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TREASURY AND AGANCY SECURITIES MARKETS

Instructor: Mahwish Khokhar

CHAPTER 16IntroductionTreasury Securities are issued by the US Department of the Treasury and are backed by the full faith and credit of the US government.Consequently, market participants view them as having no credit risk. Historically, interest rates on TS have been benchmark interest rates throughout the US economy. Treasury SecuritiesTwo factors account for the prominent role of US Treasury Securities:Volume (in terms of dollars outstanding)LiquidityThe department of the treasury is the largest single issuer of the debt in the world.The large volume of the total debt and the large size of any single issue have contributed to making the treasury market the most active and hence the most liquid market in the world.Contd..The spread between the bid and ask prices is considerably narrower than in other sectors of the bonds market, and most issues can be traded easily.Many issues in the corporate and municipal markets are illiquid by contrast and cannot be traded easily. Types of Treasury SecuritiesThere are two categories of government securities:DiscountCoupon SecuritiesThe fundamental difference between the two securities lies in the form of the stream of payments that the holder receives, which is reflected in turn in the prices at which the securities are issued. Contd..Coupon securities pay interest every six months, plus principal at maturity. Discount securities pay only a contractually a fixed amount at maturity, called maturity value or face value. Discount instruments are issued below maturity value, and return to the investor the difference between maturity value and the issue price Contd..Current Treasury practice is to issue all the securities with maturities of one year or less as discount securities and these securities are called Treasury Bills.All securities with maturities of two years or more are issued as Coupon Securities.Treasury coupon securities issued between the maturities of 2 and 10 years are called Treasury Notes.Those with maturities of more than 10 years are called Treasury Bonds.While there is difference between the treasury notes and treasury bonds but in this chapter we will call them simply as treasury bonds.

Contd..Treasury inflation protection securities: On January 29, 1997, the US department of the Treasury issued for the first time Treasury Securities that adjust for inflation. These securities are popularly referred to as TIPS or TIIS (Treasury inflation indexed securities).TIPS works as follows:The coupon rate on the securities is set at a fixed rate.

Contd..That rate is determined at an auction process.The coupon rate is called the real rate on which an investor earns more than inflation rate. The adjustments for inflation is as follows:The principal on which the Treasury Department will base both the dollar amount of the coupon payment and the maturity value is adjusted semiannually. This is called the inflation adjusted principal.

Contd..For Example:Suppose that the coupon rate for TIPS is 3.5% and the annual inflation rate is 3%.Suppose further that an investor purchases on January 1, $100,000 of par value (principal) of this issue. The semiannual inflation is 1.5% (3% divided by 2).The inflation adjusted principal at the end of the first six month period is $101,500.The coupon rate is then 1.75% multiplied by the inflation adjusted principal at the coupon payment date ($101,500).The coupon payment is therefore $1776.25. Primary MarketAs we all know that the primary market is the market for newly issued securities.Auction Cycles: The US Department of the Treasury make the determination of the procedure for auctioning new treasury securities, when to auction them, and what maturities to issue.There have been occasional changes in the auction cycles and the maturity of the issues auctioned. Currently, there are weekly three-month and six-month bill auctions. Contd..Determination of the Results of an Auction: The auction for treasury securities is conducted on a competitive bidding basis.Competitive bids must be submitted for up to a $1 million face amount. Such tenders are only based on quantity not yields. The auction results are determined only by deducting the total noncompetitive tenders and nonpublic purchases (such as purchases by Federal Reserve itself) from the total securities being auctioned.The remainder is the amount to be awarded to the selected bidders.Contd..For Example, in April 1996 there was an auction for two years treasury note . The amount auctioned by the treasury was $19.946 billion.The noncompetitive bids totaled $1.169 billion. This meant that there was $18.777 billion to be distributed to the competitive bidders. For this auction there was bids for $47.604 billion. See table 16.1, page 293.Contd..Primary Dealers: Any firm can deal in government securities, but in implementing its open market operations, the Federal Reserve will deal directly only with dealers that it designates as primary dealers or recognized dealers.Basically, the Fed wants to be sure that firms requesting status as primary dealers have adequate capital relative to positions assumed in the TS and do a reasonable amount of volume in Treasury Securities. When a firm requests for the status of primary dealer, Fed asks for its position and trading volume and if it fulfill the criteria the Fed give the firm status of its reporting agent. Contd..Submission for bids: Until 1991, primary dealers and large commercial banks that were not primary dealers would submit their bids for their own account not for their customers account.Well publicized violations of the auction process by Salomon Brothers in the summer of 1991 forced treasury officials to more closely scrutinize the activities of primary dealers and also reconsider the procedure by which treasury securities are auctioned.Specifically, specified broker/dealers could bid for their customers.Secondary MarketAs we all know the secondary market for TS is an OTC, where a group of US government securities dealers offer continuous bid and ask prices on outstanding treasuries. There is virtual 24 hours trading of TS.The three biggest markets are New York, London and Tokyo. Contd..When Issued Market: TS are traded prior to the time they are issued by the Treasury. This component of the Treasury secondary market is called when issued market or wi market.Government Brokers: Government dealers trade with the investing public and with other dealer firms. When they trade with each other, it is through intermediaries known as interdealer brokers or government brokers who display the highest bid and the lowest offer in a computer network tied to each trading desk and displayed on a monitor. Contd..Bid and Offer Quotes on Treasury Bills: The convention of quoting bids and offers is different for treasury bills and treasury coupon securities.Bids and offers on TB are quoted in a special way. Unlike bonds that pay coupon interest, TB values are quoted on a bank discount basis, not on a price basis. The yield on a bank discount is computed as follows: Y = D/F x 360/tContd..D = dollar discount. Which is equal to the difference between the face value and the price.F = face valueT = number of days remaining to maturityFor example: a TB with 100 days to maturity, a FV of $100,00 and selling at $97,569, find out the D and Y?Contd..Bid and Offer Quotes on Treasury Coupon Securities: Treasury coupon securities are quoted differently from treasury bills.They trade on a dollar price basis in price units of 1/32 here of 1% of par (par is taken to be $100).Read page 296, last paragraph.Regulation of Secondary Market: The rules for the sale of US securities have been exempt from most SEC provisions and rules. Thus, government brokers/dealers are not required to disclose the bid ask spread on the TS that they buy from or sell to customers. There are guidelines established by the National Association of Security Dealers for reasonable bid-ask spreads, but lack of disclosure to customers makes it difficult for the customers to monitor the pricing practice of the broker/dealer. Contd..Dealer use of the Repurchase Agreement Market: Suppose, a government securities dealer has purchased $10 million of a particular TS. From where the dealer can arrange for the funds to finance its position?The dealer will use its own funds to borrow from the bank. Typically, however, the dealer uses the repo market to obtain financing. In the repo market the dealer will use the $10 million of TS purchased as a collateral for a loan. The terms of the loan and the interest that dealer agrees to pay (called repo rate) are specified.A loan for more than one day is called term repo.

Contd..A Note on Terminology in the Repo Market: Read page 299.

Stripped Treasury SecuritiesThe treasury do not issue zero-coupon bonds or notes. In August 1982, however, both Merrill Lynch and Salomon Brother created synthetic zero-coupon Treasury receipts.The procedure was to purchase Treasury Bonds and deposit them in a bank custody account.The firms then issued receipts representing an ownership interest in each coupon payment on the underlying Treasury bond in the account and a receipt for ownership of the underlying Treasury bonds maturity value.

Contd..The process of separating each coupon payment as well as the principal (called the corpus), and selling securities against them is referred to as coupon stripping.The receipts are not issued by the US Treasury, the underlying bonds in the banks custody account is a debt obligation of US treasury, so the cash flow is certain. Today, stripped treasury securities are referred to ad Treasury Strips. Disadvantage: Read Page 301.Further: Page 301Thanks =)