Chapter 6 Government Securities
Government Securities • Treasury Securities • Federal Agency Securities • Municipal Securities
Treasury Securities • U.S. Treasury is responsible for the financing of the federal government’s debt (financing and refunding) and financing fiscal policy. The Treasury finances its debt by issuing T-bills, T-notes, T-bonds, inflation-index bonds, and non-marketable Treasury securities. • The federal government’s debt in 2003 was approximately $6.4 trillion. • The federal government’s deficit in 2002 was approximately $158 billion.
Federal Government Revenues and Expenditures, 2001 and 2002 Source: The President's Council of Economic Advisors, Economic Report of the President. www.gpo.gov/usbudget
Historical Government Revenues, Expenditures,and Budgets: Select Years from 1969-2002 Source: The President's Council of Economic Advisors, Economic Report of the President. www.gpo.gov/usbudget
Federal Debt: 2003 Source: Board of Governors of the Federal Reserve System, to www.publicdebt.ustreas.gov/opd/opd.htm
Websites • For information on the U.S. Treasury’s debt go to www.publicdebt.ustreas.gov/opd/opd.htm • For information on government expenditures and revenues go to www.gpo.gov/usbudget or go to www.economagic.com and click on Federal Reserve – St. Louis.
Types of Treasury Securities • Market Series: • Treasury Bills • Treasury Bonds • Treasury Notes • Treasury-Inflation Index Bonds • Non-Market Series: Securities that cannot be traded. • Government Agency Series • Foreign Series • U.S. Savings Bonds
Treasury Bills Treasury Bills • Short-term Treasury securities. • Features: • Original Maturities: 91 days, 182, and 1 year • Zero-Coupon Bonds • States exempt the interest from state taxes • Smallest denomination = $1,000 • Rates quoted as annual discount yield (banker’s discount yield)
Treasury Notes and Bonds • Treasury Notes and Bonds are intermediate and long-term Treasury securities. • Features: • Original Maturities: • Notes: maturity up to 10 years • Bonds: maturity ranges from 10-yrs to 30yrs • Semi-annual coupons • Denomination in multiples of $1,000; often $100,000 • Treasury has not issued callable bonds or notes since 1985 • Rates quoted as annual discount yield
Treasury Inflation-Index Bonds -- TIPS • The Treasury began offering Treasury inflation-indexed bonds in 1997. • The securities are called TIPS: Treasury Inflation Protection Securities.
Treasury Inflation-Index Bonds -- TIPS • TIPS are structured so that: • Each period’s coupon payment is equal to a specified fixed rate times an inflation-adjusted principal, and • at maturity, the bond pays the larger of the inflation-adjusted principal or the original par value.
Treasury Inflation-Index Bonds -- TIPS Example • Suppose the Treasury issues a 5-year TIP with a nominal principal of $1,000 and annual coupon rate of 4%. • If there is no inflation in the ensuing five years, then the TIP will pay bondholders $40 each year and $1,000 at maturity. • If there is inflation, as measured by the consumer price index, CPI, then the Treasury will adjusted the nominal principal.
Treasury Inflation-Index Bonds -- TIPS Example • Suppose the U.S. experiences an annual inflation rate of 3% the first year of the bonds. • In this case, the inflation-adjusted principal would be $1,030 and a bondholder would receive an annual coupon of $41.20 (= ($1,030)(.04)). • If the 3% inflation continues for each year, then the bondholder would receive coupon interests in each of the next four years of $41.20, $42.44, $43.71, $45.02, and $46.37, and a principal at maturity of $1,159.27.
Treasury Strips • Stripped Treasury Securities: Short-term PDBs derived from T-notes or T-bonds. • Merrill Lynch and Salomon Brothers started them in 1980. • Dealers would buy a T-bond or note, place them in a custodial account, then strip them into interest-only (IO) or principal-only PDBs to sell to investors.
Treasury Strips • The U.S. Treasury facilitated the market for generic stripped securities when in 1985 it initiated the Separate Trading of Registered Interest and Principal of Securities (STRIPS) program to aid dealers in stripping Treasury securities.
Treasury Strips • The securities created under the STRIPS program were deemed direct obligations of the government. • For clearing and payment purposes, the names of the buyers of STRIPS were included in the book entries of the Treasury, thus eliminating the need to set up custodial accounts.
Treasury Strips • For dealers, the creation of strip securities represents an arbitrage. • As we examined in Chapter 2, the equilibrium price of a bond is that price obtained by discounting its cash flows by spot rates – the rate on zero-coupon bonds. • If the market prices a bond below its equilibrium value, then dealers can earn a risk-free profit by buying the bond and stripping it into IO and PO bonds to sell. • If the market prices a bond above its equilibrium value, then dealers can realize a risk-free profit by buying stripped securities and then forming an identical coupon bond to sell. This process is known as rebundling or reconstruction.
Theoretical Spot Yield Curve • A theoretical spot yield curve is a plot of spot rates against their maturities, with the spot rates estimated using the bootstrapping technique. • In practice, the process of stripping and rebundling causes the actual yield curve for Treasury securities to approach this theoretical spot yield curve. • As a result, the theoretical spot yield curve estimated by using bootstrapping is often used by practitioners to price financial instruments and by dealers to identify arbitrage opportunities.
Theoretical Spot Yield Curve • A theoretical spot yield curve can be constructed from observed yields on T-bills and Treasury coupon-paying bonds defining the Treasury yield curve by using a bootstrapping technique. • As described in Chapter 2, the bootstrapping technique requires taking at least one pure discount bond and then sequentially generating other spot rates from coupon bonds. To illustrate, consider the Treasury securities shown in the table.
Theoretical Spot Yield Curve • There are two T-bills with maturities of six months (.5 years) and one year, trading at bond-equivalent yields of 5% and 5.25%. • Since T-bills are pure discount bonds, these rates can be used as spot rates (St) for maturities of .5 years (S.5) and one year (S1).
Theoretical Spot Yield Curve • To obtain the spot rates for 1.5 years (18 months): • Take the T-note with a maturity of 1.5 years, annual coupon rate of 5.5% (semi-annual coupons of 2.75), and currently priced at par and value that bond by discounting its cash flows at spot rates. • Solve for the spot rate for 1.5 years. Doing this yields a spot rate of S1.5 = 5.51%.
Theoretical Spot Yield Curve • To obtain the spot rate for a two-year bond (S2) we repeat the process using the two-year bond paying semi-annual coupons of 2.875 and selling at par. • This yields a spot rate of S2 = 5.577%. • Continuing the process with the other securities in the table, we obtain spot rates for bonds with maturities of 2.5 years and 3 years: S2.5 = 6.03% and S3 = 6.30% (last column of the preceding table).
Theoretical Spot Yield Curve • Consider the arbitrage from buying and stripping the 3-year 6.25% coupon bond. • A dealer could buy the issue at par and strip the issue with the expectation of selling the strips at the yields corresponding to their maturities. • The proceeds from selling the strips would be 100.1217, yielding the dealer a profit of $.1217 per $100 face value. • In contrast, if the dealer sells at the spot rates defining the theoretical yield curve, the profit is zero and the arbitrage disappears.
Theoretical Spot Yield Curve Note: Allow for small rounding differences
Theoretical Spot Yield Curve Thus, the process of stripping will change the supply and demand for bonds causing their yields to move to their theoretical spot yield curve levels.
Theoretical Spot Yield Curve • It should be noted that because the liquidity of the stripped market is less than that of Treasury securities, the spot yield curve generated from observed stripped securities is not considered as good an estimate of the Treasury yield curve as the theoretical spot yield curve generating from bootstrapping.
Treasury Auction • Auction: New T-Bills, T-Notes, and T-Bonds are sold on an auction basis through the Federal Reserve Bank of NY. Three-month T-bills (13 weeks or 91-day bills) and 6-month T-bills (26 week or 182-day bills) are auctioned every Monday.
Treasury Auction • Treasury yield auction Process: • Each dealer submits either a competitive bid (price and quantity) or noncompetitive bid (quantity only) • Bids are ranked from lowest yield (highest price) to highest yield (lowest price) that exhaust the issue (includes both competitive and noncompetitive bids) • The last price is known as the stop-out price • Noncompetitive bids get the average price
Treasury Auction: Example Example of T-bill Auction Process • Announcements of a T-bill auction are made on the Thursday preceding the Monday offering. In the announcement, the Treasury will indicate the size of the auction, the proportions of the offering that will be used to replace maturing debt and for new funding, and their estimate of cash needs for the remainder of the quarter. • Bidders must file tender forms by Monday. Competitive tenders submit a quantity bid and a yield bid based on a discount yield basis; noncompetitive tenders submit only a quantity bid up to $1M face value.
Treasury Auction: Example • Discount yield: • Price given discount yield and face value of 100 is: P0 = 100 [1- RD (Days to Maturity/360)]
Treasury Auction: Example 3. The distribution is determined by first subtracting the noncompetitive bids from the total bids; the remainder represents the amount that is awarded to competitive bidders.
Treasury Auction: Example Example: If the volume of bills requested is $12.5 billion and the amount accepted by the Treasury is $11 billion with $1.5 billion being noncompetitive, then the issue would be oversubscribed, with $1.5 billion going to noncompetitive bidders and $9.5 billion going to competitive bidders.
Treasury Auction: Example 4. The distribution to competitive bidders is determined by arraying the bids from lowest yield (highest price) to highest yield (lowest price). The discount yield is carried out to three decimal points.
Treasury Auction: Example Suppose we have the following competitive bids:
Treasury Auction: Example • The Treasury allocates to competitive bidders until $9.5 billion is distributed. The lowest price at which at least some bills are awarded is the stop price. In this case, the stop price is 3.83% or 99.032. • Those bidding above the stop price of 3.83% are awarded the quantity they requested, while those with bids below the stop price do not receive any bills – shut out.
Treasury Auction: Example • The bids at the stop price are awarded a proportion of the remaining bids. • At 3.83%, there are $0.35 billion left in bids ($9.5 billion-$9.15 billion) and $0.75 billion requested at the stop price. Each of the bidders at 3.83% would therefore receive 46.667% (= .35/.75) of his bid.
Treasury Auction: Example • The weighted average bid that the noncompetitive bidders receive is 3.786%: 7. The difference between the stop bid yield and average yield is called the tail; in this case the tail is .044% (= 3.83% - 3.786%). Average Bid = ($.2/$9.5)(3.75%) + ($.57/9.5)(3.755%) + + (.35/9.5)(3.83%) Average Bid = 3.786%
Treasury Secondary Market • The secondary market for Treasuries is part of the OTC market. • In the secondary market, recently issued Treasury securities, called on-the-run issues, are the most liquid securities with a very narrow bid-ask spread; approximately 70% of the total secondary market trading involves on-the-run issues. • In contrast, Treasury securities issued earlier, referred to as off-the-run issues, are not quite as liquid and can have slightly wider spreads.
Government Security Dealers • Both the primary and secondary markets are controlled by primary Treasury security dealers. • Primary implies you are on the Federal Reserve’s list. To be on the list, a dealer must agree to trade (act like a specialist) and have sufficient capital. • As of 2002, there were 22 primary security dealers.
Primary Government Security Dealers, 2002 Federal Reserve Bank of New York: www.newyorkfed.org/markets/pridealers_listing.html
Treasury Dealers: Profit • By taking temporary positions, dealers hope to profit from two sources: • Carry income • Position profit
Treasury Dealers: Profit • Carry incomeis the difference between the interest dealers earn from holding the securities and the interest they pay on the funds they borrow to purchase the securities.
Treasury Dealers: Profit Carry income • When dealers acquire securities, they often finance the purchase by borrowing from banks, other dealers, and other institutions. • One major source of funds for them is demand loans from banks. Demand loans are short-term loans to dealers (one or two days), secured by the dealer's securities. These loans are usually renewable and often can be called at any time by the bank. • Another important source of dealer funding is repurchase agreements. • When dealers sell their securities, the invoice price is equal to the agreed-upon price plus the accrued interest. Generally, dealers profit with a positive carry income by earning higher accrued interest than the interest they pay on their loans.
Treasury Dealers: Profit Position Profit • The position profit of dealers comes from long positions and short positions. • In a long position, a dealer purchases the securities and then holds them until a customer comes along. The dealer will realize a position profit if rates decrease and prices increase during the time she holds the securities. • In a short position, the dealer borrows securities and sells them hoping that rates will subsequently increase and prices will fall by the time he purchases the securities.
Government Security Dealers:Interdealer Market • There is also an interdealer market in which primary and nonpriamry dealers trade billions of dollars each day amongst themselves. • This interdealer market functions through government security brokers that for a commission match dealers and other investors who want to sell with those wanting to buy. • The government brokers include such firm as Cantor Fitzgerald Securities, Garban LLC, Hilliard Farber and company, Intercapital Government Securities, Liberty Brokerage, and Tullett and Tokyo Securities.