Bonds
- Debt securities
- Issued by borrower to obtain funds
- Bought and held by investors to earn a return
- Most bonds pay face value upon maturity and incremental coupon payments
Primary Market
U.S. Treasury auctions debt (Treasury Securities) to the public
- Securities issued for first time
- Investors buy directly from issuer (US Treasury, corporations, etc.)
Secondary Market
-Trading through brokers/dealers
U.S. Treasury Market
- Deepest most liquid gov’t securities market in the world
- Primary means of financing U.S. gov’t
- Safer/secure because U.S. government credibility guarantees payments
- Used by Fed to implement monetary policy
- Used as risk-free benchmark for pricing other financial instruments
Types of Treasury Securities issued
- Bills: maturity < 1 year, sold at discount, returns face value at maturity
- Notes: maturity 1-10 years, semi-annual coupons, par at maturity
- Bonds: maturities > 10 years, semi annual coupons, returns par at maturity
- TIPS (Treasury Inflation-Protected Securities): 5,10, 30 years; “real rate” coupon (inflation adjusted); principal gets adjusted over time based on inflation; coupon recalculated based on inflation adjusted rate
Floating Rate Notes (FRNs)
-2 year maturity
- Interest paid every quarter
- Interest rate resets weekly, tied to 13-week T bill yield
Treasury Auction Process
- Announcement date: government announces it will be having an auction
- Auction date: investors submit bids
- Settlement date: people who actually win the bid exchange money for security (those who win securities at the auction)
Treasury Issuance Calendar
NOTE: T-bills maturities are usually quoted in months by traders
- 4 week bills (1 month)
- 6 week bills (1 month)
- 8 week bills (2 months)
- 13 week bills (3 months)
- 17 week bills (4 months)
- 26 week bills (4 months)
- 52 week bills (12 months)
- 2 year notes
- 3 year notes
- 5 year notes
- 7 year notes
- 10 year notes
- 20 year bonds
- 30 year bonds
TIPS:
- 5 year TIPS
- 10-year TIPS
- 30-year TIPS
FRNs:
- 2-year FRN
Competitive Bid
Competitive bid: bidder specifies amount of security being auctioned, yield/rate/discount margin that is acceptable. May receive full amount, part, or none of quantity that was for bid depending on auction compared to your bid.
- Wants $X of Treasuries but only if I get Y% yield
- Competing/bidding against other investors to set the high rate
- If bid too high: may only get partially filled (i.e. Treasury takes $10M out of your $20M)
- Usually only big institutions bid competitively
Noncompetitive Bid
- Want $X of Treasuries, will take whatever yield comes out of the auction (high rate)
- Don’t influence yield rate, just accept auction result
How Treasury Auction Works
- Treasury wants to borrow $ by issuing new T Bills
- Investors place bids. Will lend X amount of money, but want X% interest.
Ex: Bank A $20M at 4.9%
Bank B $30M at 5%
Bank C $50M at 5.05%
Treasury fills cheapest bids (lowest yields) first. Start at lowest yield, work up until full $ amount they want to borrow is filled.
High rate
Highest yield that gets accepted (highest rate Treasury had to pay to sell all debt)
Single price auction
Everyone who bid/bought in the auction receives the same rate (high rate) , even those with lower yields
*Note: noncompetitive bids are accepted in full first
- Remainder are allocated to competitive bidders starting from ones with lowest bid yields/discount rates and continuing with successively higher bids up to amount required to meet offering amount.
Who Buys Treasuries at Auctions
- Primary Dealers: large banks, firms (i.e. JPM, Citi, GS). Required to submit bids in every Treasury auction to ensure constant demand (buy large amounts then resell the Treasuries in the secondary market)
- Investment funds: mutual funds like Fidelity, Vanguard, hedge funds, MMFs, pension funds. Biggest private buyers of Treasuries at auction.
- Also many other buyers, typically of smaller amounts (U.S. households, corporations, local gov’t)
- Fed CANNOT bid competitively in Treasury auctions. It can: 1) roll over maturing Treasuries 2) Buy in secondary market through SOMA
Biggest buyers of Treasuries
1) Investment funds
2 Dealers
3) Brokers
4) Foreign international
Bids for different securities
Yields - all Treasury bonds
Real yields - TIPS
Discount rates - T Bills
Discount margins - FRNs
Yield to Maturity
Internal rate of return / interest rate that makes PV of future cash flows equal to price
-YTM and price of bond have an inverse relationship
Yield to Call
Internal rate of return when cash flows terminate on the call date (basically YTM if the bond got called at the first call date)
Current Yield
= coupon payment / price
Bid-ask spread
Bid price is the highest price where a buyer is willing to buy the security
The ask or offer price is the lowest price where a seller is willing to sell the security
Bid/ask or bid/offer spread is the difference between the bid price and ask price and is used as a measure of liquidity
Liquidity describes the degree to which an asset or security cna be quickly bought or sold in the market without affecting the assets price
98-20/21: bid is 98-20 and offer is 98-21
Treasury Bond Prices
- Flat price (“clean” price): quoted market price for a bond, NOT including accrued interest (i.e. face value, premium, discount)
- Full price (“dirty” price): flat price plus accrued interest (accrued interest: coupon interest earned since last coupon payment) -> THIS IS PRICE YOU MUST ACTUALLY PAY WHEN PURCHASING A BON
T Bill rate moves with
It moves with the Fed Funds rate
In a crisis, the Fed cuts the federal funds rate → short-term rates across the curve collapse.
Investors flood into safe assets → demand for T-bills surges → prices rise → yields fall.
That’s why in 2008 and 2020 (COVID), the 3-month T-bill yield dropped to near 0%, even briefly negative.
Who are biggest foreign investors of US Treasuries?
- Japan
- UK
- China
Generic treasury 10-year notes
graph of how 10-year notes have historically behaved
