidders are large government
  securities dealers and brokers
• They ultimately determine the yield on the issue
  through the bidding process.
• Noncompetitive bidders are smaller investors
• Noncompetitive bidders receive the stop out yield
  highest yield bid accepted determined by the
  auction.

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The Treasury Auction Process

• Process
• Competitive bidders request a specific quantity
  of a bond issue and the amount they are will to
  pay (equivalently, the yield they would be
  willing to receive).
• Bids are then arranged from lowest to highest
  yield.
• Quantities are filled beginning with the lowest
  yield and continue until the bond issue is
  completely allocated.
• The highest yield accepted by the Treasury is
  referred to as the stop-out yield or the high
  yield.
• Bidders bidding higher than the high yield
  receive no allocation of the bond.
• Noncompetitive bidders receive the stop out yield
  determined by the auction.

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Federal Agency Securities

• Two types of agency issuers
• Federally related institutions.
• Government Sponsored Enterprises (GSEs)

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Federally Related Institutions

• Arms of the federal government and usually do not
  issue securities directly in the marketplace.
• Examples
• Tennessee Valley Authority (TVA)
• Export-Import Bank of the United States
• Farmers Housing Administration
• Private Export Funding Corporation (PEFC)
• Several others
• Typically exempt from SEC registration.
• Securities are usually backed by the full faith
  and credit of the U.S. Government (exceptions are
  TVA and PEFC).
• However, TVA has been major issuer of these types
  of securities.
• Most federally related institutions do not issue
  securities.

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Government Sponsored Enterprises

• Privately owned, publicly chartered enterprises
  created by congress to reduce the cost of capital
  for certain borrowing sectors of the economy.
• The sectors include Farmers, homeowners, and
  students.
• Some of these organizations provide credit to the
  housing market.
• They do so by issuing both debentures and
  mortgage-backed securities.
• We will only discuss debentures in this chapter.
• Mortgage-backed securities will be discussed in
  later chapters.

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Government Sponsored Enterprises

• Five major GSEs issue debentures
• Federal National Mortgage Association (Fannie
  Mae)
• Federal Home Loan Mortgage Corporation (Freddie
  Mac)
• Federal Agriculture Mortgage Corporation (Farmer
  Mac)
• Federal Farm Credit Bank System (FFCBS)
• Federal Home Loan Bank System (FHLBanks)
• We will briefly discuss Fannie Mae and Freddie
  Mac.

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Fannie Mae

• Fannie Mae is a NYSE-listed company serving the
  U.S. mortgage industry
• Provides banks and other mortgage lenders
  financing, credit guarantees, and other services
  to help lenders make more loans.
• Fannie Mae does not make home loans.
• To finance operations, Fannie Mae issues debt
  securities
• Benchmark bills (3, 6, and 12-month maturities)
• Benchmark notes (2, 3, 5, 10-year maturities)
• Benchmark bonds (30-year maturity)
• Callable Benchmark Notes
• Subordinated Benchmark Notes
• Investment Notes (debt securities for individual
  investors)

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Freddie Mac

• Freddie Mac is a NYSE-listed company serving
• Freddie Mac purchases mortgages from banks and
  bundles them together into a tradable security
  (securitization).
• To finance the purchase of its mortgages it
  issues the following types of debt
• Reference Bills (maturities of 1 to 12 months)
• Reference Notes (maturities of 2 to 10 years)
• Reference Bonds (maturities from 10 to 30 years)
• Callable Reference Notes
• Euro Reference Notes (Euro denominated)

Eligible for stripping
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GSE Credit Risk

• With the exception of the Farm Credit Financial
  Assistance Corporation (FFCSB), GSE securities
  are not backed by the full faith and credit of
  the U.S. government.
• Thus, there is credit risk associated with GSE
  debt.