Treasury Notes and Bonds

The U.S. government borrows funds in large part by selling Treasury notes and Treasury bonds. T-note maturities range up to 10 years, whereas bonds are issued with maturities ranging from 10 to 30 years. Both are issued in denominations of $1,000 or more. Both make semiannual interest payments called coupon payments, a name derived from pre-computer days, when investors would literally clip coupons attached to the bond and present a coupon to an agent of the issuing firm to receive the interest payment. Aside from their differing maturities at issuance, the only major distinction between T-notes and T-bonds is that T-bonds may be callable during a given period, usually the last five years of the bond's life. The call provision gives the Treasury the right to repurchase the bond at par value. Although the Treasury hasn't issued these bonds since 1984, several previously issued callable bonds are still outstanding.

Figure 2.4 is an excerpt from a listing of Treasury issues in The Wall Street Journal. Note the highlighted bond that matures in November 2008. The coupon income, or interest, paid by the bond is 4%% of par value, meaning that a $1,000 face-value bond pays $47.50 in annual interest in two semiannual installments of $23.75 each. The numbers to the right of the colon in the bid and asked prices represent units of Vfe of a point.

The bid price of the bond is 9112/32, or 91.375. The asked price is 9114/32, or 91.4375. Although bonds are sold in denominations of $1,000 par value, the prices are quoted as a percentage of par value. Thus the bid price of 91.375 should be interpreted as 91.375% of par or $913.75 for the $1,000 par value bond. Similarly, the bond could be bought from a dealer for $914.375. The + 8 bid change means the closing bid price on this day rose 8/32 (as a percentage of par value) from the previous day's closing bid price. Finally, the yield to maturity on the bond based on the asked price is 6.08%.

The yield to maturity reported in the financial pages is calculated by determining the semiannual yield and then doubling it, rather than compounding it for two half-year periods. This use of a simple interest technique to annualize means that the yield is quoted on an annual percentage rate (APR) basis rather than as an effective annual yield. The APR method in this context is also called the bond equivalent yield.

You can pick out the callable bonds in Figure 2.4 because a range of years appears in the maturity-date column. These are the years during which the bond is callable. Yields on premium bonds (bonds selling above par value) are calculated as the yield to the first call date, whereas yields on discount bonds are calculated as the yield to the maturity date.


Why does it make sense to calculate yields on discount bonds to maturity and yields on premium bonds to the first call date?

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