Tuesday, 4 December 2007

What are Treasury securities?

If you are new to the finance world and you have heard people saying things like T-Bonds, T-Notes or take the risk free rate as the 3-months T-Bills rate etc., you might be wondering what those things are. What exactly are Treasury securities?

Treasury securities (Treasuries) are issued by the U.S. Treasury. Because they are backed by the full faith and credit of the U.S. government, they are considered to be free from credit risk (though they're still subject to interest rate/price risk). The Treasury issues three distinct types of securities: bills, notes and bonds, and inflation-protected securities.

Treasury bills (T-bills) have maturities of less than one year and do not make explicit interest payments, paying only the face (par) value at the maturity date. T-bills are sold at a discount to par value and interest is received when the par value is paid at maturity (like zero-coupon bonds). The interest on T-bills is sometimes called implicit interest since the interest (difference between the purchase price and the par value) is not made in a separate "explicit" payment, as it is on bonds and notes. Securities of this type are known as pure discount securities.

  • There are three maturity cycles: 28, 91, and 182 days, adjustable by one day (up or down) due to holidays. They are also known as 4-week, 3-month, and 6-month T-bills, respectively.
  • Periodically, the Treasury also issues cash management bills with maturities ranging from a few days to six months to help overcome temporary cash shortages prior to the quarterly receipt of tax payments.

Treasury notes and Treasury bonds pay semiannual coupon interest at a rate that is fixed at issuance. Notes have original maturities of 2, 3, 5, and 10 years. Bonds have original maturities of 20 or 30 years. Although many bonds are still outstanding and still traded, the Treasury is not currently issuing new bonds.

Prior to 1984, some Treasury bonds were issued that are callable at par five years prior to maturity. The Treasury has not issued callable bonds since 1984.

Treasury bond and note prices in the secondary market are: quoted in percent and 32nds of 1% of face value. A quote of 102-5 (sometimes 102:5) is 102% plus 5/32% of par, which for a $100,000 face value T-bond, translates to a price of $102,156.25.

Since 1997, the Treasury has issued Treasury Inflation-Protected Securities (TIPS). Currently, only notes are offered but some inflation-protected 20- and 30-year bonds were previously issued and trade in the secondary market. The details of how TIPS work are as follow:

  • TIPS make semiannual coupon interest payments at a rate fixed at issuance, just like notes and bonds.
  • The par value of TIPS begins at $1,000 and is adjusted semiannually for changes in the Consumer Price Index (CPI). Even if there is deflation (falling price levels), the par value can never be adjusted to below $1,000. The fixed coupon rate is paid semiannually as a percentage of the inflation adjusted par value.
  • Any increase in the par value from the inflation adjustment is taxed as income in the year of the adjustment: TIPS coupon payment = inflation-adjusted par value multiply by 0.5 multiply by stated coupon rate.

Treasury issues are divided into two categories based on their vintage:

  • On-the-run issues are the most recently auctioned Treasury issues.
  • Off-the-run issues are older issues that have been replaced (as the most traded issue) by a more recently auctioned issue. Issues replaced by several more recent issues are known as well off-the-run issues.

The distinction is that the on-the-run issues are more actively traded and therefore more liquid than off-the-run issues. Market prices of on-the-run issues provide better information about current market yields.

Since the US Treasury does not issue zero-coupon notes and bonds, investment bankers began stripping the coupons from Treasuries to create zero-coupon securities of various maturities to meet investor demand. These securities are termed stripped Treasuries or Treasury strips. In 1985, the Treasury introduced the Separate Trading of Registered Interest and Principal Securities (STRIPS) program. Under this program, the Treasury issues coupon bearing notes and bonds as it normally does, but then it allows certain government securities dealers to buy large amounts of these issues, strip the coupons from the principal, repackage the cash flows, and sell them separately as zero-coupon bonds, at discounts to par value.

For example, a 15-year T-note has 30 coupons and one principal payment; these 31 cash flows can be repackaged and sold as 31 different zero-coupon securities. The stripped securities (Treasury strips) are divided into two groups:

  • Coupon strips (denoted as ci) refers to strips created from coupon payments stripped from the original security.
  • A principal strip refers to bond and note principal payments with the coupons stripped off. Those derived from stripped bonds are denoted bp and those from stripped notes np.

STRIPS are taxed by the IRS on their implicit interest (movement toward par value), which, for fully taxable investors, results in negative cash flows in years prior to maturity. The Treasury STRIPS program also created a procedure for reconstituting Treasury notes and bonds from the individual pieces allowing arbitraging opportunities.

That is a very brief introduction to the Treasury securities. Hope the introduction clarifies some doubts you may have. Cheers.

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