Treasury and Agency
Security Markets
Fabozzi—Chapter 6
Treasury and Agency Sectors
 Treasury Securities:
 Are debt instruments issued by the U.S. Department of the
Treasury and are backed by the full faith and credit of the
U.S. government--and thus are viewed as default risk-free
 The U.S. government is the largest single issuer of debt in
the world.
 Treasury markets are one of the most liquid markets in the
world.
nd largest bond market sector (behind mortgage sector).
 2
 Federal Agency Securities:
 Debt instruments issued by federally related institutions and
government sponsored enterprises (GSEs)
Types of Treasury Securities
 Treasury bills:


Short-term debt issued at a discount to par value (no coupons—
entire return is paid at maturity).
Original maturities of 4, 13, and 26 weeks.
 Treasury notes:

Coupon-bearing debt instrument issued with maturities greater
than 1 year but no more than 10 years.
 Treasury bonds:

Coupon-bearing debt instrument issued with maturities greater
than 10 years.
 Treasury Inflation Protection Securities (TIPS):

Debt securities whose payments are adjusted for inflation.
 Treasury securities are sold in minimum increments of $1,000.
Treasury Bills
 T-bills are quoted in a special way:

Quotes are on a bank discount basis, not a price basis.
F  P 360
Yd 

F
t




F = face value
P = market price
t = number of days until maturity
Yd = annualized yield quoted on a bank discount basis
 The quote you get from a dealer is Yd, not P.
Example of Bank Discount Quote
 A $100,000 face value T-bill has 100 days until
maturity and sells for $99,100.
 What is the bank discount quote?
F  P 360
Yd 

F
t
100, 000  99,100 360
Yd 

100, 000
100
Yd  0.0324 (or 3.42%)
 If you called for a quote on this T-bill, you would
be given a quote of 3.24% (% discount from par).
How to Find Price Given Yd
 If you got a quote of Yd, how do you find price?
Yd 
 Solve for P:
F  P 360

F
t
 t  Yd 
P  F 1 

360


 Example: A dealer gives you a quote of 3.68% on
a $100,000 face value T-bill expiring in 90 days.
What is the price of the T-bill?
 t  Yd 
 90  0.0368 
P  F 1 

100,
000
1 
  $99, 080

360
360 



Bank Discount and Return
 Is the bank discount rate the rate of return on a T-bill?
 No…for two reasons:
 The bank discount rate is the annualized percentage
difference between F and P using F as the base.
 It uses a 360 day year, not 365 as it should.
 The bank discount rate is not meaningful (or comparable
to other securities) as a return.
 Two adjustments are often made to facilitate comparison:


Bond equivalent yield—makes Yd comparable to nondiscount bonds (this will give actual rate of return).
CD equivalent yield –makes Yd comparable to quotes on
other money market instruments.
Bank Discount Rate Adjustments
 Bond Equivalent Yield:
YBE 
YBE
F  P 365

P
t
F 365
 Yd  
P 360
 CD Equivalent Yield: (see page 143)
YCDE 
360Yd
360  t  Yd
Quotes on Treasury Bonds and Notes
 T-notes and T-bonds use different conventions
than those used for T-bills. Look at examples:
 Example 1: A T-bond is quoted as 96-14:



The “96” is a percent of face value.
The “14” is the number of 32nds added to 96.
The quote would be 96 + 14/32, or 96.4375.
 Example 2: A bond is quoted as 96-14+


The “+” means add 1/64th to 96-14
The quote is 96 + 14/32 + 1/64 or 96.453125.
 Example 3: A bond is quoted as 96-142:


The “2” means add 2 256ths to 96-14
The quote is 96 + 14/32 + 2/256 or 96.4453125
More T-Note & T-Bond Conventions
 Accrued interest:

When an investor purchases a bond between coupon
payments, the buyer must compensate the seller for
coupon interest earned since last coupon payment.
 Example:


There are 183 days between coupon payments and
the annual coupon is $8 per $100 of Par Value. The
last coupon was paid 50 days ago.
If you buy this bond, how much accrued interest
must you pay to the seller?
AI 
annual dollar coupon
days in AI period

2
days in coupon period
Accrued Interest and Day Count
Conventions
 Timeline of a T-bond transaction:



Trade date: Date on which the transaction is
executed.
Settlement date: Date on which the transaction is
completed (payment made and ownership recorded).
For T-bonds (and notes) settlement is the next
business day after the trade date.
 To determine the number of days since last
coupon payment:

Count the number of days from last coupon payment
up to, but not including, settlement date.
Day Count Example
 A T-bond paid its last coupon on May 15. The next
coupon will be paid on November 15.
 If the security is purchased on September 9, and settled
on September 10. How many days are used for accrued
interest calculation?
Month
# Days
May
17
June
30
July
31
August
31
September
Total #Days
9
118
 Note we counted May 15th, but
we didn’t count September 10th.
Stripped Securities
 The Treasury does not issue zero-coupon bonds.
 However, there has been considerable demand for zero-
coupon bonds with no credit risk.
 To meet demand, dealers in the private sector began
stripping Treasury securities in 1982.
 In 1985, the U.S. Treasury began its STRIPS program to
facilitate the stripping of U.S. Treasury securities:



Today, all T-notes and T-bonds are eligible for stripping.
All zeros created under the STRIPS program are considered
direct obligations of the U.S. government.
Securities created under the STRIPS program are cleared
through the Federal Reserve’s book-entry system.
How A Bond is Stripped
 Suppose a dealer has $500,000,000 of a 10-year
5% coupon Treasury note.
 This note has 21 cash flows:



Twenty $12,500,000 cash flows come from coupons.
One $500,000,000 cash flow is from the repayment of
principal (called the corpus).
These cash flows can be sold off in $1,000 face value
zero coupon bonds.
 Strip quotes are denoted as:


“ci” if created from coupons (called coupon strips)
“bp” if created from bond principal, or “np” if created
from note principal (called principal strips).
Tax Treatment of Strips
 As zero-coupon instruments, strips pay no
interest until maturity.
 However, the U.S. government taxes the implied
gain (called accretion) as ordinary income every
year.

This creates a negative cash flow which reduces the
attractiveness of these securities.
Treasury Inflation Protection
Securities (TIPS)
 In 1997 the Treasury began issuing bonds that
adjust for inflation:

TIPS provide inflation protection for investors: the
higher the inflation rate, the higher the TIPS interest
payments become.
 TIPS pay a fixed coupon rate:


The face value is adjusted based on the inflation rate
(called inflation-adjusted principal)
The face value is indexed to CPI for urban consumers
(CPI-U), a price index for U.S. cities.
TIPS Example
 Suppose the coupon rate on TIPS is 3.5% and the annual
inflation rate is 3% (semiannual inflation rate = 1.5%).

An investor purchases $100,000 (face value) of an issue on
January 1.
 In June (when the coupon is paid), the face value is
increased by the amount of the inflation, or $101,500.

The coupon will be 0.0175  $101,500 = $1,776.25
 Suppose for the next six months the annual inflation rate
is 2%. To find the next coupon (on December 31):


Increase the face value by 1%, to $102,515.
Given the semi-annual coupon rate of 1.75%, we get a coupon
of 0.0175  $102,515 = $1,794.01
 Note: The U.S. government now taxes the inflation
adjustment of TIPS, making them less attractive since they
are less useful as an inflation hedge.
The Treasury Auction Process
 Treasury securities are sold in the primary
market via sealed-bid auctions:
Security
Frequency
T-bill
Weekly
2-year note
Monthly
3-year note
Quarterly*
5-year note
Monthly
10-year note
Quarterly*
30-year bond Quarterly*
*Quarterly Auctions occur in February,
May, August, and November
The Treasury Auction Process
 The Treasury auction determines the yield at
which an issue will be sold.
 Two types of bids are submitted, competitive and
noncompetitive.
 Competitive bidders are large government
securities dealers and brokers:

They ultimately determine the yield on the issue
through the bidding process.
 Noncompetitive bidders are smaller investors:
 Noncompetitive bidders receive the stop out yield –
highest yield bid accepted determined by the auction.
The Treasury Auction Process
 Process:
 Competitive bidders request a specific quantity of a bond
issue and the amount they are will to pay (equivalently,
the yield they would be willing to receive).
 Bids are then arranged from lowest to highest yield.
 Quantities are filled beginning with the lowest yield and
continue until the bond issue is completely allocated.
 The highest yield accepted by the Treasury is referred to
as the stop-out yield or the high yield.

Bidders bidding higher than the high yield receive no
allocation of the bond.
 Noncompetitive bidders receive the stop out yield
determined by the auction.
Federal Agency Securities
 Two types of agency issuers:


Federally related institutions.
Government Sponsored Enterprises (GSEs)
Federally Related Institutions
 Arms of the federal government and usually do not issue
securities directly in the marketplace.
 Examples:





Tennessee Valley Authority (TVA)
Export-Import Bank of the United States
Farmers Housing Administration
Private Export Funding Corporation (PEFC)
Several others
 Typically exempt from SEC registration.
 Securities are usually backed by the full faith and credit
of the U.S. Government (exceptions are TVA and PEFC).


However, TVA has been major issuer of these types of
securities.
Most federally related institutions do not issue securities.
Government Sponsored Enterprises
 Privately owned, publicly chartered enterprises
created by congress to reduce the cost of capital
for certain borrowing sectors of the economy.

The sectors include: Farmers, homeowners, and
students.
 Some of these organizations provide credit to the
housing market.



They do so by issuing both debentures and mortgagebacked securities.
We will only discuss debentures in this chapter.
Mortgage-backed securities will be discussed in later
chapters.
Government Sponsored Enterprises
 Five major GSEs issue debentures:
 Federal National Mortgage Association (Fannie Mae)
 Federal Home Loan Mortgage Corporation (Freddie Mac)
 Federal Agriculture Mortgage Corporation (Farmer Mac)
 Federal Farm Credit Bank System (FFCBS)
 Federal Home Loan Bank System (FHLBanks)
 We will briefly discuss Fannie Mae and Freddie Mac.
Fannie Mae
 Fannie Mae is a NYSE-listed company serving the U.S.
mortgage industry:


Provides banks and other mortgage lenders financing,
credit guarantees, and other services to help lenders make
more loans.
Fannie Mae does not make home loans.
 To finance operations, Fannie Mae issues debt securities:
 Benchmark bills (3, 6, and 12-month maturities)
 Benchmark notes (2, 3, 5, 10-year maturities)
 Benchmark bonds (30-year maturity)
 Callable Benchmark Notes
 Subordinated Benchmark Notes
 Investment Notes (debt securities for individual investors)
Freddie Mac
 Freddie Mac is a NYSE-listed company serving:

Freddie Mac purchases mortgages from banks and bundles
them together into a tradable security (securitization).
 To finance the purchase of its mortgages it issues the
following types of debt:





Reference Bills (maturities of 1 to 12 months)
Reference Notes (maturities of 2 to 10 years)*
Reference Bonds (maturities from 10 to 30 years)*
Callable Reference Notes
Euro Reference Notes (Euro denominated)
*Eligible for stripping
GSE Credit Risk
 With the exception of the Farm Credit Financial
Assistance Corporation (FFCSB), GSE securities
are not backed by the full faith and credit of the
U.S. government.
 Thus, there is credit risk associated with GSE
debt.