Chapter 16 – Treasury Market

1. Chapter 16 – Treasury Market • Debt Instruments of the U.S. Government • Largest borrower in the world • Very liquid markets • Considered risk-free • Main Types • Treasury Bills (maturity less than 1 year at issue) • Treasury Notes (maturity 2 to 10 years) • Treasury Bonds (maturity greater than 10 years)

2. Chapter 16 – Treasury Market • Current Level of Debt • http://www.brillig.com/debt_clock • Currently Over $7 trillion • Repayment of Debt • Interest and principal at maturity (discount) • Interest as you go and principal at the end (notes and bonds) • Price = FV / (1 + r )^n + PMT ( 1 – [1/(1+r)^n])/( r) • Another Feature of Debt – Callable Bonds

3. Chapter 16 – Treasury Market • Pricing a bond • Present Value of Interest Payments • PMT ( 1 – [1/(1+r)^n])/( r) • PMT is six month payment determined by the coupon rate and par value of the bond • r is the periodic interest rate (yield to maturity) • n is the number of payments • Present Value of Face (Par) Value • FV / (1 + r )^n • FV is the Par Value of the bond

4. Chapter 16 – Treasury Market • Treasury Auctions • Set Schedule for the different maturities • Competitive Bidding Process • Amount Announced Ahead of Time • Non-Competitive Bids – up to $1 million • Non-Competitive subtracted from offer size • Will receive at the stop bid • Bid by quantity and yield • Stop Yield is the last yield necessary to sell out the issue (highest yield accepted) – every bidder and non-competitive bidder gets this yield

5. Chapter 16 – Treasury Market • Secondary Market Trading of Treasuries • Over the Counter Market • New York, London, and Tokyo • U.S. Government Security Dealers • Settlement is next day • Traded before Issue • When-issued trading • Starts at auction announcement day • Dealers and Interdealer Brokers • Inside market

6. Chapter 16 – Treasury Market • Two Special Bonds – STRIPS and TIPS • STRIPS – Separate Trading of Registered Interest and Principal of Securities • The individual coupons and principal trade separately • The individual assets are discount bonds • TIPS - Treasury Inflation Protected Securities • Par Value (principal) adjusted semi-annual to inflation rate • New Par Value used to compute interest payment • Protected at maturity

7. Chapter 16 – Treasury Market • STRIPS • First started by Merrill-Lynch August 1982 • TIGRs – Treasury Interest Growth Receipts • Stripped U.S. Government Bonds • Others followed – Trademark Zero’s • Traded only within the “issuer” • Secondary market not very liquid • Treasury Receipts – Generic to improve liquidity • Government STRIPS starts in 1985

8. Chapter 16 – Treasury Market • Adjusting the TIPS Principal • Initial Par Value ($100,000) • Six-month Inflation rate adjusts the principal prior to determining the interest payment • Fixed coupon rate for interest payment • Increase in principal is a capital gain and taxable • If deflation occurs, potential for ending principal to be lower than issue principal • Ending principal adjusted back to issue principal if below issue principal

9. Chapter 16 – Treasury Market • Repurchase Agreements – REPOS • A contract that sells a financial asset but also provides for buying back the same asset • Collateral is identified • Buying and Selling price is set • Time of purchase and sale is set • Overnight Repo • Term Repo • Cheaper borrowing than unsecured Federal Funds Rate

10. Chapter 16 – Treasury Market • Federal Agency Securities – More Later 5-19-05 • Federal Related Institutions • Agencies owned by the Federal Government • TVA and Ginnie Mae • Government Sponsored Institutions • Private Organizations • Freddie Mac, Fannie Mae, Sally Mae, etc. • Debentures vs. Mortgage Backed • Non U.S. Government Bonds • Issues from other central governments • Example, United Kingdom’s Gilts