Chapter 6 Treasury and Agency Securities Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives After reading this chapter, you will understand the different types of securities issued by the Treasury the operation of the primary market for Treasury securities the role of government dealers and government brokers the secondary market for Treasury securities how Treasury securities are quoted in the secondary market the zero-coupon Treasury securities market the major issuers in the federal agency securities market the functions of government-sponsored enterprises that issue securities Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Treasury Securities Two factors account for the prominent role of U.S. Treasury securities: volume (in terms of dollars outstanding) liquidity The Department of the Treasury is the largest single issuer of debt in the world. The large volume of total debt and the large size of any single issue have contributed to making the Treasury market the most active and hence the most liquid market in the world. The dealer spread between bid and ask price is considerably narrower than in other sectors of the bond market. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Types of Treasury Securities The Treasury issues both marketable and non-marketable securities. Our focus here is on marketable securities. Marketable Treasury securities are categorized as fixed- principal securities or inflation-indexed securities. Fixed-income principal securities include: Treasury bills Treasury notes Treasury bonds Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Types of Treasury Securities Treasury bills are issued at a discount to par value, have no coupon rate, and mature at par value. The current practice of the Treasury is to issue all securities with a maturity of one year or less as discount securities. As discount securities, Treasury bills do not pay coupon interest. Instead, Treasury bills are issued at a discount from their maturity value; the return to the investor is the difference between the maturity value and the purchase price. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Types of Treasury Securities All securities with initial maturities of two years or more are issued as coupon securities. Coupon securities are issued at approximately par and, in the case of fixed-principal securities, mature at par value. Treasury coupon securities issued with original maturities of more than one year and no more than 10 years are called Treasury notes. Treasury coupon securities with original maturities greater than 10 years are called Treasury bonds. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Types of Treasury Securities Callable bonds have not been issued since 1984. On January 29, 1997, the U.S. Department of the Treasury issued for the first time Treasury securities that adjust for inflation. These securities are popularly referred to as Treasury inflation protection securities, or TIPS. The principal that the Treasury Department will base both the dollar amount of the coupon payment and the maturity value on is adjusted semiannually. This is called the inflation-adjusted principal. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) The Treasury Auction Process The Public Debt Act of 1942 grants the Department of the Treasury considerable discretion in deciding on the terms for a marketable security. An issue may be sold on an interest-bearing or discount basis and may be sold on a competitive or other basis, at whatever prices the Secretary of the Treasury may establish. However, Congress imposes a restriction on the total amount of bonds outstanding. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) The Treasury Auction Process Treasury securities are sold in the primary market through sealed-bid auctions. Each auction is announced several days in advance by means of a Treasury Department press release or press conference. The announcement provides details of the offering, including the offering amount and the term and type of security being offered, and describes some of the auction rules and procedures. Treasury auctions are open to all entities. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) The Treasury Auction Process The Treasury auctions securities on a regular cycle Treasury bills with maturities of 4 weeks, 13 weeks (3 months), and 26 weeks (6 months). At irregular intervals the Treasury issues cash management bills with maturities ranging from a few days to about six months. The Treasury auctions 2-, 5-, and 10-year Treasury notes. The Treasury does not issue Treasury bonds on a regular basis. The Treasury had issued 30-year Treasury bonds on a regular basis but suspended doing so in October 2001. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Determination of the Results of an Auction The auction for Treasury securities is conducted on a competitive bid basis. A noncompetitive bid is submitted by an entity that is willing to purchase the auctioned security at the yield that is determined by the auction process. When a noncompetitive bid is submitted, the bidder only specifies the quantity sought. The quantity in a noncompetitive bid may not exceed $1 million for Treasury bills and $5 million for Treasury coupon securities. A competitive bid specifies both the quantity sought and the yield at which the bidder is willing to purchase the auctioned security. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Determination of the Results of an Auction The highest yield accepted by the Treasury is referred to as the high yield (or stop-out yield). Bidders whose bid is higher than the high yield are not distributed any of the new issue (i.e., they are unsuccessful bidders). Bidders whose bid was the high yield are awarded a proportionate amount for which they bid. Within an hour of the auction deadline, the Treasury announces the auction results including the quantity of noncompetitive tenders, the median-yield bid, and the ratio of the total amount bid for by the public to the amount awarded to the public. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Secondary Market The secondary market for Treasury securities is an over- the-counter market where a group of U.S. government securities dealers offer continuous bid and ask prices on outstanding Treasuries. There is virtual 24-hour trading of Treasury securities. The three primary trading locations are New York, London, and Tokyo. The normal settlement period for Treasury securities is the business day after the transaction day (“next day” settlement). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Secondary Market The most recently auctioned issue is referred to as the on-the-run issue or the current issue. Securities that are replaced by the on-the-run issue are called off-the-run issues. At a given point in time there may be more than one off-the-run issue with approximately the same remaining maturity as the on-the-run issue. Treasury securities are traded prior to the time they are issued by the Treasury. This component of the Treasury secondary market is called the when-issued market, or wi market. When-issued trading for both bills and coupon securities extends from the day the auction is announced until the issue day. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Secondary Market Government dealers trade with the investing public and with other dealer firms. When they trade with each other, it is through intermediaries known as interdealer brokers. Dealers leave firm bids and offers with interdealer brokers who display the highest bid and lowest offer in a computer network tied to each trading desk and displayed on a monitor. Dealers use interdealer brokers because of the speed and efficiency with which trades can be accomplished. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Price Quotes for Treasury Bills The convention for quoting bids and offers is different for Treasury bills and Treasury coupon securities. Bids and offers on Treasury bills are quoted in a special way. Unlike bonds that pay coupon interest, Treasury bill values are quoted on a bank discount basis, not on a price basis. The yield on a bank discount basis is computed as follows:  where Yd = annualized yield on a bank discount basis (expressed as a decimal), D = dollar discount (which is equal to the difference between the face value and the price), F = face value and t = number of days remaining to maturity. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Price Quotes for Treasury Bills Example using yield on a bank discount basis: Consider a Treasury bill with 100 days to maturity, a face value of $100,000, and selling for $99,100 would be selling with a dollar discount of D = F – P = $100,000 – $99,100 = $900. Given D = $900, F = $100,000 and t = 90, the Treasury bill would be quoted at the following yield: Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Price Quotes for Treasury Bills The quoted yield on a bank discount basis is not a meaningful measure of the return from holding a Treasury bill. There are two reasons for this: First, the measure is based on a face-value investment rather than on the actual dollar amount invested. Second, the yield is annualized according to a 360-day rather than a 365-day year, making it difficult to compare Treasury bill yields with Treasury notes and bonds, which pay interest on a 365-day basis. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Price Quotes for Treasury Bills The measure that seeks to make the Treasury bill quote comparable to Treasury notes and bonds is called the bond equivalent yield. The CD equivalent yield (also called the money market equivalent yield) makes the quoted yield on a Treasury bill more comparable to yield quotations on other money market instruments that pay interest on a 360- day basis. It does this by taking into consideration the price of the Treasury bill rather than its face value. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Quotes on Treasury Coupon Securities Treasury coupon securities are quoted in a different manner than Treasury bills ─ on a price basis in points where one point equals 1% of par. The points are split into units of 32nds, so that a price of 96-14, for example, refers to a price of 96 and 14 32nds, or 96.4375 per 100 of par value. The 32nds are themselves often split by the addition of a plus sign or a number. In addition to price, the yield to maturity is typically reported alongside the price. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Quotes on Treasury Coupon Securities The following are examples of converting a quote to a price per $100 of par value: Quote No. of 32nds No. of 64ths No. of 256ths Price per $100 par 91-19+ 19 1 91.609375 107-222 22 2 107.6953125 109-066 6 109.2109375 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Quotes on Treasury Coupon Securities When an investor purchases a bond between coupon payments, if the issuer is not in default, the investor must compensate the seller of the bond for the coupon interest earned from the time of the last coupon payment to the settlement date of the bond. This amount is called accrued interest. When calculating accrued interest, three pieces of information are needed: the number of days in the accrued interest period the number of days in the coupon period the dollar amount of the coupon payment. The number of days in the accrued interest period represents the number of days over which the investor has earned interest. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Quotes on Treasury Coupon Securities The calculation of the number of days in the accrued interest period and the number of days in the coupon period begins with the determination of three key dates: the trade date, settlement date, and date of previous coupon payment. The trade date is the date on which the transaction is executed. The settlement date is the date a transaction is completed. For Treasury securities, settlement is the next business day after the trade date. Interest accrues on a Treasury coupon security from and including the date of the previous coupon payment up to but excluding the settlement date. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Treasury Securities (continued) Quotes on Treasury Coupon Securities The number of days in the accrued interest period and the number of days in the coupon period may not be simply the actual number of calendar days between two dates. For Treasury coupon securities, the day count convention used is to determine the actual number of days between two dates. This is referred to as the actual/actual day count convention. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stripped Treasury Securities The Treasury does not issue zero-coupon notes or bonds. However, because of the demand for zero-coupon instruments with no credit risk, the private sector has created such securities. The profit potential for a government dealer who strips a Treasury security lies in arbitrage resulting from the mispricing of the security. The process of separating the interest on a bond from the underlying principal is called coupon stripping. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stripped Treasury Securities (continued) Zero-coupon Treasury securities were first created in August 1982 by dealer firms. The problem with these securities was that they were identified with particular dealers and therefore reduced liquidity. Moreover, the process involved legal and insurance costs. Today, all Treasury notes and bonds (fixed-principal and inflation-indexed) are eligible for stripping. The zero-coupon Treasury securities created under the STRIPS program are direct obligations of the U.S. government. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stripped Treasury Securities (continued) There may be confusion when a market participant refers to a “stripped Treasury.” Today, a stripped Treasury typically means a STRIPS product. However, because there are trademark products and other types of pre-STRIPS zero-coupon products still outstanding, an investor should clarify what product is the subject of the discussion. We can refer to stripped Treasury securities as simply “strips.” Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stripped Treasury Securities (continued) On dealer quote sheets and vendor screens STRIPS are identified by whether the cash flow is created from the coupon (called ci), principal from a Treasury bond (called bp), or principal from a Treasury note (called np). Strips created from the coupon are called coupon strips and those from the principal are called principal strips. The reason why a distinction is made between coupon strips and principal strips has to do with the tax treatment by non-U.S. entities, as discussed in the next section. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Stripped Treasury Securities (continued) Tax Treatment A disadvantage of a taxable entity investing in stripped Treasury securities is that accrued interest is taxed each year even though interest is not paid. Thus these instruments are negative cash flow instruments until the maturity date. They have negative cash flow because tax payments on interest earned but not received in cash must be made. Reconstituting a Bond Reconstitution is the process of coupon stripping and reconstituting that will prevent the actual spot rate curve observed on zero-coupon Treasuries from departing notably from the theoretical spot rate curve. As more stripping and reconstituting occurs, demand and supply will cause rates to return to their theoretical spot rate levels. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities The U.S. Congress has chartered entities to provide funding support for the housing and agricultural sectors of the U.S. economy, as well as to provide funding for specific U.S. government projects. The market for the debt instruments issued by these government-chartered entities is called the federal agency securities market. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) There are several types of government-chartered entities. One type is a government-owned corporation. Another type of government-chartered entity is a government-sponsored enterprise (GSE). GSEs are divided into two types. The first is a publicly owned shareholder corporation. There are three such GSEs: the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”), and the Federal Agricultural Mortgage Corporation (“Farmer Mac”). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) The price quotation conventions for GSE securities will vary between types of debt. Short-term GSE discount notes are quoted on a yield basis, the same as that for Treasury bills explained earlier in this chapter. The most liquid GSE issues are generally quoted on two primary bases: a price basis, like Treasury securities; that is, the bid and ask price quotations are expressed as a percentage of par plus fractional 32nds of a point a spread basis, as an indicated yield spread in basis points, off a choice of proxy curves or issue. Federally related institutions are arms of the federal government and generally do not issue securities directly in the marketplace. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) Tennessee Valley Authority (TVA) The TVA was established by Congress in 1933 primarily to provide flood control, navigation, and agricultural and industrial development. The TVA issues a variety of debt securities in U.S. dollars and other currencies. The debt obligations issued by the TVA may be issued only to provide capital for its power program or to refund outstanding debt obligations. TVA debt obligations are not guaranteed by the U.S. government. However, the securities are rated triple A by Moody’s and Standard and Poor’s. The rating is based on the TVA’s status as a wholly owned corporate agency of the U.S. government and the view of the rating agencies of the TVA’s financial strengths. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) Fannie Mae In the 1930s, Congress created a federally related institution, the Federal National Mortgage Association, popularly known as “Fannie Mae,” which was charged with the responsibility to create a liquid secondary market for mortgages. Fannie Mae was to accomplish this objective by buying and selling mortgages. In 1968, Congress divided Fannie Mae into two entities: the current Fannie Mae the Government National Mortgage Association (popularly known as “Ginnie Mae”). Ginnie Mae’s function is to use the “full faith and credit of the U.S. government” to support the market for government-insured mortgages. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) Freddie Mae In 1970, Congress created the Federal Home Loan Mortgage Corporation (Freddie Mac). The reason for the creation of Freddie Mac was to provide support for conventional mortgages. These mortgages are not guaranteed by the U.S. government. Freddie Mac issues Reference Bills, discount notes, medium-term notes, Reference Notes, Reference Bonds, Callable Reference Notes, Euro Reference Notes (debt denominated in euros), and global bonds. In 2001, Freddie Mac also began issuing subordinated securities (called Freddie Mac Subs). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) Farmer Mac The Federal Agricultural Mortgage Corporation (Farmer Mac) provides a secondary market for first mortgage agricultural real estate loans. It was created by Congress in 1998 to improve the availability of mortgage credit to farmers and ranchers as well as rural homeowners, businesses, and communities. It does so by purchasing qualified loans from lenders in the same way as Freddie Mac and Fannie Mae. Farmer Mac raises funds by selling debentures and mortgage- backed securities backed by the loans purchased. The latter securities are called agricultural mortgage-backed securities (AMBS). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) FHLBanks The Federal Home Loan Bank System (FHLBanks) consists of the 12 district Federal Home Loan Banks and their member banks. The Federal Home Loan Bank Board was originally responsible for regulating all federally chartered savings and loan associations and savings banks, as well as state-chartered institutions insured by the Federal Savings and Loan Insurance Corporation. These responsibilities have been curtailed since 1989. The major source of debt funding for the Federal Home Loan Banks is the issuance of consolidated debt obligations, which are joint and several obligations of the 12 Federal Home Loan Banks. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) FFCBS The purpose of the Federal Farm Credit Bank System (FFCBS) is to facilitate adequate, dependable credit and related services to the agricultural sector of the economy. The Farm Credit Bank System consists of three entities: the Federal Land Banks, Federal Intermediate Credit Banks, and Banks for Cooperatives. Prior to 1979, each entity issued securities in its own name. Starting in 1979, they began to issue debt on a consolidated basis as “joint and several obligations” of the FFCBS. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) Resolution Trust Corporation The 1987 legislation that created FICO did not go far enough to resolve the problems facing the beleaguered savings and loan industry. In 1989, Congress passed more comprehensive legislation, the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). Farm Credit Financial Assistance Corporation (FACO) In the 1980s, the FACO faced financial difficulties because of defaults on loans made to farmers. The defaults were caused largely by high interest rates in the late 1970s and early 1980s and by depressed prices on agricultural products. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Federal Agency Securities (continued) GSE Credit Risk With the exception of the securities issued by the Farm Credit Financial Assistance Corporation, GSE securities are not backed by the full faith and credit of the U.S. government, as is the case with Treasury securities. Consequently, investors purchasing GSEs are exposed to credit risk. The yield spread between these securities and Treasury securities of comparable maturity reflects differences in perceived credit risk and liquidity. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall