Treasury and Agency Security Markets

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					Treasury and Agency
Security Markets

   Fabozzi—Chapter 6
  Treasury and Agency Sectors
 Treasury Securities:
       Are debt instruments issued by the U.S. Department of the

        Treasury and are backed by the full faith and credit of the
        U.S. government--and thus are viewed as default risk-free
       The U.S. government is the largest single issuer of debt in

        the world.
       Treasury markets are one of the most liquid markets in the

       2
         nd largest bond market sector (behind mortgage sector).

 Federal Agency Securities:
      Debt instruments issued by federally related institutions and

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

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

         F = face value
         P = market price
         t = number of days until maturity
         Yd = annualized yield quoted on a bank discount basis
 The quote you get from a dealer is Yd, not P.
 Example of Bank Discount Quote
 A $100,000 face value T-bill has 100 days until
  maturity and sells for $99,100.
 What is the bank discount quote?

                       (or 3.42%)
 If you called for a quote on this T-bill, you would
  be given a quote of 3.24% (% discount from par).
  How to Find Price Given Yd
 If you got a quote of Yd, how do you find price?

 Solve for P:

 Example: A dealer gives you a quote of 3.68% on
  a $100,000 face value T-bill expiring in 90 days.
  What is the price of the T-bill?
  Bank Discount and Return
 Is the bank discount rate the rate of return on a T-bill?
 No…for two reasons:
     The bank discount rate is the annualized percentage

      difference between F and P using F as the base.
     It uses a 360 day year, not 365 as it should.

 The bank discount rate is not meaningful (or comparable
  to other securities) as a return.
 Two adjustments are often made to facilitate comparison:
          Bond equivalent yield—makes Yd comparable to non-
           discount bonds (this will give actual rate of return).
          CD equivalent yield –makes Yd comparable to quotes on
           other money market instruments.
Bank Discount Rate Adjustments

 Bond Equivalent Yield:

 CD Equivalent Yield: (see page 143)
Quotes on Treasury Bonds and Notes
 T-notes and T-bonds use different conventions
  than those used for T-bills. Look at examples:
 Example 1: A T-bond is quoted as 96-14:
        The ―96‖ is a percent of face value.
        The ―14‖ is the number of 32 nds added to 96.
        The quote would be 96 + 14/32, or 96.4375.
 Example 2: A bond is quoted as 96-14+
        The ―+‖ means add 1/64 th to 96-14
        The quote is 96 + 14/32 + 1/64 or 96.453125.
 Example 3: A bond is quoted as 96-142:
        The ―2‖ means add 2 256 ths to 96-14
        The quote is 96 + 14/32 + 2/256 or 96.4453125
More T-Note & T-Bond Conventions
 Accrued interest:
        When an investor purchases a bond between coupon
         payments, the buyer must compensate the seller for
         coupon interest earned since last coupon payment.
 Example:
        There are 183 days between coupon payments and
         the annual coupon is $8 per $100 of Par Value. The
         last coupon was paid 50 days ago.
        If you buy this bond, how much accrued interest
         must you pay to the seller?
Accrued Interest and Day Count
 Timeline of a T-bond transaction:
        Trade date: Date on which the transaction is
        Settlement date: Date on which the transaction is
         completed (payment made and ownership recorded).
        For T-bonds (and notes) settlement is the next
         business day after the trade date.
 To determine the number of days since last
  coupon payment:
        Count the number of days from last coupon payment
         up to, but not including, settlement date.
 Day Count Example
 A T-bond paid its last coupon on May 15. The next
  coupon will be paid on November 15.
 If the security is purchased on September 9, and settled
  on September 10. How many days are used for accrued
  interest calculation?
   Month         # Days    Note we counted May 15th, but
   May               17     we didn’t count September 10th.
   June              30
   July              31
   August            31
   September          9
   Total #Days      118
  Stripped Securities
 The Treasury does not issue zero-coupon bonds.
 However, there has been considerable demand for zero-
  coupon bonds with no credit risk.
 To meet demand, dealers in the private sector began
  stripping Treasury securities in 1982.
 In 1985, the U.S. Treasury began its STRIPS program to
  facilitate the stripping of U.S. Treasury securities:
         Today, all T-notes and T-bonds are eligible for stripping.
         All zeros created under the STRIPS program are considered
          direct obligations of the U.S. government.
         Securities created under the STRIPS program are cleared
          through the Federal Reserve’s book-entry system.
 How A Bond is Stripped
 Suppose a dealer has $500,000,000 of a 10-year
  5% coupon Treasury note.
 This note has 21 cash flows:
        Twenty $12,500,000 cash flows come from coupons.
        One $500,000,000 cash flow is from the repayment of
         principal (called the corpus).
        These cash flows can be sold off in $1,000 face value
         zero coupon bonds.
 Strip quotes are denoted as:
        ―ci” if created from coupons (called coupon strips)
        ―bp‖ if created from bond principal, or ―np‖ if created
         from note principal (called principal strips).
 Tax Treatment of Strips
 As zero-coupon instruments, strips pay no
  interest until maturity.
 However, the U.S. government taxes the implied
  gain (called accretion) as ordinary income every
        This creates a negative cash flow which reduces the
         attractiveness of these securities.
 Treasury Inflation Protection
 Securities (TIPS)
 In 1997 the Treasury began issuing bonds that
  adjust for inflation:
         TIPS provide inflation protection for investors: the
          higher the inflation rate, the higher the TIPS interest
          payments become.
 TIPS pay a fixed coupon rate:
         The face value is adjusted based on the inflation rate
          (called inflation-adjusted principal)
         The face value is indexed to CPI for urban consumers
          (CPI-U), a price index for U.S. cities.
  TIPS Example
 Suppose the coupon rate on TIPS is 3.5% and the annual
  inflation rate is 3% (semiannual inflation rate = 1.5%).
         An investor purchases $100,000 (face value) of an issue on
          January 1.
 In June (when the coupon is paid), the face value is
  increased by the amount of the inflation, or $101,500.
         The coupon will be 0.0175  $101,500 = $1,776.25
 Suppose for the next six months the annual inflation rate
  is 2%. To find the next coupon (on December 31):
         Increase the face value by 1%, to $102,515.
         Given the semi-annual coupon rate of 1.75%, we get a coupon
          of 0.0175  $102,515 = $1,794.01
 Note: The U.S. government now taxes the inflation
  adjustment of TIPS, making them less attractive since they
  are less useful as an inflation hedge.
The Treasury Auction Process
 Treasury securities are sold in the primary
  market via sealed-bid auctions:
           Security         Frequency
           T-bill           Weekly
           2-year note      Monthly
           3-year note      Quarterly*
           5-year note      Monthly
           10-year note     Quarterly*
           30-year bond Quarterly*
         *Quarterly Auctions occur in February,
         May, August, and November
  The Treasury Auction Process
 The Treasury auction determines the yield at
  which an issue will be sold.
 Two types of bids are submitted, competitive and
 Competitive bidders are large government
  securities dealers and brokers:
         They ultimately determine the yield on the issue
          through the bidding process.
 Noncompetitive bidders are smaller investors:
 Noncompetitive bidders receive the stop out yield –
  highest yield bid accepted determined by the auction.
 The Treasury Auction Process
 Process:
       Competitive bidders request a specific quantity of a bond

        issue and the amount they are will to pay (equivalently,
        the yield they would be willing to receive).
       Bids are then arranged from lowest to highest yield.

       Quantities are filled beginning with the lowest yield and

        continue until the bond issue is completely allocated.
 The highest yield accepted by the Treasury is referred to
  as the stop-out yield or the high yield.
          Bidders bidding higher than the high yield receive no
           allocation of the bond.
 Noncompetitive bidders receive the stop out yield
  determined by the auction.
Federal Agency Securities

 Two types of agency issuers:
        Federally related institutions.
        Government Sponsored Enterprises (GSEs)
 Federally Related Institutions
 Arms of the federal government and usually do not issue
  securities directly in the marketplace.
 Examples:
          Tennessee Valley Authority (TVA)
          Export-Import Bank of the United States
          Farmers Housing Administration
          Private Export Funding Corporation (PEFC)
          Several others
 Typically exempt from SEC registration.
 Securities are usually backed by the full faith and credit
  of the U.S. Government (exceptions are TVA and PEFC).
          However, TVA has been major issuer of these types of
          Most federally related institutions do not issue securities.
Government Sponsored Enterprises
 Privately owned, publicly chartered enterprises
  created by congress to reduce the cost of capital
  for certain borrowing sectors of the economy.
        The sectors include: Farmers, homeowners, and
 Some of these organizations provide credit to the
  housing market.
        They do so by issuing both debentures and mortgage-
         backed securities.
        We will only discuss debentures in this chapter.
        Mortgage-backed securities will be discussed in later
Government Sponsored Enterprises

 Five major GSEs issue debentures:
       Federal National Mortgage Association (Fannie Mae)

       Federal Home Loan Mortgage Corporation (Freddie Mac)

       Federal Agriculture Mortgage Corporation (Farmer Mac)

       Federal Farm Credit Bank System (FFCBS)

       Federal Home Loan Bank System (FHLBanks)

 We will briefly discuss Fannie Mae and Freddie Mac.
 Fannie Mae
 Fannie Mae is a NYSE-listed company serving the U.S.
  mortgage industry:
          Provides banks and other mortgage lenders financing,
           credit guarantees, and other services to help lenders make
           more loans.
          Fannie Mae does not make home loans.
 To finance operations, Fannie Mae issues debt securities:
        Benchmark bills (3, 6, and 12-month maturities)

        Benchmark notes (2, 3, 5, 10-year maturities)

        Benchmark bonds (30-year maturity)

        Callable Benchmark Notes

        Subordinated Benchmark Notes

        Investment Notes (debt securities for individual investors)
 Freddie Mac
 Freddie Mac is a NYSE-listed company serving:
          Freddie Mac purchases mortgages from banks and bundles
           them together into a tradable security (securitization).
 To finance the purchase of its mortgages it issues the
  following types of debt:
          Reference Bills (maturities of 1 to 12 months)
          Reference Notes (maturities of 2 to 10 years)*
          Reference Bonds (maturities from 10 to 30 years)*
          Callable Reference Notes
          Euro Reference Notes (Euro denominated)
    *Eligible for stripping
 GSE Credit Risk
 With the exception of the Farm Credit Financial
  Assistance Corporation (FFCSB), GSE securities
  are not backed by the full faith and credit of the
  U.S. government.
 Thus, there is credit risk associated with GSE