The Treasury Securities Market: Overview and Recent ... · The Treasury Securities Market: Overview...

The Treasury Securities Market:Overview and Recent Developments

Dominique Dupont and Brian Sack, of the BoardsDivision of Monetary Affairs, prepared this article.Emilie Archambeault provided research assistance.

The market for U.S. Treasury securities is by manymeasures the largest, most active debt market in theworld. At the end of September 1999, the amountof Treasury debt held outside federal governmentaccounts totaled about $3.6 trillion, close to theamount of outstanding debt securities issued by allU.S. corporations combined.1 Moreover, enormousamounts of Treasury securities are traded every busi-ness day. Over the first nine months of 1999, theprimary dealers in government securities, which areamong the most active participants in the market,together executed an average of $190 billion worth oftransactions in the securities each day.2

The heavy trading is an indication of the pivotalrole of U.S. Treasury securities in world financialmarkets. Investors of many typescommercialbanks, investment banks, money market funds, insur-ance companies, individual investors, and foreigncentral banks, among othersuse the Treasury mar-ket for investing and hedging purposes. Yields on thesecurities are widely viewed as benchmarks in thepricing of other debt securities and are analyzed forthe information they might reveal about market par-ticipants expectations about the future path of theeconomy and monetary policy.

This article begins with a description of the struc-ture of the Treasury market, including the process bywhich securities are issued in the primary market andthe mechanics of the secondary market. The determi-nants of investor demand for Treasury securities arethen discussed in some detail. The article concludeswith a discussion of several recent developments andemergent trends that have affected the market, includ-ing the advent of inflation-indexed securities, a reduc-tion in the issuance of Treasury securities, and shifts

toward electronic trading and alternative clearingarrangements.

OVERVIEW OF THE MARKET

The market for U.S. Treasury securities has a com-plex structure and involves numerous participantsthe Department of the Treasury, the Federal ReserveSystem, government securities dealers and brokers,and other holders of Treasury securities.

Scope of the Market

The federal government finances its expenditures inexcess of tax receipts through the sale of debt obliga-tions. Over the years, the Congress has delegated tothe Department of the Treasury its authority underthe Constitution to issue debt securities. The UnitedStates, initially as the Continental Congress, firstincurred debt in 1776 when it borrowed funds tofinance the Revolutionary War.3 Total Treasury debtremained fairly small in the first half of the nine-teenth century but rose sharply with the Civil Warand again with World War I (chart 1). After decliningslightly, the debt increased nearly threefold duringthe Great Depression and exploded in the 1940s asthe government financed expenditures related toWorld War II. From its postwar low in 1949, out-standing Treasury debt grew gradually for nearly twodecades before accelerating at the time of the Viet-nam War and during the subsequent period of highinflation. In the 1980s, the growth of the stock of debtpicked up further, spurred by the tax cuts and rapidincreases in defense spending of the decade.

In recent years, budget surpluses have halted theupward climb in the total amount of Treasury debtheld outside government accounts. However, theoverall magnitude of outstanding debt remains sub-stantial, a legacy of past budget deficits. At the end of

1. Corporate debt securities include corporate bonds and commer-cial paper outstanding and exclude debt and mortgage-backed securi-ties issued by federal agencies and government-sponsored enterprises.

2. Source: Federal Reserve Bank of New York.

3. Rafael A. Bayley, The National Loans of the United States ofAmerica from July 4, 1776 to June 30, 1880, as Prepared for the TenthCensus of the United States (Washington, DC: U.S. GovernmentPrinting Office, 1883).

September 1999, the total par value of outstandingTreasury debt, including that held in governmentaccounts, stood at about $5.6 trillion, or about 61 per-cent of the total annual output of the economy. Thisfraction, though considerable, is well below the peakafter World War II (chart 2).

Types of Treasury Securities

Of the $5.6 trillion in outstanding debt at the end ofSeptember 1999, about $3.2 trillion was in the formof marketable securitiesinstruments that may betraded after their initial purchase. These securities arethe focus of this article. New marketable securitiesare regularly offered in maturities ranging from thir-teen weeks to thirty years. Billssecurities having a

maturity of one year or lesssell at a discount fromtheir face value (par) and do not pay interest beforematurity. Investors realize a return on bills from theincrease in their price to face value at maturity.Notessecurities having an initial maturity of one toten yearsand bondssecurities having an initialmaturity of more than ten yearsoffer investorssemiannual interest payments, or coupons.

More than half the marketable Treasury debt out-standing is in the form of notes, while bills and bondseach represent about 20 percent (chart 3). Some ofthe outstanding bonds are callable securities, whichmay be redeemed by the Treasury before their matu-rity; however, only noncallable securities have beenissued since 1985. Most of the marketable debt out-standing (about 97 percent) is in the form of nominalsecuritiessecurities for which the coupon andprincipal payments are fixed in dollar terms. Since1997, the Treasury has also issued securities whosecoupon and principal payments are indexed to therate of inflation. (The indexed-securities program isdescribed later in the section Availability of a NewInstrument.)

The Treasury also issues a considerable amount ofnonmarketable securities, which, in contrast to mar-ketable securities, may not be traded after their initialpurchase. Nonmarketable debt is primarily in theform of Government Account Series (83 percent),State and Local Government Series (7 percent), andsavings bonds (7 percent). Government AccountSeries securities are held mainly by off-budget gov-ernment programs, such as social security, which bylaw must invest accumulated surpluses in nonmarket-

1. Total outstanding Treasury debt, 18511999

1851 1880 1910 1940 1970 1999

0.025

0.1

0.5

2.5

10

50

250

1,0002,0005,000

Billions of dollars, log scale

Note. Data for 1999 are through the second quarter.Source. U.S. Department of the Treasury.

2. Ratio of total outstanding Treasury debt to gross domesticproduct, 193099

1939 1959 1979 1999

0.2

0.4

0.6

0.8

1.0

1.2

Ratio

Note. Data for 1999 are through the second quarter.Source. U.S. Department of the Treasury; U.S. Department of Commerce.

3. Distribution of marketable Treasury debt outstanding,by type of security, September 30, 1999

Bills, 20% (653.2)

Other, < 1% (15.0)

Indexed, 3% (92.4)

Bonds, 20% (643.7)

Notes, 57% (1,828.8)

Note. Numbers in parentheses are amounts outstanding, in billions ofdollars.

Source. Monthly Statement of the Public Debt of the United States (U.S.Department of the Treasury), September 1999.

786 Federal Reserve Bulletin December 1999

able Treasury securities. State and Local GovernmentSeries (SLGS) securities are Treasury securitiesoffered to those governments as a result of 1969federal legislation restricting them from investingproceeds from tax-exempt bonds in higher-yieldinginvestments; yields on SLGS securities are set on acase-by-case basis to make it possible for the pur-chaser to comply with that legislation, although theyields must be at least 5 basis points below the yieldson marketable Treasury securities having comparablematurities. Savings bonds, which are issued in smalldenominations, are redeemable at any time after ashort initial holding period. In addition to offeringsmall investors an instrument for saving, some sav-ings bond series have special characteristics such asindexation to the rate of inflation and special taxexemptions on interest payments used to pay forqualified higher education expenses.

Issuance of Treasury Securities:The Primary Market

Marketable Treasury securities are issued throughregularly scheduled auctions in what is called theprimary market. The process importantly involvesthe Federal Reserve Banks, which serve as conduitsfor the auctions.4 Because market activity is concen-trated in New York, the Federal Reserve Bank ofNew York coordinates much of the auction activity.

Primary Dealers

Approximately 2,000 securities brokers and dealersare registered to operate in the government securitiesmarket.5 Although all these firms may bid at Treasuryauctions, participation is typically concentratedamong a small number of these firms, the primarydealers. Primary dealers are selected by the Federal

Reserve Bank of New York as counterparties foropen market operations (government securities trans-actions related to the Federal Reserves implementa-tion of monetary policy). They are required to partici-pate meaningfully in both open market operationsand Treasury auctions and to provide policy-relevantmarket information to the New York Reserve Bank.Along with the consolidation of the financial industryhas come a decline in the number of primary dealers,from a peak of forty-six in 1988 to thirty as ofOctober 1999.

Auctions

To foster liquidity in the market, the Treasury issuessecurities consistently and predictably through aregular schedule of auctions. The process beginsseveral days before the scheduled auction when theTreasury announces the details of the upcomingissue, including the amount to be auctioned and thematurity date. After the auction is announced butbefore it takes place, investors begin trading theyet-to-be-issued security in what is called the when-issued market. Transactions in this market are agree-ments to exchange securities and funds on the day thenew security is issued (although a considerable por-tion of when-issued positions are unwound before theissue date). The when-issued market allows newTreasury issues to be efficiently distributed to inves-tors and provides useful information to potential bid-ders about the prices the Treasury may receive at theupcoming auction.

On the day of the auction, bids may be submittedto a Federal Reserve Bank or Branch or to the Trea-surys Bureau of the Public Debt. Although all enti-ties may submit bids for their own accounts, deposi-tory institutions and registered government securitiesbrokers and dealers may also bid on behalf of theircustomers. Many of these bids are entered throughTAAPS (Treasury Automated Auction ProcessingSystem), an automated system for processing auctionbids that was implemented in the early 1990s.

Two types of bids may be submitted at the auction.Competitive bids specify both the quantity of thesecurity sought and a yield.6 If the specified yield iswithin the range accepted at the auction, the bidder isawarded the entire quantity sought (unless the speci-fied yield is the highest rate accepted, in which casethe bidder is awarded a prorated portion of the bid,

4. This is one of several ways in which the Reserve Banks act asfiscal agents of the Treasury, as permitted by the Federal Reserve Act.Other fiscal agency services provided to the Treasury aredetailed in Gerald D. Manypenny and Michael L. Bermudez, TheFederal Reserve Banks as Fiscal Agents and Depositories of theUnited States, Federal Reserve Bulletin, vol. 78 (October 1992),pp. 72737.

5. These firms are registered with the Securities and ExchangeCommission, as required by the Government Securities Act of 1986,which establishes a comprehensive legal framework regulating allgovernment securities brokers and dealers so as to ensure the integrityof the government securities market. The legislation focuses on thecapitalization of brokers and dealers and grants the Treasury authorityto develop and implement rules regarding transactions of governmentsecurities. The enforcement of these rules is delegated to existingregulatory agencies and self-regulatory organizations.

6. At bill auctions, the bidder specifies a discount rate, describedbelow, rather than a yield.

The Treasury Securities Market: Overview and Recent Developments 787

as described below). Noncompetitive bids, whichtypically account for a small proportion of auctionamounts in part because of restrictions on their size,do not specify a yield; instead, bidders agree toaccept the yield determined at the auction and inreturn are guaranteed the amount of the securitysought.

In most auctions, noncompetitive bids must besubmitted by noon and competitive bids by 1:00 p.m.(all times are local New York time, unless statedotherwise). To determine the range of yields to beaccepted, the quantities specified in all noncompeti-tive bids are summed and that total is subtracted fromthe total offered. Competitive bids are then acceptedin ascending order in terms of their yields until thequantity of accepted bids reaches the quantity offered.Bids at the highest accepted yield, referred to as thestop-out yield, are prorated so that the total amountof bids accepted equals the total amount offered.The results of the auction are typically announced by1:30 p.m.

Since November 1998, all Treasury securities havebeen auctioned according to the uniform-pricemethod.7 Each successful competitive bidder andeach noncompetitive bidder is awarded securities atthe price corresponding to the stop-out yield. Previ-ously, most securities had been issued according tothe multiple-price method, meaning that securitieswere awarded at prices corresponding to the yield ofeach successful competitive bid. In such auctions,bidders must be concerned with the winnerscursethe tendency for a successful bidder to pay aprice higher than the value assessed by other auctionparticipants.8 By mitigating the winners curse, theuniform-price auction may elicit more aggressivebids, possibly increasing the Treasurys revenue.

As of the end of September 1999, nominal Trea-sury securities were offered under the followingschedule: $6.5 billion of thirteen-week bills and$7.5 billion of twenty-six-week bills auctionedweekly; $10 billion of fifty-two-week bills everyfour weeks; $15 billion of two-year notes monthly;$15 billion of five-year notes and $12 billion often-year notes quarterly; and $10 billion of thirty-year bonds semiannually.9 The auctions of five-, ten-,

and thirty-year nominal securities are held around themiddle of the quarter and are referred to as midquar-ter refundings. Inflation-indexed notes and bondsare also brought to market quarterly. In addition tothese regularly scheduled issues, the Treasury occa-sionally offers cash management billssecuritieshaving very short maturities issued to bridge tempo-rary funding needs. The borrowing cost for cashmanagement bills has tended to be a bit higher thanthat for regularly issued instruments.10

Instead of issuing a new security, the Treasury mayadd to, or reopen, an existing issue, allowing it toincrease the outstanding amount of the issue. Securi-ties with larger amounts outstanding tend to be moreliquid, making them more attractive to investors. TheTreasury systematically reopens Treasury bills: Everyfourth twenty-six-week bill is a reopening of a fifty-two-week bill (which is as often as possible giventhe auction schedule), every thirteen-week bill is areopening of a twenty-six-week bill, and some cashmanagement bills are reopenings of other bills. Incontrast, the Treasury has only infrequently reopenednotes and bonds; since 1990, about 20 percent of theauctions of ten-year notes and thirty-year bonds havebeen reopenings. The infrequency of reopenings ofnotes and bonds may be due partly to an obstaclepresented by the Internal Revenue Services OriginalIssue Discount (OID) rule, which prevents the Trea-sury from reopening an issue trading at a price dis-count equal to or greater than 0.25 percent of parvalue per full year of remaining maturity.11 OnNovember 3, 1999, the Treasury issued a temporaryrule allowing it to reopen securities within one yearof issuance regardless of the size of the discount.

The Treasury has adjusted the auction scheduleover time in keeping with its changing financingneeds (table 1). It has stopped issuing securities atthose maturities it judged to be less popular withinvestors, preferring to concentrate issuance in fewermaturities in order to preserve the sizes of thoseissues. In particular, it canceled the twenty-year bondin 1986, the four-year note in 1990, the seven-yearnote in 1993, and the three-year note in 1998. It alsorecently reduced the frequency of issuance of thefive-year note from monthly to quarterly and thefrequency of issuance of the thirty-year bond fromthree times to twice a year by eliminating the Novem-ber auction. The Treasury has discussed possible

7. Before that time, the Treasury conducted uniform-price auctionsfor some of its issues, including two- and five-year notes. See boxRegulatory Reforms.

8. Vincent Reinhart, An Analysis of Potential Treasury AuctionTechniques, Federal Reserve Bulletin, vol. 78 (June 1992),pp. 40313.

9. These totals do not reflect quantities allocated to the FederalReserve or to foreign official institutions.

10. David Simon, Segmentation in the Treasury Market: Evi-dence from Cash Management Bills, Journal of Financial and Quan-titative Analysis, vol. 26 (March 1991), pp. 97108.

11. The OID rule does not apply if the Treasury declares an acute,protracted shortage in a security. See box Regulatory Reforms.


future cutbacks in the issuance of one-year bills andtwo-year notes as well.

Changes in the auction schedule have naturallyaffected the maturity of outstanding Treasury debt.The average maturity of marketable debt has variedconsiderably over the past three decades (chart 4).More recently, the maturity peaked at about six yearsat the beginning of the 1990s, after which the Trea-sury began to shorten the maturity in an attempt toreduce its borrowing costs. Over the past severalyears, the maturity has again begun to rise as a resultof a reduction in the issuance of securities havingshorter maturities (discussed in the section Reduc-tion in the Supply of Nominal Treasury Debt). Theelimination of the November thirty-year bond auctionmay help counter this rise.

Trading in Treasury Securities:The Secondary Market

The market for government securities is an over-the-counter market in which participants trade with oneanother on a bilateral basis rather than on an orga-nized exchange. (Treasury securities are officially reg-istered at the New York Stock Exchange, but tradingin that market is negligible.) Trading activity takesplace between primary dealers, nonprimary dealers,and customers of these dealers, including financialinstitutions, nonfinancial institutions, and individuals.

Many dealers, particularly the primary dealers,make markets in Treasury securities by standingready to buy and sell securities at specified prices. Inthe process of making markets, dealers purchasesecurities at the bid price and sell the same securitiesat a slightly higher price, the offer price. Throughthese sales and purchases, the dealer can facilitatetransactions between customers while taking onlytemporary positions in the security. In doing so, thedealer earns the difference between the bid and offerprices, referred to as the bidoffer spread.

In addition to transacting directly with customers,primary dealers frequently trade with one another.The majority of transactions between primary dealersand other large market participants take place throughthe six interdealer brokers. These brokers provide thedealers with electronic screens that display the bestbid and offer prices among the dealers. Dealers canexecute trades through an interdealer brokereitherhitting a bid price or taking an offer pricefora small fee. In this structure, the interdealer brokersprovide two important services: They disseminateprice and trade information efficiently and provideanonymity to market participants.

1. Frequency of auctions of Treasury securities, by maturity, 198599

YearType of security

13-week 26-week 52-week 2-year 3-year 4-year 5-year 7-year 10-year 20-year 30-year

1985 . . . . . Weekly Weekly Every 4th Monthly Quarterly Quarterly Quarterly Quarterly Quarterly Quarterly Quarterly1986 . . . . . week None1987 . . . . . (1/15/86)1988 . . . . .1989 . . . . .1990 . . . . . None1991 . . . . . (12/31/90) Monthly1992 . . . . . (1/31/91)1993 . . . . . None Semiannually1994 . . . . . (4/15/93) (8/16/93)1995 . . . . .1996 . . . . . 6/yr (7/15/96) 3/yr (8/15/96)1997 . . . . . Quarterly1998 . . . . . None Quarterly (8/15/97)1999 . . . . . (5/15/98) (8/17/98) Semiannually1

Note. Date indicates when a security was first issued under a new scheduleor, if discontinued, when a security was last issued.

1. In August 1999, the Treasury announced that it would discontinue theNovember auction and issue 30-year bonds in February and August only.

Source. Treasury Bulletin.

4. Average maturity of marketable Treasury debt,196499

1969 1979 1989 1999

3

4

5

6

Years

Note. Excludes inflation-indexed securities and holdings of the FederalReserve. Data for 1999 are through September.

Source. U.S. Department of the Treasury.


The thirty primary dealers are among the mostactive participants in the secondary market. In thesecond quarter of 1999, they engaged in an averageof $193 billion in transactions in Treasury securitieseach day (table 2)about $105 billion with otherdealers through interdealer brokers and the other$88 billion either with customers or directly withother dealers.12 This activity is fairly concentrated:The six primary dealers with the highest volume oftransactions in Treasury securities accounted forabout 50 percent of the primary dealers tradingactivity.

Treasury securities can be traded almost around theclock (about twenty-two hours a day). Trading beginsin Tokyo at 7:30 p.m. (New York time) and continuesuntil 3:00 a.m., when it passes to the London mar-ket.13 Trading in London continues until 7:30 a.m., atwhich time it begins in New York, where it continuesuntil 5:30 p.m. Although market activity is world-wide, about 94 percent of the trading volume trans-acted through interdealer brokers takes place duringNew York trading hours, leaving about 4 percent and2 percent of volume during London and Tokyo hoursrespectively.14 Moreover, according to market partici-pants, a significant portion of overseas trading occursat times when trading operations are being shiftedfrom one market to another.15 Overseas markets for

Treasury securities appear to be less liquid than U.S.markets; dealers reportedly post wider bidofferspreads and stand ready to buy or sell smalleramounts of securities at the posted prices.16 The finalexchange of securities for cash (settlement) typicallyoccurs in New York, regardless of where the transac-tion originated.

Quoting Conventions

Treasury coupon securities are quoted in terms oftheir price, expressed in dollars. The quoted price of acoupon security is the clean price, which excludesaccrued interest. When a transaction takes place, thepurchaser must pay the seller the clean price plus theaccrued interest, which is determined by the couponamount multiplied by the fraction of the couponperiod that has passed.

The value of a Treasury coupon security is oftenexpressed in terms of its yield to maturity, or yield,rather than its price. The yield on a Treasury securityis the constant interest rate at which the presentdiscounted value of future coupon and principal pay-ments equals the current price of the security. Ineffect, the yield represents the rate of return an inves-tor would earn if he or she held the security tomaturity, assuming semiannual compounding ofinterest. By definition, the yield and the price move inopposite directions: An increase in the price impliesthat an investor must pay more today to receive thesame, fixed payments in the future, and therefore therate of return, or the yield, on the initial investmentis lower. Although levels of yields are expressed inpercentage points, researchers and market partici-pants often express changes in yields in basis points(hundredths of a percentage point).

In contrast to coupon securities, Treasury bills arequoted in terms of a discount rate, which is thedifference between the face value and the marketprice as a percentage of the face value, scaled to anannual rate assuming a 360-day year (that is, multi-plied by 360 and divided by the number of daysremaining to maturity). The yield to maturity for aTreasury bill is the difference between the face valueand the market price as a percentage of the marketprice, scaled to an annual rate using the actual num-ber of days in the year.

12. In comparing these figures, note that dealer-to-dealer transac-tions are counted twice.

13. To be precise, because Japan has not adopted daylight savingtime, the market opens in Tokyo at 7:30 p.m. eastern daylight time or6:30 p.m. eastern standard time.

14. Michael J. Fleming, The Round-the-Clock Market for U.S.Treasury Securities, Federal Reserve Bank of New York, EconomicPolicy Review, vol. 3 (July 1997), pp. 932. This analysis is based on1994 data; preliminary analysis by the author using 1998 data does notsuggest significant changes in the patterns of overseas trading ofTreasury securities.

15. Brian Madigan, and Jeff Stehm, An Overview of the Second-ary Market for U.S. Treasury Securities in London and Tokyo,Finance and Economics Discussion Series 9417 (Board of Gover-nors of the Federal Reserve System, Divisions of Research andStatistics and Monetary Affairs, July 1994).

16. Michael J. Fleming, The Round-the-Clock Market for U.S.Treasury Securities; also Market Liquidity: Research Findings andSelected Policy Implications, Committee on the Global FinancialSystem, Bank for International Settlements (May 1999).

2. Daily trading volume in Treasury securities, 1999:Q2

Type of securityAverage among all

primary dealers(millions of dollars)

Percentage amongmost active

primary dealers

Bills . . . . . . . . . . . . . . . . . . . . . . . . . . 29,451 44

Coupon securities . . . . . . . . . . . . . 162,614 52

Indexed securities . . . . . . . . . . . . . 1,282 74

Total . . . . . . . . . . . . . . . . . . . . . . . 193,347 51

Note. The most active primary dealers are the six with the highest volume oftransactions in each type of security during the quarter.

Source. Federal Reserve Bank of New York.


Safekeeping and Transfer of Securities

Recordkeeping for Treasury securities is done in oneof two ways. In one system, ownership and legalinterests are recorded electronically, in a series ofbook-entry records on the books of the FederalReserve Banks and depository institutions: The Fed-eral Reserve manages the National Book-Entry Sys-tem (NBES), which maintains records for depositoryinstitutions; depository institutions, in turn, maintainrecords for their customers. Alternatively, an investorcan maintain a book-entry securities account directlywith the Treasury through the Treasury Direct sys-tem. The securities held in Treasury Direct are pur-chased when originally issued and are typically heldto maturity.

Through the NBES, depository institutions canelectronically transfer Treasury securities amongthemselves to settle their trades and the trades of theircustomers. Most of these trades are settled on adelivery-versus-payment basis whereby the securitiesare electronically deposited in the receiving insti-tutions account and the corresponding payment issimultaneously electronically deposited in the send-ing institutions account at the Federal Reserve. Thedepository institutions, in turn, adjust their custom-ers records to reflect the transfer.

To facilitate the settlement process, the FederalReserve grants finality when securities transfers arecompleted over the NBESthat is, the paymentsassociated with these transactions are final and irrevo-cable. In addition, the Federal Reserve, for a fee,provides intraday credit, commonly called daylightoverdrafts, to financially healthy depository institu-tions. To limit the credit risk arising from such creditextensions, the Federal Reserve imposes limits, basedon several factors, on depository institutions day-light overdraft capacity. The Federal Reserve requiresthat depository institutions cover their daylight over-drafts by the end of the day. If a depository institutionends the day with a negative account balance, theinstitution incurs an overnight overdraft, which car-ries a much higher fee than a daylight overdraft.

Because only depository institutions have access tothe NBES, other buyers and sellers of governmentsecurities must use a depository institution as anintermediary.17 Settlement activity is highly concen-trated in a few depository institutions known as clear-ing banks. Clearing banks tend to be very largeorganizations because sizable investments in com-

puter hardware and software are necessary to handlethe large flow of transactions. These banks alsoextend intraday credit to their customers, allowingthem to overdraw their money accounts to pay forsecurities. To finance their intraday lending to cus-tomers, clearing banks rely on daylight overdraftcredit from the Federal Reserve. The charges fordaylight credit are then typically passed on by theclearing banks to their customers.

THE DEMAND FOR TREASURY SECURITIES

The supply of Treasury securities, as noted earlier, islargely a function of the need to finance the cumula-tive budget deficits of the U.S. government. Thedemand for those securities is determined largely bytheir usefulness for investment and hedging purposes.

Treasury Securities in Investors Portfolios

Treasury securities are held by various types of inves-tors, including domestic financial intermediaries suchas depository institutions; institutional investors; stateand local governments; international investors; andthe Federal Reserve System, which participatesactively in the market as part of its implementation ofmonetary policy (chart 5).

The widespread holding of Treasury securities isan indication of several appealing characteristics. Aswith other fixed-income products, the payments on

17. Some government-sponsored enterprises also have access tothe NBES.

5. Distribution of Treasury securities, by ownership,March 31, 1999

Depository institutions,7% (247.6)

Federal Reserve, 12% (464.5)Others, 14% (518.7)

Foreign andinternational,33%(1,270.8)

State and local governments, 7% (266.6)

Institutionalinvestors,27% (1,023.9)

Note. Numbers in parentheses are amounts, in billions of dollars. Excludesinterest-bearing public debt held in U.S. government accounts (mainly invest-ments in the social security and federal retirement trust funds). For state andlocal governments, includes about $167.45 billion of nonmarketable Treasurydebt. Institutional investors include insurance companies, mutual funds, andpension funds.

Source. Treasury Bulletin, September 1999, tables OFS-1, OFS-2.


nominal Treasury securities are specified in advance,providing the investor with a known stream ofincome. (Investors who prefer a single future pay-ment rather than a stream of coupon payments mayinstead hold STRIPS, described in the box TheTreasury STRIPS Market.) Fixed-income securitiesare often an important component of well-balancedportfolios that seek to minimize the variance ofreturns for a given expected return.

Treasury securities are particularly appealing toinvestors because they offer greater safety and liquid-ity than other fixed-income securities. The paymentsof principal and interest on the securities are backedby the full faith and credit of the U.S. government. Inlight of the sound financial history of the federalgovernment and its ability to raise substantial taxrevenues, Treasury securities are considered to havethe lowest risk of default of any major financial

investment in the world. Moreover, the interestincome derived from Treasury securities is exemptfrom state and local taxes. In addition, some Treasurysecurities are extremely liquid, which may be particu-larly important to investors engaging in hedging andother trading-intensive investment activities. Demandarising from such activities is not spread evenlyacross all Treasury securities but is concentrated ina limited number of issues with superior liquidity(as discussed in the section Factors Affecting Indi-vidual Treasury Securities).

Liquidity is an important factor influencing theFederal Reserves holdings of Treasury securities aswell. The Federal Reserve tends to hold Treasurysecurities having maturities shorter than the averagematurity of marketable securities held by other inves-tors, partly because securities having shorter maturi-ties tend to be more liquid and because it can fairly

The Treasury STRIPS Market

Although regular coupon payments may suit the needs ofsome investors, others may prefer securities offering asingle payment when the security matures. These instru-ments, called zero-coupon securities, sell at a discount totheir face value, allowing investors to realize a return fromthe increase in the price of the instrument to its maturitydate.

In 1985 the Treasury initiated a program that allowsinvestors to split a Treasury note or bond into zero-couponsecurities, or STRIPS, corresponding to each coupon pay-ment and the principal payment of the underlying security.1

For example, stripping a Treasury bond that has twentyyears left to maturity generates forty coupon STRIPS, onematuring every six months for twenty years, and one princi-pal STRIP maturing in twenty years. The final couponSTRIP and the principal STRIP are treated as distinctsecurities despite having identical maturity dates. Since theinception of the program, all newly issued ten-year notesand thirty-year bonds have been eligible for stripping. Theprogram was expanded in September 1997 to include alltwo-, three-, and five-year notes as well.

The program also allows (as of 1987) the reconstitutionof a stripped security from STRIPS matching all the securi-tys coupon and principal payments. The principal paymentneeded to reconstitute a Treasury security must be gener-ated from the principal STRIP originating from the securitybeing reconstituted. By contrast, the coupon payment streammay be created from coupon STRIPS derived from anysecurity; that is, coupon STRIPS with the same maturitydate are fungible.

1. STRIPS is an acronym for Separate Trading of Registered Interest andPrincipal of Securities.

The considerable interest in zero-coupon securities wasevident long before the advent of the STRIPS program.Several investment banks began holding Treasury securitieswith custodians in special trust accounts and selling thecomponents of those securities to investors. The STRIPSprogram made this process more efficient and cost-effective,as STRIPS could be registered in the Federal Reservesbook-entry system in the same manner as other Treasurysecurities.

The total amount of STRIPS outstanding increased rap-idly following the introduction of the program, reaching$200 billion by 1993 before leveling out. Stripping activityhas been concentrated in longer-term securities, possiblybecause stripping makes it possible to create Treasury secu-rities having longer duration than available from coupon-bearing Treasury securities, which may be of interest toinvestors having very long investment horizons. At the endof September 1999, about 32 percent of all outstandingTreasury bonds were held in stripped form. Stripping activ-ity has been more limited for securities having shortermaturities, in part because stripping simply replicates manyof the zero-coupon securities that are created by strippinglonger-term securities.

The STRIPS market is characterized by heavy flows ofgross stripping and reconstitution activity, with an averageof about $11 billion of securities stripped and reconstitutedeach month over the first three quarters of 1999. Strippingand reconstitution transactions can be implemented rela-tively quickly and at very little cost, facilitating arbitragebetween the markets. As a result, there is a relatively tightpricing relationship between a strippable Treasury securityand its stripped components.


rapidly reduce the size of its holdings of such securi-ties, should it need to, by merely not replacing matur-ing holdings. The advantages of holding a liquidportfolio became evident in 1984 when the FederalReserve had to sell a significant amount of Treasurysecurities to offset the massive influx of reserves intothe banking system provided through a large volumeof discount-window loans at the time.18 The FederalReserve reduced the maturity of its portfolio fromabout four years in 1985 to about three years in 1991.In 1992, the Federal Reserves policymaking commit-tee decided that the portfolio had reached a sufficientlevel of liquidity and instructed the trading desk atthe Federal Reserve Bank of New York to keep theaverage maturity from falling further. In the follow-ing years, because of the paydown of Treasury billsoutstanding, the average maturity crept back up toabout four years.

Overall, Treasury securities may appeal to inves-tors seeking the safety and liquidity offered by thosesecurities, and the securities prices are determinedby the value investors ascribe to those characteristicsin the context of their investment strategies.

Determinants of the Yield Curve

The values of Treasury securities are often summa-rized by the yield curve, which plots the yields ofall noncallable securities against their maturities. Anexample is the yield curve on September 23, 1999(chart 6). This curve has an upward-sloping, concaveshape. Securities having maturities of less than fiveyears are highly concentrated because shorter-term

securities are auctioned more frequently and becausemany previously issued longer-term securities fallin that maturity range. The gap between noncallablesecurities having maturities of ten years and fifteenyears arises because the Treasury switched from issu-ing twenty-year bonds to issuing thirty-year bonds inthe mid-1980s.

Securities having similar maturities tend to havesimilar yields because they offer fixed payments oversimilar periods. Securities having very different matu-rities are also linked. In particular, longer-term inter-est rates generally reflect expectations about thefuture path of short-term interest rates. This relation-ship, which is often referred to as the expectationshypothesis, arises because an investor can chooseamong several strategies, including purchasing aTreasury security whose maturity extends over his orher investment horizon or purchasing a short-termsecurity and continuing to reinvest in that security(that is, roll it over) through the investment period.19

The former strategy offers a return equal to the yieldon the longer-term security, whereas the latter offersa return determined, approximately, by the average ofthe yields on the short-term security over the invest-ment horizon.20 Substitution between the two strate-gies tends to keep the expected returns from the twostrategies close to one another, although not exactlyequal because of differences in risk (discussedbelow).

Yields on short-term Treasury securities are impor-tantly influenced by monetary policy decisions by theFederal Reserve. Under current operating procedures,the Federal Reserve sets a target level for the federalfunds ratethe rate at which depository institutionsmake uncollateralized overnight loans to one another.Yields on short-term securities do not deviate sub-stantially from that rate because the institutions areable to substitute between making short-term loans inthe federal funds market and purchasing Treasurysecurities having very short maturities.21

Longer-term yields, because they reflect expecta-tions of future short-term yields, can be significantlyinfluenced by the outlook for monetary policy. For

18. Cheryl L. Edwards, Open Market Operations in the 1990s,Federal Reserve Bulletin, vol. 83 (November 1997), pp. 85974.

19. The vast literature on the yield curve includes alternativeversions of the expectations hypothesis as well as many criticisms.This article merely notes a general relationship between longer-termyields and expectations about future short-term interest rates withouttaking a stand on any particular variant of the expectations hypothesis.

20. Rates on longer-term Treasury securities are actually related toa weighted average of future short-term rates, where the pattern of theweights is determined by the size of the coupon payment on thelonger-term instrument.

21. The relationship between yields on short-term Treasury securi-ties and the federal funds rate is not exact, in part because ofdifferences in tax treatment and credit risk.

6. Yield curve for Treasury securities, September 23, 1999

0 5 10 15 20 25 30Years to maturity

5.0

5.2

5.4

5.6

5.8

6.0

6.2

6.4

Yield to maturity (percent)

Old twenty-year bonds

Recently issued securities



example, the yield curve was very steep on Febru-ary 2, 1994, prior to a sequence of monetary policytightenings that hiked the federal funds rate target3 percentage points over the next twelve months(chart 7). In contrast, on June 16, 1989, yields onlong-term bonds were below those on short-termsecurities before a sequence of policy easings that cutthe target federal funds rate about 312 percentagepoints over the subsequent twenty-four months.

Some differences in yields on Treasury securitiesare not related to expected future movements in inter-est rates. These differences for the most part reflectcompensation for risk and are often referred to asterm premia. Although they are viewed as free ofdefault risk, Treasury securities involve interest raterisk, as movements in their yields generate capitalgains or losses for investors.22 The uncertainty sur-rounding the return from holding a Treasury security

depends on the amount of variation in the yield onthat security and on the sensitivity of the price of thesecurity to changes in yields. The latter is determinedby the duration of the security, which is given by amathematical formula that summarizes how far intothe future, on average, the payments of a security areto be made. The duration of a zero-coupon bond,because it makes only a single payment, equals itsmaturity. The duration of a coupon-bearing security,because it makes coupon payments before it matures,is less than its maturity.

Longer-term bonds tend to have more interest raterisk because they have longer duration. Intuitively,the price of these securities must change more for agiven change in yield because the change in yieldmust be realized over a longer period. The effects oflonger duration are evident in table 3, which presentssome summary statistics on yields and one-monthholding returns (including coupon payments andcapital gains or losses) for securities with differ-ent maturities. Yields tend to vary less as the securi-tys maturity increases, indicating (according to theexpectations hypothesis) that many of the movementsin shorter-term yields are expected to be transitory.However, this pattern is more than offset by differ-ences in the duration of the securities, so that overthe period considered, the standard deviation of theholding return for the thirty-year bond was nearlyfive times greater than that for the two-year note.Because investors typically demand a premium forbearing additional risk, longer-term Treasury securi-ties, on average, offer higher yields than shorter-terminstruments.23 Indeed, for this sample the average

22. Some of the movements in yields may occur in response toexpected changes in inflation. Unexpected movements in inflation thatare not reflected in Treasury yields also present a risk to investors byeroding the purchasing power of the returns on the security. The riskspresented by inflation are discussed in more detail in the section oninflation-indexed securities.

23. The amount of variation in holding returns is not necessarilythe measure of risk considered by investors. Most finance modelsindicate that the covariance of holding returns with the returns onother assets or with changes in consumption determines the riskpremium on an asset.

7. Yield curve for Treasury securities

0 5 10 15 20 25 30Years to maturity

8

9

10

June 16, 1989

3

4

5

6

7

Yield to maturity (percent)

February 2, 1994


3. Characteristics of selected Treasury securities,December 1987September 1999

Security

Average Standard deviation

Duration(years)

Yield(percent)

One-monthchange in

yield(basis points)

One-monthholdingreturn1

(percentagepoints)

Two-year note . . . . . 1.81 6.24 30.2 1.93

Five-year note . . . . . 4.29 6.72 29.9 4.27

Ten-year note . . . . . 6.91 7.03 26.9 6.43

Thirty-year bond . . 11.95 7.34 23.1 9.39

Note. Data are for the most recently issued security in each maturity class.1. Standard deviation of monthly holding returns expressed at an annual rate,

assuming that monthly returns are independent across time.Source. Federal Reserve Bank of New York; authors calculations.


yield on the thirty-year bond was more than a fullpercentage point higher than that on the two-yearnote. In general, the greater risk of holding longer-term securities imparts an upward-sloping shape tothe yield curve.

The expected return from holding a Treasury secu-rity depends not only on the level of its yield but alsoon the volatility of its yield. The reason is that theincrease in the price of the security resulting from adecline in its yield is greater in magnitude than thedecrease in the price resulting from a equal-size risein its yield. If the uncertainty surrounding futureyield changes is symmetric, potential capital gainswill exceed potential capital losses, increasing theexpected return. As a result, the yield on a Treasurysecurity can fall below its expected return by theamount that is gained from the imbalance in potentialreturns. The magnitude of this effectoften referredto as the convexity premiumincreases with thesecuritys maturity. The convexity premium is oftenthought to add curvature to the shape of the yieldcurve by pushing down longer-term yields more thanshorter-term yields.

Factors AffectingIndividual Treasury Securities

Although the factors described in the preceding sec-tion largely determine the overall shape of the yieldcurve, there is also considerable variation among theyields on individual Treasury securities having simi-lar maturities. Some of this variation reflects addi-tional characteristics of the Treasury market thataffect the yields of particular securities.

Liquidity

Overall, the Treasury market is extraordinarily liquid.Enormous amounts of securities are traded every day.Even counting only the transactions of the primarydealers, the value of the entire stock of marketableTreasury debt would turn over completely in aboutthree weeks. The considerable trading volume allowsmarket participants to move in and out of largeTreasury positions rapidly with little effect on theprices of those securities. Because of the extensivetrading and the high degree of competition and trans-parency among dealers, dealers typically make mar-kets in Treasury securities at narrow bidofferspreads. Bidoffer spreads for Treasury securities arereported to be 1.6 or less per $100 face value. Bycomparison, bidoffer spreads for investment-grade

corporate bonds average about 13.3 and for high-yield corporate bonds, 19.1.24

The liquidity of the Treasury market is not evenlydistributed across securities, however. Most of thetrading activity takes place in on-the-run issuesthemost recently issued securities in a particular matu-rity class. The difference in trading volume betweenon-the-run securities and previously issued (off-the-run) securities is striking. In recent years, more thanhalf of reported interdealer broker trading in nominalTreasury debt, on average, took place in on-the-runsecurities, even though off-the-run issues outnum-bered on-the-run issues more than twenty to one.25

Because of the remarkable liquidity of on-the-runTreasury securities, some investors are willing to paya premium for (that is, accept a lower yield for) thosesecurities compared with similar, off-the-run securi-ties. The preference for liquidity was evident in thenumber of securities trading at yields that deviatedfrom the rest of the yield curve on September 23,1999 (chart 6). Yields on recently issued five-, ten-,and thirty-year securities were well below those onoff-the-run securities with similar maturities. In con-trast, some securities traded at yields notably abovethe curve, including long-ago-issued twenty-yearbonds that are much less liquid.26 At times, the mar-kets preference for liquidity becomes acute, andspreads between on-the-run and off-the-run issueswiden appreciably, as observed during the marketturmoil in fall 1998 (see box The Flight to Qualityand Treasury Yields).

Hedging Demand

Treasury securities are also commonly used as hedg-ing instruments, primarily to offset the interest raterisk inherent in positions in other fixed-income secu-rities. Dealers often have positions in other fixed-income products, including corporate debt securitiesand mortgage-backed securities, arising in part fromtheir role in issuing and making markets in suchsecurities. Dealers may also choose to establish large

24. Figures for corporate debt securities are from G. Hong andA. Warga, An Empirical Study of Bond Market Transactions,Financial Analysts Journal (forthcoming).

25. Volume data are collected by GovPX, a joint venture ofprimary dealers and some interdealer brokers that reports data ontransactions taking place through five of the six interdealer brokers.Reported trading volume primarily captures dealer-to-dealer trades.Retail and institutional investors may trade off-the-run issues ingreater proportion than dealers.

26. Market participants may also be reluctant to hold the twenty-year bonds because institutional considerations may make it lessappealing to purchase securities that have coupon rates well abovecurrent yields.


positions in nonTreasury fixed-income products aspart of their portfolio strategies.

To hedge the interest rate risk associated with thosepositions, dealers frequently take short positionsin Treasury securities. As described in more detailbelow, the short position is established by sellingsecurities that the dealer does not own but insteadborrows, with the intention of purchasing those secu-rities at a later time. By doing so, the dealer profitsif yields rise, which could offset some of thelosses incurred in long positions in other fixed-income securities.

Several characteristics of Treasury securities makethem well suited for hedging positions in other fixed-

income products. Probably most important is theirremarkable liquidity. Because their balance sheetpositions can change rapidly, dealers want to be ableto quickly alter their holdings of the hedging instru-ment in order to maintain the proper hedges. There-fore, a preferred hedging instrument is one that canbe traded quickly and at little cost. A second char-acteristic is that dealers can readily establish shortpositions in these instruments at reasonable costsbecause the repo market in Treasury securities isactive (discussed in the next section).

Of course, Treasury securities and their derivativesdo not offer a perfect hedge against movements in thevalue of other types of debt instruments. This became

The Flight to Quality and Treasury Yields

Treasury securities generally have lower yields than otherfixed-income products because of their safety and liquidity.At times, the markets concern about risk and liquidity hasbecome pronounced, resulting in a flight to quality intoTreasury securities despite their lower yields.

Such a flight occurred in the fall of 1998. After thedevaluation of the Russian ruble in August of that year andsubsequent difficulties in other emerging-market econo-mies, investors aversion toward risk appeared to intensify.That sentiment was reinforced by the prospect of a defaultby Long-Term Capital Management, a prominent hedgefund that in August and September had sustained sharplosses from its investment positions. By generating sizablelosses for the firms counterparties and forcing the abruptunwinding of the firms extensive positions in the Treasuryand other markets, a default could have significantly dis-rupted markets.1

Liquidity in many markets declined sharply over thisperiod, with bidoffer spreads widening and large transac-tions becoming more difficult to complete. Anecdotalreports suggest that bidoffer spreads on Treasury securitieswidened from their normal levels of 1.6 or less per $100 toas high as 16 for on-the-run issues and 25 for off-the-runissues. Moreover, investors showed a dramatic preferencefor the greater liquidity offered by on-the-run issues. Yieldspreads between the most recently issued and second mostrecently issued securities (the liquidity premium on on-the-run securities) widened sharply, as investors were willing tohold the more liquid securities at lower yields (chart).

The increased concern about liquidity and the reducedwillingness of investors to bear risk also caused a wideningof spreads between other fixed-income securities and Trea-sury securities. The widening affected even highly rated

1. Hedge Funds, Leverage, and the Lessons of Long-Term Capital Man-agement, Report of the Presidents Working Group on Financial Markets(April 1999).

debt. Market strains began to subside following the FederalReserve intermeeting policy easing on October 15, 1998.Soon thereafter, bidoffer spreads on Treasury securities,premiums for on-the-run issues, and yield spreads betweengovernment-sponsored enterprise and Treasury securitiesbegan to decline.

1998 1999

80

100

120

140

Yield spread on AA corporate bond indexover on-the-run ten-year Treasury note

4

8

12

Indicators of increased concern about liquidity and risk

Basis points

Liquidity premium on on-the-run five-year Treasury security

NOTE. Data are daily and extend through October 1999.SOURCE. Bloomberg.


apparent in the fall of 1998, when investors becameincreasingly concerned about the safety and liquidityof their investments.27 The ensuing flight to qual-ity (see box) pushed down yields on Treasury secu-rities sharply relative to yields on corporate andmortgage-backed debt securities (some of whichactually rose), generating large losses in short posi-tions in Treasury securities that were not offset bygains in other fixed-income securities. Since thattime, market participants have evinced an increasingreliance on nonTreasury securities for their hedg-ing needs, including debt issued by government-sponsored enterprises.

Related Markets

The demand for Treasury securities is also impor-tantly affected by the markets for repurchase agree-ments and derivatives.

Repurchase Agreements

Dealers and other investors often establish short posi-tions in Treasury securities as part of their hedgingactivity or, more generally, as part of their portfoliostrategies. To establish short positions, they sell secu-rities they do not own and deliver those securities tothe purchaser by obtaining them in the market forrepurchase agreements, the repo market.

The repo market allows participants to exchangefunds and securities on a temporary basisin effect,borrowing and lending using Treasury and other debtsecurities as collateral. More specifically, a firmengaging in a repo transaction simultaneously sells aparticular security to a counterparty and agrees torepurchase that same security at a specified price at alater date, often the next day. This firm is said torepo out the security, by which it borrows moneyat what is called the repo rate, which is based on thedifference between the current price and the agreed-tofuture price. A reverse repo is simply the other sideof the transactionagreeing to purchase particularsecurities temporarily and to resell them to the samecounterparty at a specified price at a later date. In thiscase, the firm reverses in the security.

Investors can therefore deliver securities that theysold short by reversing in the securities repeatedlyuntil they decide to cover the position by purchasing

the securities outright. On the other side, investorsfrequently rely on the repo market to finance theirlong positions in Treasury securities by repoing outthose securities. Partly as a result of these activities,trading volume in the repo market is heavy: Primarydealers reported about $1.2 trillion of lending andborrowing in the repo market on their balance sheetsas of October 20, 1999.

Most repo transactions involving Treasury securi-ties take place at what is called the general-collateralrepo rate. This interest rate typically follows thefederal funds rate closely, as depository institutionscan use either market as a source of overnight financ-ing.28 However, if the demand for a particular Trea-sury security in the repo market is sufficiently high,or if the supply of that security is limited, the reporate for that security can fall below the general-collateral repo rate. In such a case, the security is saidto go on special in the repo market. The firmreversing in the desired security is willing to pay acost to obtain that security by letting the holder of thesecurity borrow at an interest rate below the generalmarket rate.

This situation frequently arises in on-the-run Trea-sury securities, as these issues are heavily used inestablishing short positions for hedging and otherpurposes, resulting in considerable demand for themin the repo market. The repo rate for the on-the-runten-year note has often fallen several percentagepoints below the general-collateral repo rate (chart 8).Researchers have found that the specialness of anon-the-run issuethe difference between its repo rateand the general-collateral ratetends to build follow-ing an auction as a larger proportion of the issuecomes to be held by investors who do not make thesecurity available to the repo market. The specialnesstypically peaks around the announcement of the nextauction, after which it declines as short positionsbegin to shift to the next on-the-run issue.29 In addi-tion to this regular pattern, other factors influencethe specialness of these securities. For example,increased hedging activity around periods of heavyissuance of corporate debt or mortgage-backed secu-rities can lead to sizable short positions that causeparticular securities to go on special in the repomarket.

Securities that are on special in the repo marketfrequently trade at lower yields (higher prices) than

27. A Review of Financial Market Events in Autumn 1998, Com-mittee on the Global Financial System, Bank for International Settle-ments (October 1999).

28. The main difference between the transactions is that a repotransaction is akin to a collateralized loan, whereas a federal fundstransaction is an uncollateralized loan.

29. Frank Keane, Repo Rate Patterns for New Treasury Notes,Federal Reserve Bank of New York, Current Issues in Economics andFinance, vol. 2 (September 1996).


other securities with comparable maturities, as isoften the case for on-the-run Treasury securities.30 Ifa security is on special in the repo market, holderscan realize a profit by borrowing against the securityat below-market rates; because this profit increasesthe return on the security for a given yield, investorsmay be willing to hold the security at a lower yield.However, investors that value the greater liquidity ofon-the-run securities may be willing to hold themwithout repoing them out despite their lower yields.

The patterns observed around Treasury auctions,which reflect the activity associated with bringingnew issues to market, account for a significant por-tion of the movements in yields and repo rates for themost recently issued securities. However, extensivespecialness in the repo market has at times alsosignaled severe shortages of particular Treasury secu-rities that have disrupted the effective functioning ofthe market for those securities. Several such short-ages took place around the time that Salomon Broth-ers admitted in 1991 to repeated violations of Trea-sury auction rules. In response, several regulatoryand policy changes were implemented to preventviolations of auction rules and to alleviate suchshortages if they develop (see box RegulatoryReforms).

To facilitate transactions in the repo market, theFederal Reserve Bank of New York operates a securi-ties lending program that allows primary dealers toborrow individual Treasury securities from the Fed-eral Reserves portfolio overnight by posting a differ-ent Treasury security as collateral. The program uses

a competitive auction format. Under the current struc-ture, initiated on April 26, 1999, the Bank conducts adaily auction at which it accepts bids in terms of alending fee for borrowing particular securities.When a bid is accepted, the particular security isdelivered to the dealers account. The dealer, in turn,delivers a different Treasury security to the FederalReserve as collateral and pays the lending fee. Thelending fee is closely related to the spread betweenthe general-collateral repo rate and the repo rate forthe borrowed security, because from the dealersperspective the transaction is similar to repoing outa (general-collateral) security and reversing in thedesired security. The minimum bid is 150 basispoints, high enough that borrowing activity is limitedto those securities that are scarce, and hence deeplyon special, in the repo market.

The Federal Reserves portfolio of Treasury securi-ties as of October 31 of this year totaled $492 billion.By making a portion of these holdings available forborrowing, the securities lending program increasesthe potential supply of Treasury securities availableto the repo market, which should help reduce thescarcity of particular issues. The Federal Reserveoriginally stood ready to lend up to 25 percent of itsholdings of any security but on September 7, 1999,increased the limit to 45 percent. Over the twomonths following the increase, dealers borrowed anaverage of about $1.4 billion of Treasury securities,typically distributed across several different securi-ties, every business day.

Derivatives

A large and active market exists for derivative securi-ties whose values are based on the prices of Treasury

30. For a discussion of the repo market and its effects on Treasuryyields, see Darrell Duffie, Special Repo Rates, Journal of Finance,vol. 51 (June 1996), pp. 493526.

8. Overnight repo rates for Treasury securities, 199599

1996 1997 1998 1999

2

4

6

Percent

General-collateral security

Ten-year on-the-run security

Note. Data are daily and extend from November 7, 1995, to October 22,1999.



securities. Futures and options contracts for two-,five-, and ten-year notes and for bonds are listed bythe Chicago Board of Trade (CBOT), and similarfutures contracts are offered on the Cantor FinancialFutures Exchange. In addition, the Chicago Mercan-tile Exchange offers options and futures on variousTreasury bills and other short-term interest rateproducts.

As of the end of October 1999, open interest forCBOT long-bond futures (that is, the total number ofcontracts held by market participants) was about635,000, with each contract based on $100,000 facevalue of the Treasury bond. Daily trading volume inthese contracts over the month averaged about300,000 contracts. The CBOT also offers trading inoptions on Treasury futures (contracts that allow the

Regulatory Reforms Following Violations of Auction Rules by Salomon Brothers

Following the April and May 1991 Treasury auctions, sev-eral widely publicized short squeezes occurred in thetwo-year note during which an apparent scarcity of thesecurities caused their yields and repo rates to fall substan-tially below those for other Treasury securities. The infor-mation available to the Treasury suggested that the Maysqueeze had resulted from a concentration of auction awardsto Salomon Brothers and some of its customers. In addition,there had earlier been inquiries into several Salomon Broth-ers bids at the February 1991 auction of the five-year notethat appeared to violate the rule limiting the amount bid bya single bidder to 35 percent of the publicly offered amount.

These events prompted investigations by the Securitiesand Exchange Commission (SEC) and the Antitrust Divi-sion of the Department of Justice, leading Salomon Broth-ers to conduct its own investigation. In August 1991, thefirm admitted to submitting unauthorized customer bids atseveral auctions in 1990 and 1991 and to failing to reportlarge net long positions on auction tender forms as required.Subsequently, the Treasury, the SEC, and the FederalReserve jointly reviewed the government securities marketand issued a report describing a number of policy andregulatory changes aimed at improving the functioning ofthe market and avoiding such violations in the future.1

Some of the reforms were implemented immediately, andothers were recommended for legislative approval.

Many of the reforms were intended to make Treasuryauctions accessible to more participants. The set of firmsallowed to submit bids for customers was broadened toinclude all government securities brokers and dealers,not just primary dealers and depository institutions. Therequirements for becoming a primary dealer were loosenedby eliminating the rule that to qualify the dealer mustaccount for at least 1 percent of the dollar volume of allcustomer trades in the secondary market. In addition, themaximum for noncompetitive tender awards for notes andbonds was raised from $1 million to $5 million; however, toensure that noncompetitive awards were reserved for thesmaller bidders for whom they were intended, noncompeti-tive bids were restricted to bidders having no positions inthe when-issued, futures, or forward markets at the time ofthe auction and not submitting competitive bids.

1. Joint Report on the Government Securities Market (Washington, DC:Government Printing Office, January 1992).

Other changes were aimed more directly at the enforce-ment of auction rules. Customer bids are now spot-checkedby the Federal Reserve Bank of New York to ensure theirauthenticity, and all large auction awards are now confirmeddirectly with the customer. The report also emphasized theneed to automate the auction procedure, which has sincetaken place.

The report also considered the benefits of replacing thethen-current multiple-price auction system for notes andbonds with a uniform-price system, under which all success-ful bidders would be awarded securities at the lowest price.The report suggested that such a change might alleviatesome concern among auction participants about biddingabove the market consensus. Consequently, more investorsmight bid on their own rather than through primary dealers,reducing the primary dealers advantage at the auctions thatarises from knowing the bidding intentions of their custom-ers. The Treasury subsequently began an experiment withthis auction method for two- and five-year notes. ByNovember 1998, all Treasury securities were being auc-tioned on a uniform-price basis.

In addition, some changes were implemented to detectand respond to short squeezes in the secondary market. Agroup made up of representatives of the SEC, the Treasury,the Federal Reserve Bank of New York, and the Board ofGovernors of the Federal Reserve System was establishedto improve surveillance efforts. The Treasury stated itsintention to reopen any security that was experiencing anacute, protracted shortage in order to increase the supplyof the security. The reopening could be implemented inseveral different ways, one of which is to immediatelyauction an amount sufficiently large to eliminate the possi-bility that the squeeze would persist.

Finally, the Congress enacted the Government SecuritiesAct Amendments of 1993. Among other provisions, theamendments give the Treasury the authority to requireholders of large positions in a particular security to reporton their positions if a shortage emerges. The Treasury hasconducted two tests of the reporting system, one in June1998 and the other in July 1999. In both cases, the Treasuryrequired investors with reportable positions in excess of$212 billion in the specified security to file large-positionreports.


holder to buy or sell a futures contract at a specifiedprice). For options on long-bond futures, open inter-est totaled about 950,000 contracts and daily tradingvolume averaged about 130,000 contracts. Becauseof the liquidity of this market, combined with theease with which investors can establish short posi-tions by selling futures contracts, these instrumentsare also commonly used for hedging purposes.

The seller of a CBOT Treasury futures contractagrees to deliver a Treasury security to the purchaserof the contract at a specified price at a future date.Most positions in these futures contracts are closedout prior to delivery by entering into offsetting trades,and delivery does not take place. However, the possi-bility of delivery links the price of the contract tothe deliverable Treasury securities. Typically, severalsecurities are eligible for delivery into the contract.31

The long-bond futures contract, for example, allowsany Treasury bond with more than fifteen yearsremaining to maturity at the expiration of the contractto be delivered (for the March 2000 contract, thirty-five such securities are eligible).

One of the securities eligible for delivery is thecheapest to deliver. That is, the cost to the seller ofthe futures contract of purchasing the security tomake delivery will be lower than the cost of deliv-ering any other eligible security. The price of thecontract is influenced primarily by the value of thecheapest-to-deliver security. Moreover, the cheapest-to-deliver status has at times significantly affected theyield of that Treasury security. In particular, thecheapest-to-deliver security is often traded moreactively as market participants hedge their futuresposition, which enhances the securitys liquidity.Because of this enhanced liquidity and because someinvestors may need to purchase the security to makedelivery into the futures contract, the cheapest-to-deliver security may trade at a premium to Treasurysecurities having similar maturities.

RECENT DEVELOPMENTSAFFECTING THE MARKET

The structure and behavior of the Treasury market iscontinually changing. Some of the developments andemergent trends that have recently influenced themarket are discussed in this section.

Availability of a New Instrument:Inflation-Indexed Securities

A significant innovation in the Treasury market inthe past several years has been the introduction of anew type of debt instrument: Treasury inflation-indexed securities, or TIIS.32 Since the programsinception in January 1997, about $92 billion of TIIShave been issued.33 Unlike previously issued Trea-sury securities, the coupon and principal paymentson TIIS increase with a measure of the general pricelevelthe consumer price index (CPI). Indexationprovides protection against the possibility that infla-tion will erode the amount of goods and services thatcould be purchased with the interest or principalpayments.

The Mechanics of TIIS

Whereas the principal amount of a nominal Treasurysecurity remains fixed in nominal terms, the principalamount on a TIIS adjusts over time by the rate ofinflation. The value of the principal on a given dayis calculated by multiplying the principal amountat issuance by a daily index ratio determined by areference CPI for that day divided by the referenceCPI on the day of issue. The reference CPI is basedon the nonseasonally adjusted CPI lagged about twoand one-half months, as published by the Bureau ofLabor Statistics (BLS).34

If the average rate of inflation is positive, theprincipal amount of the TIIS generally rises over thelife of the security.35 Coupon payments will alsoincrease in line with the rate of inflation, as coupon

31. Eligible securities trade at a premium or a discount to facevalue simply because of differences in their coupon rates. To adjustfor this effect, the CBOT contract scales the invoice amounttheamount that the investor who is long the futures contract must payupon receiving an eligible securityby a conversion factor for thatsecurity.

32. Several government-sponsored enterprises, corporations, andlocal governments followed the Treasurys lead by issuing indexeddebt in early 1997. In addition, the Treasury began selling inflation-indexed savings bonds, called I-bonds, in September 1998.

33. When adjusted for the accrual of inflation compensation, thetotal amount of TIIS outstanding is higher than this amount.

34. Specifically, the CPI refers to the nonseasonally adjusted U.S.City Average All Items Consumer Price Index for All Urban Consum-ers. The reference CPI for the first day of a given month is the CPIreported for the third preceding calendar month, and the reference CPIfor days over the rest of the month is a weighted average of thereference CPI figures on the first days of the current month and thefollowing month. The lag involved in calculating the index ratio isunavoidable because the monthly CPI is released with a lag and thereference CPI for the beginning of the following month must beknown.

35. A period of deflation could decrease the principal amount ofthe TIIS. However, the TIIS program provides that the cumulativeadjustment to the principal amount at the maturity of the security maynot be negative.


payments on TIIS are determined by the specifiedcoupon rate multiplied by the principal amount. Thequoted prices of TIIS do not reflect the accumulatedamount of inflation compensation; the value of thesecurity exchanged when a TIIS is traded is thequoted price multiplied by the current index ratioplus the amount of accrued interest.

TIIS do not offer perfect protection against infla-tion risk, for several reasons. First, TIIS holders facesome inflation risk because of the lag involved incalculating the reference index. Second, holders paytaxes on inflation compensation, so the degree ofinflation protection is reduced by an investors taxrate.36 In addition, TIIS holders face some risk thatthe method used to calculate the CPI will change.37

The BLS has implemented several methodologicalchanges in recent years, partly in response to recom-mendations by the Boskin Commission, an advisorygroup appointed to study the CPI. Some market par-ticipants estimate that these changes have shavedabout 0.7 percentage point from the indexs annualrate of growth. Such a reduction directly affects therate at which payments on TIIS increase, and hencethe value of TIIS. The risk of additional changes inthe method of calculating the CPI may result in a riskpremium in TIIS yields; however, many market par-ticipants believe that most of the likely changes havealready been implemented.

The Potential Appeal of TIIS

The protection against inflation provided by TIIS,previously unavailable in the Treasury market, maybe valued by investors, who tend to be concernedabout real rates of return (that is, about the amount ofgoods and services they will be able to purchase withthe payments from a security). Because the paymentsautomatically adjust to compensate for inflation, theyield on an inflation-indexed security reflects the realrate of return that would be realized over the maturityof the security. The yield on a nominal security, incontrast, includes not only the anticipated real returnon the security, but also compensation for inflation.This inflation compensation includes the expected

level of inflation as well as an inflation risk premium,as described below.

By holding an inflation-indexed security to matu-rity, an investor can lock in a long-term real rate ofreturn, a strategy that may be appealing to investorswith long investment horizons. Investors with shorterhorizons also can protect themselves against inflationby holding TIIS, although they are subject to realinterest rate risk; that is, changes in TIIS yields willgenerate capital gains or losses that depend on theduration of the security.

However, the risks from holding TIIS are likely tobe smaller than those from holding nominal Treasurysecurities. In addition to real interest rate risk, returnson nominal securities are subject to the risks pre-sented by unpredictable changes in inflation. Anincrease in expected inflation, for example, typicallycauses yields on nominal Treasury securities to rise(assuming that investors demand the same real returngoing forward), generating capital losses for currentinvestors. In contrast, TIIS would maintain the samereal return without a change in yields, and thus hold-ers of TIIS would not suffer any capital losses.38 Byeliminating this inflation risk, TIIS may offer morestable real returns than nominal Treasury securities.

Thus, investors may demand a higher expected realreturn on nominal Treasury securities than on TIIS tocompensate them for the additional risks of holdingthose securities.39 By issuing indexed debt, the gov-ernment, rather than the investor, assumes the risksassociated with unpredicted changes in inflation andtherefore does not have to pay this inflation riskpremium to the investor, which may lower the gov-ernments cost of borrowing.

An additional benefit of issuing TIIS, it has beenargued, is that yields on indexed debt might providepolicymakers with a timely and informative measureof market expectations about real interest rates. Inthat case, the difference between yields on TIIS andyields on nominal Treasury securitiesthe measureof inflation compensation on nominal securitiesmay contain valuable information about investorsoutlook for inflation. This measure of inflation com-pensation reflects primarily the expected level ofinflation over the maturity of the instruments plus the

36. This effect is inconsequential if TIIS are held in nontaxableaccounts. The taxation of the inflation compensation on TIIS iscomparable to that for nominal Treasury securities, on which theinflation compensation (embedded in the coupon rate) is also taxed.

37. If the CPI is discontinued or substantially altered in a mannerthat is deemed materially adverse to the interests of an investor, theTreasury, in consultation with the BLS, will substitute an appropriatealternative index. However, incremental improvements in the CPI donot receive special treatment.

38. In addition, TIIS protect investors from unexpected changes ininflation that are not reflected in nominal yields. Such changes wouldnot generate capital losses on nominal Treasury securities but wouldstill erode the real returns on those securities.

39. The measure of risk considered here is the variation in realreturns. Investors may instead be concerned about the covarianceof returns with the returns on other assets or with changes inconsumption.


inflation risk premium, but it may also be influencedby differences in the liquidity of the securities.40

The possibility that interest costs may be lower,along with potential attendant benefits, may explainwhy a growing number of countries are issuingindexed debt. Canada and France have launched newprograms over the past decade, and a number of othercountries, some with high and variable levels of infla-tion, had established indexed debt programs muchearlier. The United Kingdom implemented its pro-gram in 1981, and as of September 1999 indexedgilts represented about 22 percent of all outstandingU.K. government debt.41 By comparison, TIIS repre-sented about 3 percent of all marketable U.S. govern-ment debt at that time. However, because of the sizeof the U.S. Treasury market, the dollar amount ofTIIS outstanding is approaching the dollar-equivalentamount of outstanding indexed gilts.

Market Activity in TIIS

To date, the Treasury has issued six inflation-indexedsecuritiesone five-year note, three ten-year notes,and two thirty-year bonds. Each issue has beenreopened once, leaving its total size roughly between$14 billion and $16 billion. Currently, the Treasuryissues only ten- and thirty-year TIIS, alternatingbetween the two maturities at auctions in the firstmonth of every quarter.

Activity in the secondary market for TIIS hasremained moderate relative to comparable nominalissues. According to data for primary dealers col-lected by the Federal Reserve Bank of New York,daily trading volume in TIIS over the second quarterof 1999 averaged about 1.7 percent of TIIS outstand-ing, compared with about 5.0 percent for nominalTreasury notes and bonds. The more limited activityin TIIS may reflect the nature of these securities:They provide safe, stable long-run returns and maytherefore appeal to investors who are less inclined totrade their holdings actively.

Other measures suggest that TIIS are somewhatless liquid than off-the-run nominal Treasury securi-ties.42 Discussions with some primary dealers indi-cate that bidoffer spreads on TIIS, in terms of prices,are typically about 1.6 to 6.3 per $100 face value.

This spread is somewhat wider than bidoffer spreadsfor nominal Treasury securities, which are reportedly1.6 or less, but it is much narrower than bidofferspreads for corporate bonds.

According to market participants, liquidity in theTIIS market is gradually improving. Aside from thepickup in volume during the market turmoil in thethird quarter of 1998, the volume of TIIS transactionsamong primary dealers reported to the New YorkReserve Bank has been about 26 percent higher in1999 than in 1998, whereas the volume in nominalTreasury coupon securities has declined 12 percent.TIIS volume is concentrated around the auctioncycle: Over the past four auctions, average dailyvolume during the four weeks after the announce-ment of an auction has been 92 percent higher thanthat during other weeks. Although the Chicago Boardof Trade offers options and futures contracts on TIISsimilar to those on other Treasury securities, marketactivity has been negligible.

Yields on TIIS

The first TIIS issued, a ten-year note, was auctionedon January 29, 1997, at a yield of 3.45 percent. Sincethen, the yield on the ten-year TIIS has generallyrisen to the current level above 4 percent (chart 9).Over that period, the yield on TIIS has been lessvolatile than that on the nominal ten-year security.On an average day, the ten-year TIIS yield changedless than 112 basis points, compared with more than4 basis points for the nominal security. In addition,the yield on the nominal security has moved in amuch wider range of about 212 percentage points,compared with about 34 percentage point for the TIISyield.

The spread between these yieldsthe inflationcompensation on the ten-year nominal Treasurynotefell over 1997 and the first half of 1998, alongwith the actual rate of CPI inflation and a surveymeasure of long-run inflation expectations amongprofessional forecasters. However, the decline ininflation compensation was more dramatic than thatof the survey measure, suggesting that some of thenarrowing of the yield spread may have been drivenby a decline in the inflation risk premium.

Relative changes in yields may also be explainedin part by differences in the liquidity of nominalsecurities and TIIS. In the fall of 1998, yields onnominal Treasury securities dropped sharply, pushingten-year inflation compensation as low as 69 basispoints. This dramatic narrowing of the yield spread,though it may have partially reflected a change in the

40. Differences in duration and convexity between TIIS and nomi-nal securities may also affect the yield spread.

41. Quarterly Gilts Review: 3rd Quarter 1999, United KingdomDebt Management Office (October 1999).

42. No distinction is made between on-the-run and off-the-run TIISbecause there are no large differences in liquidity between thosesecurities, as is the case with nominal Treasury securities.


outlook for inflation, was undoubtedly driven by ashift in investors preferences toward more-liquidassets, particularly on-the-run nominal Treasury secu-rities. Inflation compensation returned to higher lev-els in 1999 as the demand for liquidity lessened andinflation expectations rose.

TIIS yields also appear to be significantly influ-enced by supply. In particular, seven of the fourteenlargest daily changes in the ten-year TIIS yield overthe period shown in chart 9 took place immediatelybefore or after TIIS auctions. The largest movementsin the ten-year nominal yields, by contrast, were all inresponse to either macroeconomic news or the reallo-cation into safe and liquid assets during the fall of1998.

Reduction in the Supplyof Nominal Treasury Debt

In response to the budget surpluses of the past twoyears, the Treasury has decreased its securities issu-ance enough to shrink the amount of marketable debtoutstanding. This development has several implica-tions for the Treasury securities market.

Developments in the Treasury Bill Market

After decades of increases, marketable Treasury debtoutstanding has decreased over the past two years.43

Because the issuance of Treasury bills has been cutmore sharply than that of Treasury coupon securities,the decline has not been evenly spread across thematurity spectrum (table 4). From December 1996 toSeptember 1999, total coupon securities outstandingdeclined about 7 percent whereas total bills outstand-ing decreased about 16 percent. In association withthe downtrend in supply, the average daily tradingvolume in bills reported by primary dealers declinedabout 44 percent over the period (chart 10). In con-trast, the average daily trading volume in nominalcoupon securities reported by primary dealers in Sep-tember 1999, though off its peak of fall 1998, wasonly about 2 percent below its level in December1996.

The decline in the amount of bills outstanding mayhave weakened the connection between yields onbills and those on longer-term Treasury securities.44

The spread between the six-month yield implied by asmoothed yield curve based on coupon securities andthe yield on the six-month bill has increased over thepast four years (chart 10). Although bills have typi-cally commanded higher prices (lower yields) thancoupon securities of similar maturities because oftheir greater liquidity, the recent increase in thespread is correlated with the decrease in the supply ofbills and could suggest a scarcity premium on bills.45

Two conflicting effects may have been at play in thebill market: The reduction in issuance may havemade bills

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