CHAPTER 16

TREASURY AND AGANCY

SECURITIES MARKETS
Instructor: Mahwish Khokhar

Introduction
Treasury

Securities are issued by the US

Department of the Treasury and are backed by
the full faith and credit of the US government.
Consequently, market participants view them
as having no credit risk.
Historically, interest rates on TS have been
benchmark interest rates throughout the US
economy.

Treasury Securities
Two

factors account for the prominent role of US

Treasury Securities:
Volume (in terms of dollars outstanding)
Liquidity

The

department of the treasury is the largest single

issuer of the debt in the world.
The large volume of the 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.

Contd..
The

spread between the bid and ask prices is

considerably narrower than in other sectors of
the bonds market, and most issues can be
traded easily.
Many issues in the corporate and municipal
markets are illiquid by contrast and cannot be
traded easily.

Types of Treasury Securities

There

are two categories of government

securities:
Discount
Coupon Securities

The

fundamental difference between the two

securities lies in the form of the stream of
payments that the holder receives, which is
reflected in turn in the prices at which the
securities are issued.

Contd..
Coupon

securities pay interest every six

months, plus principal at maturity.
Discount securities pay only a contractually a
fixed amount at maturity, called maturity
value or face value.
Discount instruments are issued below
maturity value, and return to the investor the
difference between maturity value and the
issue price

Contd..
Current

Treasury practice is to issue all the securities

with maturities of one year or less as discount securities
and these securities are called Treasury Bills.
All securities with maturities of two years or more are
issued as Coupon Securities.
Treasury coupon securities issued between the
maturities of 2 and 10 years are called Treasury Notes.
Those with maturities of more than 10 years are called
Treasury Bonds.
While there is difference between the treasury notes
and treasury bonds but in this chapter we will call them
simply as treasury bonds.

Contd..
Treasury

inflation protection securities: On

January 29, 1997, the US department of the
Treasury issued for the first time Treasury
Securities that adjust for inflation. These
securities are popularly referred to as TIPS or
TIIS (Treasury inflation indexed securities).
TIPS works as follows:
The coupon rate on the securities is set at a fixed

rate.

Contd..
That rate is determined at an auction process.
The coupon rate is called the real rate on which an

investor earns more than inflation rate.

The

adjustments for inflation is as follows:

The principal on which the Treasury Department

will base both the dollar amount of the coupon

payment and the maturity value is adjusted
semiannually. This is called the inflation adjusted
principal.

Contd..
For

Example:

Suppose that the coupon rate for TIPS is 3.5% and the

annual inflation rate is 3%.

Suppose further that an investor purchases on January
1, $100,000 of par value (principal) of this issue.
The semiannual inflation is 1.5% (3% divided by 2).
The inflation adjusted principal at the end of the first six
month period is $101,500.
The coupon rate is then 1.75% multiplied by the
inflation adjusted principal at the coupon payment date
($101,500).
The coupon payment is therefore $1776.25.

Primary Market
As

we all know that the primary market is the

market for newly issued securities.
Auction Cycles: The US Department of the

Treasury make the determination of the procedure

for auctioning new treasury securities, when to
auction them, and what maturities to issue.
There have been occasional changes in the auction
cycles and the maturity of the issues auctioned.
Currently, there are weekly three-month and sixmonth bill auctions.

Contd..
Determination of the Results of an Auction: The

auction for treasury securities is conducted on a

competitive bidding basis.
Competitive bids must be submitted for up to a $1
million face amount. Such tenders are only based on
quantity not yields.
The auction results are determined only by deducting
the total noncompetitive tenders and nonpublic
purchases (such as purchases by Federal Reserve
itself) from the total securities being auctioned.
The remainder is the amount to be awarded to the
selected bidders.

Contd..
For Example, in April 1996 there was an auction

for two years treasury note . The amount auctioned

by the treasury was $19.946 billion.
The noncompetitive bids totaled $1.169 billion.
This meant that there was $18.777 billion to be
distributed to the competitive bidders.
For this auction there was bids for $47.604 billion.
See table 16.1, page 293.

Contd..
Primary Dealers: Any firm can deal in government

securities, but in implementing its open market

operations, the Federal Reserve will deal directly only
with dealers that it designates as primary dealers or
recognized dealers.
Basically, the Fed wants to be sure that firms requesting
status as primary dealers have adequate capital relative
to positions assumed in the TS and do a reasonable
amount of volume in Treasury Securities.
When a firm requests for the status of primary dealer,
Fed asks for its position and trading volume and if it
fulfill the criteria the Fed give the firm status of its
reporting agent.

Contd..
Submission for bids: Until 1991, primary dealers

and large commercial banks that were not primary

dealers would submit their bids for their own
account not for their customers account.
Well publicized violations of the auction process by
Salomon Brothers in the summer of 1991 forced
treasury officials to more closely scrutinize the
activities of primary dealers and also reconsider the
procedure by which treasury securities are
auctioned.
Specifically, specified broker/dealers could bid for
their customers.

Secondary Market
As

we all know the secondary market for TS

is an OTC, where a group of US government
securities dealers offer continuous bid and ask
prices on outstanding treasuries.
There is virtual 24 hours trading of TS.
The three biggest markets are New York,
London and Tokyo.

Contd..
When Issued Market: TS are traded prior to the time

they are issued by the Treasury. This component of the

Treasury secondary market is called when issued
market or wi market.
Government Brokers: 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 or government brokers
who display the highest bid and the lowest offer in a
computer network tied to each trading desk and
displayed on a monitor.

Contd..
Bid and Offer Quotes on Treasury Bills: The

convention of quoting bids and offers is different

for treasury bills and treasury coupon securities.
Bids and offers on TB are quoted in a special way.
Unlike bonds that pay coupon interest, TB values
are quoted on a bank discount basis, not on a price
basis. The yield on a bank discount is computed
as follows:
Y = D/F x 360/t

Contd..
D = dollar discount. Which is equal to the

difference between the face value and the price.

F = face value
T = number of days remaining to maturity
For

example: a TB with 100 days to maturity,

a FV of $100,00 and selling at $97,569, find
out the D and Y?

Contd..
Bid and Offer Quotes on Treasury Coupon Securities: Treasury

coupon securities are quoted differently from treasury bills.

They trade on a dollar price basis in price units of 1/32 here of 1%
of par (par is taken to be $100).
Read page 296, last paragraph.
Regulation of Secondary Market: The rules for the sale of US
securities have been exempt from most SEC provisions and rules.
Thus, government brokers/dealers are not required to disclose the
bid ask spread on the TS that they buy from or sell to customers.
There are guidelines established by the National Association of
Security Dealers for reasonable bid-ask spreads, but lack of
disclosure to customers makes it difficult for the customers to
monitor the pricing practice of the broker/dealer.

Contd..
Dealer use of the Repurchase Agreement Market:

Suppose, a government securities dealer has purchased

$10 million of a particular TS. From where the dealer
can arrange for the funds to finance its position?
The dealer will use its own funds to borrow from the
bank. Typically, however, the dealer uses the repo
market to obtain financing. In the repo market the
dealer will use the $10 million of TS purchased as a
collateral for a loan.
The terms of the loan and the interest that dealer
agrees to pay (called repo rate) are specified.
A loan for more than one day is called term repo.

Contd..
A Note on Terminology in the Repo Market:

Read page 299.

Stripped Treasury Securities

The

treasury do not issue zero-coupon bonds or notes. In

August 1982, however, both Merrill Lynch and Salomon
Brother created synthetic zero-coupon Treasury receipts.
The procedure was to purchase Treasury Bonds and
deposit them in a bank custody account.
The firms then issued receipts representing an ownership
interest in each coupon payment on the underlying
Treasury bond in the account and a receipt for ownership
of the underlying Treasury bonds maturity value.

Contd..
The

process of separating each coupon payment as

well as the principal (called the corpus), and selling
securities against them is referred to as coupon
stripping.
The receipts are not issued by the US Treasury, the
underlying bonds in the banks custody account is a
debt obligation of US treasury, so the cash flow is
certain.
Today, stripped treasury securities are referred to
ad Treasury Strips.
Disadvantage: Read Page 301.
Further: Page 301

Thanks =)