Fixed Income: Treasury/Fed.

Agency
Lecture Set II

Professor John P. Miller

Professor John P. Miller Fixed Income: Treasury/Fed. Agency 1 / 16

Treasury Securities

Backed by the full faith and credit of the U.S. government

Securities are available in book-entry form: investor only receives a
receipt as evidence of ownership making ownership transfers easy
Interest income subject to federal tax but not state and local tax

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Types of Treasury Securities
Treasury Bills
Maturity of 1 year or less
Issued as a discount: pays no coupon
Treasury Notes
Maturity greater than 1 year and less than or equal to 10 years
Pays semiannual coupon
Matures at par value
Treasury Bonds
Maturity greater than 10 years
Pays semiannual coupon
Matures at par value
Treasury Inflation Protection Securities (TIPS)
Program began in 1997
Issued at 5-, 10-, 20- and 30-year maturities
Pays semiannual coupon on adjusted maturity value
Maturity value is dependent on the level of the Consumer Price Index for
All Urban Consumers – CPI-U
Professor John P. Miller Fixed Income: Treasury/Fed. Agency 3 / 16
Treasury Inflation-Protected Securities (TIPS)
Inflation-adjusted principal: CPI-U is used to adjust principal of the
bond
Suppose dated date (issue date) is 7/15/06 and reference CPI-U is
201.95161
On subsequent dates principal is adjusted by dividing current CPI-U by
the reference CPI-U to get an index ratio
Pricing the TIP for 1/15/12 settle with CPI-U of 226.33474, then the
index ratio is 226.33474/201.95161 = 1.12074
Tax implications: Principal increases are taxed each year
In case of deflation, bond matures at the greater of initial par and the
adjusted principal
Example: $1,000 2.5% 10-year TIPS, 7/15/2016 maturity, settled on
1/15/12
Current bond principal: $1,000 × 1.12074 = $1,120.74
TIPS coupon = 1,120.74 × 0.025/2 =$14.01
If the TIPS price is $116-07, then invoice is

(116 + 7/32)/100 × 1,120.74 + 14.01 = 1,316.52

Professor John P. Miller Fixed Income: Treasury/Fed. Agency 4 / 16

Treasury Auction Process

Public Debt Act of 1942 gives the Department of the Treasury

discretion over aspects
Issues sold on an interest-bearing or discount basis
Auction issued competitively or other basis
Treasury securities are sold in primary market through sealed-bid
auctions
Bills with 4 week, 13 week, 26 week, and 52 week maturities are
auctioned on a regular cycle
Cash management bills are sometimes auctioned with maturities from a
few days to six months
Treasury auctions 2-, 3-, 5-, 7-, and 10-year notes, 20-year and 30-year
bonds
Sometimes offers to auction additional amounts of outstanding
securities: “reopenings’’

Professor John P. Miller Fixed Income: Treasury/Fed. Agency 5 / 16

Treasury Auction Process: Determination of Results

Types of bids
Noncompetitive: Entity submits quantity (not to exceed $5 million) of
security to purchase at the yield determined by auction process
Competitive: Entity submits both the quantity of the security and the
yield
Steps to the auction process
First deduct total noncompetitive bids and nonpublic purchases
With the remaining amount, order the bids from lowest yield to the
highest
Starting with the lowest yield, allocate to bidder until remaining amount
is distributed
The highest yield bid accepted is the stop-out yield (or high yield)
All bidders awarded securities receive the stop-out yield
Coupon is adjusted down to the nearest 8th, and then prices are adjusted
to achieve the stop-out yield

Professor John P. Miller Fixed Income: Treasury/Fed. Agency 6 / 16

Treasury Secondary Market

Treasuries are traded over-the-counter by dealers

Trading is virtually 24 hours with trading locations in New York, London
and Tokyo
Settlement is next day
Current issues are referred to as on-the-run
When current issues are followed by a new issue, they become
off-the-run
Securities become when-issued (or wi) between the time the auction is
announced until the date of issue
Dealers trade amongst themselves through intermediate brokers such as
Cantor Fitzgerald

Professor John P. Miller Fixed Income: Treasury/Fed. Agency 7 / 16

Treasury Bills
Treasury bills (T-bills) trade on a bank discount basis1 :
t
D = 100 × Yd ×
360
where Yd is the discount yield, D is the dollar discount and t is the
days to maturity
t


The price is then given as P = 100 × 1 − Yd × 360
Example: A T-bill with 92 days to maturity is quoted at 3.065%, then
the price is given as
 
92
P = 100 × 1 − 0.03065 × = 99.21672
360
Suppose you purchase $100,000 face of the T-bill today, the invoice
amount will be paid the next day:
Invoice = 100,000 × 99.21672/100 = 99,216.72

If held to maturity, the profit is 100,000 - 99,216.72 = 783.28

Given a price, we can compute the discount rate
100 − P 360 100 − 99.21672 360
Yd = × = × = 0.03065
100 t 100 92
1
Use 366 if a leap year
Professor John P. Miller Fixed Income: Treasury/Fed. Agency 8 / 16
T-Bills: Converting Discount to a Bond-Equivalent Yield
100−P 365
If maturity is less than or equal to 6 months: Yb = P × t
100 − 99.21672 365
Yb = × = 0.03132
99.21672 92
If maturity is more than 6 months: Need to account for semi-annual
compounding      
Yb 365 Yb
P 1+ × 1+ t− × = 100
2 2 365
 
t t P − 100
⇒ Yb2 × − 0.25 + Yb × + =0
2 × 365 365 P
2
This can be expressed
 in quadatric form: ax + bx + c = 0 where
a = 2×365t t
− 0.25 , b = 365 and c = P −100
P with the solution given as
√
−b+ b2 −4ac
2a
Example: What is the bond equivalent yield of a T-bill priced at 3.673% with
358 days to maturity  
358
P = 100 × 1− 0.03673 = 96.34741
360
358 96.34741−100


a= 730 − 0.25 , b = 358/365 and c = 96.34741 so Yb = 3.82925%
Professor John P. Miller Fixed Income: Treasury/Fed. Agency 9 / 16
Stripped Treasury Securities

In February 1985, Treasury announced its Separate Trading of

Registered Interest and Principal Securities (STRIPS)
Coupon strips are denoted by ci on quote sheets
Principal strips are denoted by bp if stripped off a bond or np if stripped
off a note
Fixed-principal notes and bonds that pay interest on the same dates
have the same CUSIP (Committee of Uniform Security Identification
Procedures)
When stripped, the ci’s retain the same CUSIP, however, the principal
strips are assigned new CUSIPs
Accrued interest on principal strips is taxed each year, resulting in
negative cash flows until it matures
If the combined value of the coupon and principal strips trade below the
value of the Treasury, these securities can be reconstituted

Professor John P. Miller Fixed Income: Treasury/Fed. Agency 10 / 16

Federal Agency Securities

Agencies issue debentures to fund activities

Agencies are not required to register with SEC and interest paid on their
securities is exempt from state and local taxes
Federally Related Institutions
Backed by the full faith and credit of U.S. government:
Examples: Commodity Credit Corp., Farmers Housing Adm., General
Services Adm., Government National Mortgage Ass. (GNMA) and Rural
Electrification Adm.
Not backed by full faith and credit of U.S. government:
Examples: Tennessee Valley Authority and Private Export Funding Corp
Government-Sponsored Enterprises (GSEs)
Federal National Mortgage Ass. (Fannie Mae), Federal Home Loan
Mortgage Corp (Freddie Mac), Federal Home Loan Bank (FHLB), Federal
Agricultural Mortgage Corp (Farmer Mac) and the Federal Farm Credit
Bank System

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Tennessee Valley Authority

Established in 1933 to provide flood control, navigation, and agricultural

and industrial development
TVA is the largest public power system in U.S.
Issue bonds that are not guaranteed by U.S. government but are rated
AAA by Moody’s and S&P for the following reasons:
Bondholders are given first pledge on net proceeds from power
Electricity rates charged by TVA is sufficient to insure payment of
operation costs and debt servicing
Retail bonds are callable, and they are also redeemable upon death a par
plus accrued interest
Putable Automatic Reset Securities (PARRS) are not callable but have
a 5-year fixed coupon, then resets under certain conditions; however, it
allows the holder to put the bond at par if the coupon is reduced
Institutional bonds have been issued in British pounds and Euros in
addition to U.S. offerings

Professor John P. Miller Fixed Income: Treasury/Fed. Agency 12 / 16

GSEs

Privately owned and publicly chartered entities

Created to reduce the cost of capital for certain borrowing sectors
Debt not backed by U.S. government

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GSEs: Fannie Mae

Established in 1934 to create a liquid secondary market for mortgages

In 1968 was separated into Government National Mortgage Association
(GNMA) and Federal National Mortgage Association (FNMA) in order to
remove some debt off U.S. Federal balance sheet during period of fiscal
stress related to the Vietnam War
Issues Benchmark Bills, Notes and Bonds, Callable Benchmark Notes,
Subordinated Benchmark Notes, Investment Notes
Notes and bonds are noncallable, issued in 2-, 3-, 5-, 10- and 30-year
maturities
Subordinate Benchmark Notes may have deferred interest up to the
maximum of 5 years or the maturity, interest accrues at the coupon
rate, and FNMA may not declare dividends nor purchase stock when
interest is deferred

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GSEs: Freddie Mac and Federal Home Loan Bank System

Federal Home Loan Mortgage Corporation (FHLMC): Established in

1970 to create support for conventional mortgages
Issue Reference Bills, Reference Notes and Bonds, Callable Reference
Notes and Euro Reference Notes
Notes and bonds have maturities 2 to 30 years, Callable Reference Notes
2 to 10 years
New issues and/or reopened issues are brought to market according to a
schedule calendar
Reference Notes and Bonds are eligible for stripping
Federal Home Loan Bank System (FHLB): Originally regulated S&Ls
and state chartered banks insured by FSLIC
Issues consolidated debt obligations
TAP program aggregates demand for 1.5-, 2-, 3-, 5-, 7- and 10-year issues
and offers them daily

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GSE: Farmer Mac and Federal Farm Credit Bank System

Farmer Mac: Established in 1998 to provide a secondary market for first

mortgage real estate loans
Farmer Mac operates like Fannie Mae and Freddie Mac: issues debentures
and sells packages of mortgage-back securities backed by the loans it
purchased
Federal Farm Credit Bank System: Facilitates adequate credit to
agricultural sector
Established in 1916
Consists of three entities: Federal Land Banks, Federal Intermediate
Credit Banks, and Banks for Cooperatives
Issues short-term bonds of two years or less

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