I.  Treasury Securities

• distinguished by default risk (none), large volume, and high liquidity
• Treasury is largest debt issuer in the world
• Tbills-- zero coupon  (4, 13, 26 weeks)
• Tnotes, Tbonds coupon (2, 5, 10 years)
• TIPS -- Treasury Inflation-Protection Securities
•  10-year Tnote
• idea:  these securities guarantee a real return, not a nominal return, if held until maturity
• guarantee the purchasing power of interest and face value payments, not the dollar value
• how do they work?
• the coupon rate is set at auction and does NOT change
• the face value is adjusted annually by the percentage increase in the CPI
• (if the CPI were to actually fall, the face value will not fall below its original auction value)
• the coupon payment is based on the fixed coupon rate and the adjusted face value
• example
• at auction (year 0):  F = $10,000, coupon rate = 4%; coupon payment = (.04)(10000)/2 = $200
• year 1:  CPI 3%
• new F = $10,000(1.03) = $10,300
• new coupon payment = (.04)(10300)/2 = $206
• year 2:  CPI 2%
• new F = $10,300(1.02) = $10,506
• new coupon payment = (.04)(10506)/2 = $210.12
• advantages of TIPS:  bondholder does not bear inflation risk, and federal government has extra incentive to keep inflation low
• disadvantage of TIPS:  coupon rate is lower relative to Treasuries that are not indexed to inflation, and additions to face value are taxed when made, even though face value will not be received until maturity

• by auction--issued by Treasury Dept., but Federal Reserve runs the auction
• auction frequency
• 4, 13, 26 week Tbills are auctioned weekly
• 2 yr Tnotes are auctioned monthly
• 5, 10 yrs Tnotes, TIPS are auctioned quarterly
• 30 yr Tbonds were auctioned semiannually, but the issuance of 30 year bonds has been suspended indefinitely in light of projected surpluses as of November 2001
• types of bids--minimum of $1000, increments of $1000 in face value
• competitive bids
• bid by yield, lowest yields will be successful (in getting the securities); quantity for any one bidder is limited to 35% of offering
• tradeoff:  name reservation price, but bid may not be successful
• noncompetitive bids
• bid by quantity (up to $1 million for Tbills, up to $5 million of Tnotes & Tbonds); agree to pay average yield of successful competitive bids
• tradeoff: guaranteed success, but do not name reservation price; also stricter quantity limits
• only primary dealers (large Treasury dealers, about 20 dealers) submit competitive bids, anyone may submit a noncompetitive bid
• Fed OMO are only with primary dealers
• awarding Treasuries
• total amount - Federal Reserve purchases - noncompetitve bids = amount for competitive bidders
• competitives bids are awarded starting with the lowest yield bid, and going up until all available Treasuries are awarded
• stop yield--highest accepted competitive bid (bids at the stop yield get only a fraction of their requested quantity)
• tail = stop yield - average of successful competitive bids
• a small tail implies that bidders were in agreement in valuing the securities, a large tail suggests greater uncertainty
• What do the bidders pay?  Treasuries are awarded as  single-price auction, (1992, 1998)
• each successful competitive bidder and each noncompetitive bidder is awarded securities at the price equivalent to the stop yield
• also called a "Dutch auction."
• no "winner's curse" --i.e. the lowest competitive bidder does not end up paying a higher price than other bidders
• 1991 Salomon Bros. Treasury auction scandal
• submitted fraudulent bids to exceed quantity limits
• resulted in fine and the switch to single price auction format in awarding Treasuries
• Fed made auction process more open, computerized (instead of sealed written bids)

• OTC (over-the-counter) market (some trading on NYSE, but this is a small % of total volume)
• dealers offer continuous bid/ask prices
• Treasuries have the narrowest bid/ask spread in debt markets
• due to liquidity and zero default risk of Treasury inventory
• liquidity within the Treasury market depends on distance from auction date
• "on-the-run" or "current coupon" Treasuries are closest to their auction date and are the most liquid of Treasuries
• "off-the-run" Treasuries are farther from their auction date and are relatively less liquid (larger bid/ask spread)
• Treasuries are also bought/sold prior to their auction in the "wi" (when issued) market
• Price quotation
• Tbills--quoted on a bank discount basis (discount yield)
• discount yield = [(F-P)/F] x (360/d)
• contrast this with the yield to maturity = [(F-P)/P] x (365/d)
• the discount yield always understates the true yield to maturity
• why use it?  the discount yield is more computationally convenient
• example
• Tbill, F = $100,000, 90 days to maturity, discount yield = 5.25%
• what is the price of the Tbill?
• .0525 = [(100,000 - P)/100,000](360/90)
• 5250/4 = 100,000 -P
• 1312.5 = 100,000 - P = bond discount
• P = $98,687.50
• what is the yield to maturity?
• YTM = [(100,000 - 98687.5)/98687.5](365/90)
• YTM = 5.39%
• Tnotes & Tbonds--quoted by price
• per $100 of face value, up to 1/32 of $1
• example:  $100,000 = F, ask price = 117:19
• $117 19/32 per $100
• 19/32 = .59375
• P = $117,593.75
• Regulation
• no reporting of trades, no display of bid/ask quotes for the general public
• price quotes from interdealer trade is not available to the public--primary dealers have information advantage
• dealers not required to disclosure their bid/ask spreads to customers

• Treasury does NOT issue zero coupon Tnotes or Tbonds
• in early 1980s (1982), securities firms began to create synthetic zero coupon Treasuries
• i.e. issued their own long-term zero coupon debt that was backed Treasury payments (see figure 16-1, p 300)
• each cash flow in coupon Treasuries sold separately as its own zero coupon bond (backed by Treasury cash flows)
• trademarked securities
• Merrill Lynch--TIGRs (Treasury Income Growth Receipts)
• Salomon Bros.--CATS (Certificates of Accrual on Treasury Securities)
• Lehman Bros.--LIONs (Lehman Investment Opportunities Notes)
• DOGS (Dibs on Government Securities)
• problems with trademarked securities
• Treasury STRIPS program 1985
• standardized stripped Treasury market, replacing the trademarked securities (making them more liquid)
• made STRIPS direct obligations of the federal government (making them default free)
• not as large a market as regular Treasuries, but still an active and liquid market