Chapter 2
BOND ISSUERS
2-1
The United States Treasury
 The U.S. Treasury performs primarily
the following functions.
Collects taxes.
Pays the bills of the government.
There is a deficit if taxes are less
than payments. There is a surplus if
taxes are greater than payments.
2-2
Several Things Noteworthy
about U.S. Treasury Debt
 The total debt is huge, in the vicinity of
14 trillion dollars.
 The Treasury has a very large number
of debt issues.
 Individual debt issues are extremely
large in size and therefore highly
liquid. Liquid securities can be bought
and sold rapidly without affecting the
price.
2-3
LINKS TO TREASURY
WEBSITE
 http://www.treasurydirect.gov/govt/rep
orts/pd/mspd/mspd.htm
 INTEREST ON NATIONAL DEBT
 http://www.treasurydirect.gov/govt/cha
rts/charts_expense.htm
2-4
FISCAL YEAR DEFICIT
2-5
FUTURE CHALLENGES
2-6
The Treasury Must Raise Very
Large Amounts of Money.
 One reason for the large dollar volume
of securities that must be sold is the
need to replace maturing securities by
new issues.
 The Treasury must finance deficits.
2-7
Marketable Debt vs.
Nonmarketable
 Basically the Treasury sells two types
of debt. Marketable debt is sold to the
public and can be resold to other
buyers. This is approximately half of
the debt.
 Nonmarketable debt cannot be resold.
It is composed of two major
components. Savings bonds.
Government retirement accounts.
2-8
Three Types of Marketable
Debt
 Treasury bills. Maturities of one year
less. No coupons.
 Treasury notes. Original maturities of
up to 10 years. Semi-annual coupons.
 Treasury bonds. Original maturities of
30 years. Semi-annual coupons. The
most recently issued Treasury bond is
usually called the long bond.
2-9
T-Bills
0
-P
-99.50
91 days
Bills
+PAR
+100
2-10
Notes and Bonds
0
1
2
...
n
-P
+c
+c
...
+c +PAR
-100
+6
+6
...
+6 +100
2-11
DEBT DISTRIBUTION
 http://www.treasurydirect.gov/govt/cha
rts/principal/principal_debt.htm
2-12
Maturity of Debt
Interest
Rates
58% Notes
14% Bonds
28% Bills
Most common pattern
is upward slope
Maturity
Spreads out maturities
2-13
Interest
Rates
Bills only
Maturity
Bills only would alter shape
2-14
Auction Procedures
 The Treasury announces auctions to
the public. It states the total amount
of a particular issue that it would like
to sell and then solicits bids.
 There are two types of bids.
2-15
Types of Bids
 Noncompetitive bids are for par values
< $5 million. These bidders agree to
pay the price of the average winning
competitive bid.
 Competitive bidders specify a par
value and a price. Typically
competitive bids are submitted by
bond dealers who resell these bonds
to the public.
2-16
Price
Accept
Supply
Reject
Competitive
Bids Demand
12
Total supply
= $15b
Noncompetitive
= $ 3b
Competitive bids
= $12b
Price/$ PAR
.99
.98
Accept
.97
.96
Reject
PAR
4
4
4
4
CUM
4
8
12
2-17
Impact of Single-price
Auction upon Demand Curve
Price
Supply curve
Accepted bids
Rejected bids
Price in
single-price
auction
Lowest
accepted
discriminatory
bid
Amount of bonds
2-18
Flat Auction Demand Curve
– No Winners’ Curse
Price/$
Supply
$
2-19
Announcement Date, Auction
Date, and Issue Date
Time
Announcement
date
Auction
date
Issue
date
2-20
Treasury Inflation Protected Securities
(TIPS)
c = Stated coupon
Par = Original par value
j = Inflation rate in period j
0
1
2
3
1
2
3
Time 1 par value: Par(1 + 1)
Time 1 coupon: c(Par)(1 + 1)
Time 2 par value: Par(1 + 1) (1 + 2)
Time 2 coupon: c(Par)(1 + 1)(1 + 2)
Time j par value: Par(1 + 1) … (1 + j)
Time j coupon: c(Par)(1 + 1) … (1 + j)
2-21
Municipal Bonds
 Bonds issued by state and local
governments.
 General obligation bonds. Backed by
the full taxing authority of the
municipality.
 Revenue bonds. Backed by the
revenues from a particular project.
Much higher default rate.
2-22
 In recent years, a large proportion of
revenue bonds have been insured
against defaults by private insurance
companies.
2-23
Yields on Municipal Bonds
 Suppose that the interest rate on a
default free taxable bond is y and that
the tax rate for the marginal bond
buyer is t.
 Then the yield to maturity for a default
free municipal bond would be y(1 – t).
 However, the yield for a municipal
bond is also affected by two other
factors.
2-24
Municipal Bond Yield Factors
 Default risk.
 Lower liquidity.
 Suppose that the default risk adds a
premium of d and liquidity risk adds a
premium of l. Then, the yield to
maturity for a municipal bond equals
y(1 – t) + d + l.
2-25
y(1  t )  d  l.
0.10(1  0.25)  0.005  0.005  0.085
0.075  0.005  0.005  0.085.
2-26
Benefits and Costs of
Municipal Bonds
 The yield to maturity for a municipal
bond is less than the yield for a
taxable bond that is otherwise
identical. This represents a subsidy to
the borrowing municipality.
 The tax free status of municipal bonds
represents a subsidy to buyers, that is,
individuals in high tax brackets –
wealthy individuals.
2-27