| GENERAL
DESCRIPTION
U.S. Treasury bills, notes,
and bonds (collectively known as "Treasuries") are issued by the Treasury
Department and represent direct obligations of the U.S. government. Treasuries
have very little credit risk and are backed by the full faith and credit
of the U.S. government. Treasuries are issued in various maturities
up to 30 years.
CHARACTERISTICS
AND FEATURES
Treasury Bills
T-bills are negotiable, non-interest-bearing securities
with original maturities of three months, six months, and one year. T-bills
are offered by the Treasury in minimum denominations of $10,000 with multiples
of $5,000 thereafter, and are offered only in book-entry
form. T-bills are issued at a discount from
face value and are redeemed at par value. The difference between the
discounted purchase price and the face value of the T-bill is the interest
income which the purchaser receives. The yield on a T-bill is a function
of this interest income and the maturity of the T-bill. The returns are
treated as ordinary income for federal tax purposes and are exempt from
state and local taxes.
Treasury Notes and Bonds
Treasury notes are currently
issued in 2-, 3-, 5-, and 10-year maturities on a regular schedule. Treasury
bonds are currently issued in 30-year maturities. Treasury notes are
not callable. Notes and bonds pay interest semiannually when coupon
rates are set at the time of issuance based on market interest rates
and demand for the issue. Notes and bonds are issued monthly or quarterly,
depending on the maturity of the issue. Notes and bonds settle regular
way, which is one day after the trade date (T+1). Interest is calculated
using an actual/365-day count convention.
USES
Banks use Treasuries for investment, hedging, and speculative purposes.
The lack of credit risk and deep liquidity encourages the use of Treasuries
as investment vehicles, and they are often held in a bank's investment
portfolio as a source of liquidity. Since it is the deepest and most efficient
financial market available, many fixed income and derivative
instruments are priced relative to Treasuries. Speculators often use Treasuries
to take positions on changes in the level and term structure of interest
rates.
DESCRIPTION
OF MARKETPLACE
Issuing Practices
T-bills are issued at regular intervals on a yield auction basis. The
three-month and six-month T-bills are auctioned every Monday. The one-year
T-bills are auctioned in the third week of every month. The amount of
T-bills to be auctioned is released on the preceding Tuesday, with settlement
occurring on the Thursday following the auction. The auction of T-bills
is done on a competitive-bid basis (the lowest yield bids are chosen because
they will cost the Treasury less money). Noncompetitive bids may also
be placed on purchases of up to $1.0 million. The price paid by these
bids (if allocated a portion of the issue) is an average of the price
resulting from the competitive bids.
Two-year and five-year notes are issued once a month. The notes are
generally announced near the middle of each month and auctioned one week
later. They are usually issued on the last day of each month. Three-year
and 10-year note auctions are usually announced on the first Wednesday
of February, May, August, and November. The notes are generally auctioned
during the second week of those months and issued on the 15th day of the
month. Thirty-year bond auctions are usually announced on the first Wednesday
of February and August. Treasury bonds are generally auctioned during
the second week of those months and issued on the 15th day of the month.
Primary Market
Treasury notes and bonds are issued through yield auctions of new issues
for cash. Bids are separated into competitive bids and noncompetitive
bids. Competitive bids are made by primary government dealers, while noncompetitive
bids are made by individual investors and small institutions. Competitive
bidders bid yields to three decimal places for specific quantities of
the new issue. Two types of auctions are currently used to sell securities:
Multiple-price auction.
Competitive bids are ranked by the yield bid, from lowest to highest.
The lowest price (highest yield) needed to place the allotted securities
auction is determined. Treasuries are then allocated to non-competitive
bidders at the average yield for the accepted competitive bids. After
all Treasuries are allocated to noncompetitive bidders, the remaining
securities are allocated to competitive bidders, with the bidder bidding
the highest price (lowest yield) being awarded first. This procedure continues
until the entire allocation of securities remaining to be sold is filled.
Regional dealers who are not primary government dealers often get their
allotment of Treasury notes and bonds through primary dealers, who may
submit bids for the accounts of their customers as well as for their own
accounts. This type of auction is used for auctions of the 3-year and
10-year notes and for the 30-year bond.
Single-price auction.
In this type of auction, each successful competitive bidder and each
noncompetitive bidder is awarded securities at the price equivalent to
the highest accepted rate or yield. This type of auction is used for the
two-year and five-year note auctions.
During the one- to two-week period between the time a new Treasury note
or bond issue is auctioned and the time the securities sold are actually
issued, securities that have been auctioned but not yet issued trade actively
on a when-issued basis. They also trade when-issued during the announcement
to the auction period.
Secondary Market
Secondary trading in Treasuries occurs in the over-the-counter (OTC)
market. In the secondary market, the most recently auctioned Treasury
issue is considered current or on-the-run. Issues auctioned before current
issues are typically referred to as off-the-run securities. In general,
current issues are much more actively traded and have much more liquidity
than off-the-run securities. This often results in off-the-run securities
trading at a higher yield than similar maturity current issues.
Market Participants
Sell Side
All U.S. government securities are traded OTC, with the primary government
securities dealers being the largest and most important market participants.
A small group of interdealer brokers disseminates quotes and broker trades
on a blind basis between primary dealers and users of the Government Securities
Clearing Corporation (GSCC), the private clearinghouse created in 1986
to settle trades for the market.
Buy Side
A wide range of investors use treasuries for investing, hedging, and
speculation. This includes commercial and investment banks, insurance
companies, pension funds, and mutual fund and retail investors.
Market Transparency
Price transparency is relatively high for Treasury securities since several
information vendors disseminate prices to the investing public. Govpx,
an industry-sponsored corporation, disseminates price and trading information
via interdealer broker screens. Prices of Treasuries are active and visible.
PRICING
Treasury Bills
Treasury bills are traded on a discount
basis. The yield on a discount basis is computed using the following
formula:
Annualized Yield = [(Face Value / Price) / Face Value]
* (360 / Days Remaining to Maturity)
Treasury Notes and Bonds
Treasury note and bond prices are quoted on a percentage
basis in 32nds. For instance, a price of 98:16 means that the price of
the note or bond will be 98.5 percent of par (that is, 98 16/32). Notes
and bonds can be refined to 64ths through the use of a plus tick. A 98:16+
bid means that the bid is 98 and 16 1 /2 32nds (that is, 98 16.5/32),
which is equivalent to 98.515625 percent of par. When the note or bond
is traded, the buyer pays the dollar price plus accrued interest as of
the settlement date. Yields are also quoted on an actual /365-day count
convention.
HEDGING
Treasuries are typically hedged in the futures or options
markets or by taking a contra position in another Treasury security. Also,
if a position in notes or bonds is hedged using an over-the-counter option,
the relative illiquidity of the option may diminish the effectiveness
of the hedge.
RISKS
Market Risk
The risks of trading Treasury securities arise primarily
from the interest-rate risk associated with holding positions and the
type of trading conducted by the institution. Treasury securities are
subject to price fluctuations because of changes in interest rates. Longer-term
issues have more price volatility than shorter-term instruments. A large
concentration of long-term maturities may subject a bank's investment
portfolio to increased interest-rate risk. For instance, an institution
which does arbitrage trading by buying an issue that is relatively cheap
(that is, off-the-run securities) in comparison to historical relationships
and selling one that is relatively expensive (that is, current securities)
may expose itself to large losses if the spread between the two securities
does not follow its historical alignments. In addition, dealers may take
positions based on their expectations of interest-rate changes, which
can be risky given the size of positions and the impact which small changes
in rates have on the value of longer duration instruments. If this type
of trading is occurring, the institution's risk-management system should
be sufficiently sophisticated to handle the magnitude of risk to which
the dealer is exposed.
Liquidity Risk
Due to lower liquidity, off-the-run securities generally
have a higher yield than current securities. Many institutions attempt
to arbitrage these pricing anomalies between current and off-the-run securities.
LEGAL LIMITATIONS FOR
BANK INVESTMENT
U.S. Treasury bills, notes, and bonds are type I securities
with no legal limitations on a bank's investment.
REFERENCES
Fabozzi, Frank J., and T.
Dessa Fabozzi, ed. The Handbook of Fixed Income Securities. 4th ed. Chicago:
Irwin Professional Publishing, 1995. Stigum, Marcia L. The Money Market.
3d ed. Homewood, Ill.: Dow Jones-Irwin, 1990. U.S. Department of the Treasury.
Buying Trea-sury Securities. Washington, D.C.: The Bureau of the Public
Debt, 1995.
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