Us Treasury Securities Market

Four types of government securities trade in the U.S. securities markets:

1. Treasury bills are short-term securities with a maturity period of up to one year. Currently, the Treasury Department issues 4-week, 13-week, and 26-week bills. These bills are discount instruments; they do not pay coupon interest. Holders of the bills receive the face amount at maturity.

2. Treasury notes are medium-term securities that have a maturity of between 2 and 10 years. Currently, the Treasury issues notes with a maturity period of 2, 3, 5, or 10 years. The 10-year note is the current interest rate benchmark.

3. Treasury bonds are long-term securities with a maturity period of 30 years. The Treasury suspended issuance of the 30-year bond in October 2001. Notes and bonds pay coupons every six months; hence, they are also called coupon

Treasury securities (or coupon Treasuries). The Department of Treasury reissued the long bond in 2006.

4. Treasury Inflation Protection Securities (TIPS) are inflation-indexed notes and bonds; the interest rate is fixed but the principal is adjusted for inflation. At maturity, holders will receive the greater of the par amount at original issue or the inflation-adjusted principal.

Coupon Stripping

In February 1985, the Treasury introduced a coupon-stripping program called Separate Trading of Registered Interest and Principal of Securities (STRIPS). For coupon Treasury securities, Coupon-stripping strips the interest payment and treats the component coupons and the principal as separate securities. In the marketplace, these STRIPS are frequently referred to as Treasury zeros or Treasury zero coupons. Each coupon strip entitles the owner to a specified amount of cash (coupon) on a specific date (coupon date), while the owner of the principal strip receives the principal amount at maturity. For example, suppose that a 10-year note with a face value of $1 million and a 4 percent coupon rate is stripped into its principal and 20 semiannual interest payments. The result is 21 Treasury zeros, with each coupon strip paying $20,000 and the principal strip paying $1 million. Each of the 21 strips becomes a security, and each can trade separately. As such, the program provides investors an additional option to buy just one of the coupon components or the principal component that was previously not available.

The U.S. Department ofTreasury allows the reconstitution of stripped securities. To reconstitute a stripped security, a financial institution or a government securities broker-dealer must obtain the appropriate principal component and all related coupon strips for the security. The principal and interest components must be in the appropriate minimum or multiple amounts for the particular security being reconstituted. Once the components have been acquired, the institution forwards them to a Federal Reserve Bank and requests that they be reassembled into a fully constituted Treasury security. The ability to reconstitute a stripped security improves market efficiency, because there will be arbitrage opportunities if the price of the security is different from the value of its components.

Treasury Inflation-Indexed Securities

The first auction of TIPS, a 10-year note, was held in January 1997. Since then, the Treasury has also issued TIPS with maturities of 5, 10, 20, and 30 years. Differences between the yield on a regular Treasury security and that on a TIPS can be used to gauge market's expectations about future inflation. When TIPS are issued, the coupon rate set at auction remains fixed throughout the term of the security. The principal amount is adjusted for inflation, but the inflation-adjusted principal will not be paid until maturity. The principal amount will not drop below the par, even though deflation could cause the principal to decline. The index for measuring the inflation rate is the nonseasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U).

Interest on TIPS is based on a fixed coupon rate applied to the inflation-adjusted principal, so investors are guaranteed a real rate of return above inflation. The real yield is typically lower than the nominal yield. For example, at the close of markets on October 5, 2006, the yield on the 10-year TIPS was 2.38 percent while that on the 10-year fixed-principal note was 4.71 percent. The yield differential of 2.33 percent reflected inflation expectations.

Because of the safety of Treasury securities and the political stability of the United States, foreigners often purchase U.S. Treasury securities whenever there is a financial or political crisis overseas. This phenomenon is known as a flight to quality. As we discuss later, the demand for the newest Treasury security in any maturity segment is generally higher than for older securities. The higher level of liquidity means that it is easy to trade large volumes. Consequently, the foreign money that flows into the United States as a result of a flight to quality is often used to purchase the on-the-run Treasury securities. This phenomenon is called a flight to liquidity.

Market Quotations

The Wall Street Journal and the business sections of most newspapers publish closing quotes (the last bid and offer prices at the close of the previous trading session) on all Treasuries, under the heading "Treasury Bonds, Notes & Bills." Data vendors such as Bloomberg and GovPX publish real-time quotes on their proprietary networks and websites. For Treasury bills, quotes include the maturity date, the number of days to maturity, bid, asked, changes, and asked yield. The bid and asked are quoted in terms of a rate discount. The bid rate is generally lower than the asked rate, because the price and interest rate are inversely related. The asked yield is the investment yield or bond equivalent yield based on the asked discount rate quoted.

Quotes on notes and bonds include the coupon rate, maturity, bid price, asked price, change in price, and asked yield. The price quotes are based on the percentage of par value. For example, a bid of 99:04 means that the dealer is bidding a price of 99 4/32, or 99.125 percent of the face value, and an asked of 99:06 means that the dealer is offering to sell at 99 6/32, or 99.1875 percent of the par amount. The difference of 2/32 between the bid and asked is referred to as the bid-asked spread. Changes are in 32nds. For example, a change of "+5" means that the asked price went up 5/32 over the prior day. The asked yield represents the yield to maturity based on the asked price plus accrued interest. Yield to maturity is the rate that discounts all future periodic coupons and principal at maturity to the asked price. When the yield to maturity is plotted against term to maturity, the result is a yield curve.

Treasury strips are also quoted in terms of price. The type of strip is indicated by abbreviations: "ci" indicates a coupon strip, "np" represents a note principal strip, and "bp" denotes a bond principal strip. TIPS are quoted on a price basis as well, but the yield is the real yield. It represents the yield investors receive in excess of and above inflation.

Treasury Issuing Process and Auctions

The Department of Treasury sells government securities at regularly scheduled auctions. Most Treasuries offered at an auction are bought by the primary dealers, which are financial institutions that are active in trading government securities and have established business relationships with the Federal Reserve Bank of New York. Individual investors purchase on a much smaller scale. The minimum amount that may be purchased at an auction is $1,000, and any bid in excess of $1,000 must be in multiples of $1,000.

The auction process begins with a public announcement by the Treasury. The announcement typically includes the following information:

• The offering amount

• A description of the offering, including the term and type of security, CUSIP number, auction date, issue date, dated date, maturity date, and interest payment dates

• Whether the security is eligible for STRIPS

• Procedures for submitting bids, the maximum bid amount, and payment terms

Auction Process

After the Treasury announces an auction, bids are accepted up to 30 days before the auction and may be submitted electronically via the Treasury Automated Auction Processing System (TAAPS), Treasury Direct website, by mail, or in person. Two types of bids can be submitted: noncompetitive and competitive. Small investors and individuals generally submit noncompetitive bids, in which the investor indicates the amount she wants to purchase without specifying a purchase price. The investor will receive the dollar amount submitted in the bid. In a noncompetitive tender, a bidder may not bid for more than $1 million in a bill auction or more than $5 million in a note or bond auction. The price is unknown until the auction results are announced. Primary dealers acting for their own accounts or on behalf of clients usually submit sealed competitive bids specifying both the amount and the price they are willing to pay. The bid is accepted if the bid yield is not higher than the stop yield. Otherwise, it is rejected.

A dealer is prohibited from bidding both competitively and noncompetitively for its own account in the same auction. Bids are submitted in terms of discount rate for bills, stated in three decimal places in 0.005 percent increments. The Treasury requires that competitive bids in note and bond auctions be expressed in yields using three decimals in 0.001 percent increments. These bids are accepted until 1:00 P.M. EST on the day of the auction. Ordinarily, primary dealers submit their competitive bids through TAAPS at the last possible moment, sometimes literally seconds before the deadline. The deadline for noncompetitive tenders is 12:00 noon EST on the auction date.

Competitive bidders are permitted to submit more than one bid. But no bidder may bid more than 35 percent of the total amount of the security being sold. Specifically, under the 35 percent rule, the bidder's net long position in the auction may not exceed 35 percent of the amount of the security in the auction.

The bids submitted through TAAPS are consolidated at the Federal Reserve Banks in New York, Chicago, and San Francisco. These bids are then sorted and reviewed electronically by the U.S. Treasury in Washington, DC. The Treasury nets out the total amount of noncompetitive tenders and allocates the balance to competitive bidders with bids at or below the high yield (the highest yield accepted at an auction), also known as the stop yield. The auction is a single-price or Dutch auction, meaning that both competitive and noncompetitive bidders are awarded securities at the price that results from the high yield (or high discount rate, for bills). All tenders at lower yields are accepted in full. All competitive bids at higher yields are rejected. The coupon rate is the high yield rounded down to the nearest one-eighth.

Example of a Treasury Auction

Suppose that the Treasury has received $1 billion in noncompetitive tenders in an $11 billion auction for five-year notes. In that case, $10 billion in securities will be awarded to competitive bidders. For this auction, there are six competitive bidders, A, B, C, D, E, and F. Table 11.4 shows the yield and the amount by each bidder, ranked from the lowest yield to the highest. The highest yield at which the $10 billion of securities can be sold is 4.250 percent. Under the Dutch auction system, all accepted bidders (A, B, C, D, and E) will pay a price that reflects a yield of 4.250 percent. In this example, D and E each bid $2 billion at 4.250 percent. After the security is awarded to A, B, and C, the remaining amount is $2 billion, so bidders D and E will each receive a $1 billion allocation.

The ratio of the bids received to the amount awarded is known as the bid-to-cover ratio. A high bid-to-cover ratio implies strength in the auction. Another mea-

TABLE 11.4 Yield and Quantity of Competitive Bids

Bid Yield

Bid Amount

Bidder

(%)

($ Billions)

A

4.245

2

B

4.246

3

C

4.248

3

D

4.250

2

E

4.250

2

F

4.252

1

sure known as the tail of the auction is the difference between the average yield of all accepted bids and the high yield. When traders form trading strategies after the auction, they use the tail as a measure of the auction's success. The interpretation of a tail is more art than science, however. Generally, a short tail signals strength, so traders will trade more aggressively. A long tail indicates weakness in market demand, and hence traders will be cautious on the downside. At times, however, a long tail has a different implication. In an uncertain market environment, some bidders who need to have a specific security will be extremely aggressive. This will lead to a long tail. A short tail indicates a lack of such aggressiveness.

The auction results are released to the public within two hours of the auction, frequently by 1:30 or 2:00 P.M. EST. The announcement includes the amount of bids received, the total accepted, and the bid-to-cover ratio, as well as the high, low, and median bids, and the issuing price. For a coupon Treasury, the announcement includes a coupon rate as well.

When-Issued Trading and Dealer Bidding Strategies

A major feature of Treasury auctions is the "when, as, and if issued" trading, known as when issued trading. The when-issued (WI) trading begins immediately after the Treasury announcement and lasts until the settlement date, the date on which payment is made to settle a trade. Prior to the auction date, dealers and investors actively participate in the WI market. They may take either a long position or a short position in the security for a future settlement on the issue date. Thus, WI trades are forward contracts to be settled on the new issue settlement date.

Before the auction, WI trading is in terms of yields. The Treasury announces the coupon after the auction. After the coupon is announced, WI trading is on a price basis rather than a yield basis. Generally, the securities are issued several days after the auction. WI trading ends when the new security settles. Prior to the settlement of the note, the buyer does not have to pay for the purchase. The process of issuance is depicted in Figure 11.1.

WI trading affects the strategies bidders use in the auction because it affects their positions going into the auction. Bidders who buy a security in the WI market before the auction go into the auction with long positions. Those who have sold the security

FIGURE 11.1 Auction Process of U.S. Treasury Securities

FIGURE 11.1 Auction Process of U.S. Treasury Securities

WI trading begins (in yield)

Auction results and coupon rate announced

WI trading begins (in yield)

Auction results and coupon rate announced

WI trades (in price)

WI trades (in price)

go into the auction with short positions. The WI market also serves in a price discovery role; trading in this market provides vital information on the strength of demand for the security and on the disparity of bidders' views about the market. Such information is useful in preparing bids. Alternatively, dealers who believe they have very valuable private information such as future interest rates may refrain from WI trading so that they can use that information in their bids.

ShortSqueeze

Dealers typically enter the auction with significant short positions, because they have sold the security before the auction to clients who prefer to own the new issue. This presents significant risks, however. A dealer who is short and is unable to obtain a sufficient quantity of the security at the auction must either cover the short position before the issue date by buying in the WI market or must borrow the security on the issue date to make good on delivery. The most common mechanism used to borrow Treasury securities is the reverse repurchase agreement, in which the dealer lends money to the security holder in exchange for use of the security. In such a reverse repurchase transaction, however, the dealer is still short in the security and is exposed to the possibility of being unable to purchase it at the anticipated price. In other words, the dealer is caught in a short squeeze. A short squeeze occurs when an auction participant, or a group of participants, gains control of the security and withholds the supply from the cash or repurchase agreement markets.

A well-known short squeeze occurred in 1991. Salomon Brothers admitted to having controlled 94 percent of the two-year notes auctioned on May 22, 1991, in violation of the Treasury regulation that prohibits a bidder's long position from exceeding 35 percent of the issue in any single auction. Salomon acquired 44 percent of the notes at the auction and allegedly prearranged significant trades with big investors to give the firm a dominant position in the security. The two-year notes are generally in high demand because they have the shortest maturity of coupon Treasury securities. Many investors around the world buy them at auction and hold them to maturity, but the price sometimes declines modestly immediately after the auction, when interest in the note fades. Consequently, a common trading strategy is for traders and arbitrageurs to short ahead of the auction and cover the short after the price declines. Opposite to what was expected, the price of this particular two-year note jumped sharply after the auction. The two-year notes became so scarce that the collateral-specific repurchase agreement rates were about 75 to 200 basis points special. That is, holders of this particular note were able to borrow in the repo market at a favorable rate substantially below the market rate.

The scandal cost Salomon its top management, and it was fined nearly $300 million. The firm lost its credibility in the marketplace and might not have survived had not Warren Buffett, a major shareholder, provided a capital infusion and astute management to restore credibility. More importantly, in response to these problems, the Treasury introduced major changes in the Treasury market, including the right to reopen an issue. It also experimented for the first time with a Dutch auction for the two-year and five-year notes. As noted previously, the Treasury has now adopted the Dutch auction for all Treasury securities. Note that at the time of the Salomon scan dal, the Treasury used multiple-price auctions to sell Treasury securities. Each accepted bid would pay a price that reflected the yield in the bid submitted. Thus, different dealers would pay different prices for the same security.

Coupon Rolls

Treasury coupon rolls play an important part in the process of distributing new Treasury coupon securities. In a coupon roll trade, a dealer purchases an on-the-run, or most recently issued, Treasury security from a customer for next-day settlement and simultaneously sells to that customer the same amount of the recently announced new security for forward settlement. In a reverse roll, a dealer sells an outstanding issue and buys a new security. The forward in a roll trade, a WI sale, settles on the new issue settlement date. The roll is the spread between the yield on the new security and that on the outstanding issue in the same maturity segment. A "give" in rolls indicates that the WI security provides a higher yield than the outstanding issue. A "take" in rolls implies the opposite—that the new issue has a lower yield.

Dealers use rolls to accommodate customers who have a preference for liquidity and tend to trade rolls to maintain positions in the current issues. Dealers also use rolls to position themselves for bidding at upcoming auctions. A dealer will seek to execute a roll if he is short in the outstanding issue because he anticipates a market decline or has to accommodate customers. By executing a roll, a dealer closes the short position on the outstanding issue and creates a short position on the new security. Hence, the dealer has an incentive to bid more aggressively at the upcoming auction.

Trading and Clearing of Treasury Securities

Once a Treasury security is issued, trading mainly occurs over-the-counter, with dealers, brokers, and other investors making trades by phone. In recent years, some dealers have set up electronic trading systems. The most active trading is generally in the on-the-run issues.

Treasury bills trade on a basis of discount rate and typically settle on the same day. The discount, the difference between the security's purchase price and its face value, is the investor's return. The following formula is used to determine the purchase price for short-term bills:

x FV, where p = The purchase price FV = The face value d = The discount rate

M = The number of days from settlement to maturity.

As an example, suppose a bill with a current maturity of 175 days is quoted at a bid of 4.12 percent and an offer of 4.11 percent. The purchase price per $1 million for the bill is:

Coupon Treasuries trade on a price basis. The typical transaction size is $1 million to $100 million for institutions. Trades on coupon Treasuries generally settle on the next market day (called T+1 where T is the trade day), but cash or corporate settlements (T+3) can be arranged. The invoice price (also called the dirty price) of a coupon security consists of the quoted price (also called the clean price) plus the accrued interest. The accrued interest is calculated based on the actual number of days from last coupon payment to trade settlement and the actual number of days in the coupon period (or an actual/actual basis). For example, suppose that a 5 percent, 10-year note is quoted at a bid of 98:20 and an offer of 98:22. Assume that the number of days between the last coupon date and settlement is 136 days and the number of days in the coupon period is 183. If an investor purchases $1 million at par, the total invoice price is

f

f 22 >

$1,000,000 x

98 + —

%

+

V

I 32 ;

2 183

2 183

The total invoice price reflects the quoted price ($986,875, the first term on the right side of the equation) plus the accrued interest ($18,579.23, the second term on the right). The buyer has to pay the offer price plus the accrued interest to the dealer. Note that the Treasury pays interest every six months. Hence, the accrued interest calculation uses half of the annual coupon rate.

Dealer Trading

Every morning, dealers distribute to the traders information about each issue such as the price, yield, dollar value of a basis point or dollar value of an 01 (DV01), and the yield value of a 32nd. The DV01 is the change in the price of a bond resulting from a one-basis-point change in its yield. Frequently, the DV01 is expressed in dollars per million. The yield value of a 32nd is estimated by calculating the yield to maturity if the bond price changes by one 32nd. The difference between the initial yield and the new yield is the yield value of a 32nd. As an example, a 5 percent, 10-year note trading at par and yielding 5 percent has a value of a basis point (V01) of 0.07798 points, or a DV01 of $779.8 per $1 million dollars of par. This is calculated by taking the difference between the price at a yield of 5.00 percent (par) and the price at a yield of 4.99 percent (100.07798 percent of par). The formula for the yield value of a 32nd is

1/(32 X V01), which gives a yield value of a 32nd of 0.401 basis point. In the bills market, the DV01 is 0.01 percent of FV X (M/360). Therefore, the DV01 of a 90-day bill is $25.

A dealer makes money from several sources. First, the bid-asked spread; the price spread varies from 1/128 to 4/32, depending on liquidity, volatility, and remaining maturity. Second, a dealer may profit from a favorable market movement such as appreciation in the securities that the dealer is long and depreciation in the securities in which the dealer has a short position. Another source is carry, or the difference between the interest earned on the securities held in inventory and the financing costs. A positive carry, meaning that interest income is more than interest expense, is a source of profit. Conversely, when interest expense is greater than interest income, the dealer has a negative carry. For example, the carry is -12 basis points if the financing rate is 4.72 percent and the accrued interest is 4.60 percent.

Dealers frequently trade with each other through government interdealer brokers because of the speed and efficiency these brokers provide. Dealers give bids and offers to the brokers, who display the highest bid and lowest offer in a computer network linked to each trading desk. Traders responding to a bid or an offer, by "hitting" or "taking," pay a commission to the broker. Brokers keep the names of the dealers confidential. The quotes provided by the brokers represent prices in the interdealer market, also called the inside market.

In addition to interdealer brokers, GovPX provides real-time information on transactions by the primary dealers. Specifically, it publishes the best bid and best offer, the size, yields, the last trade side (hit/take), and the last trade size. GovPX has a distribution network that includes Bloomberg, Reuters, Bridge, Telerate, and MoneyLine.

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