Treasury Market Final Summary
Treasury Market Final Summary
Professor Roberts
Monmouth University
What is a Financial Instrument?
Definition: A financial instrument is a promise of future cash flows.
Risk factors regarding financial instruments:
Cash flows are uncertain.
Timing of cash flows is uncertain.
The value of cash flows can change over time.
Importance: Understanding the risks that investors are being paid to take is crucial before pricing securities.
Big Idea: Risk Is Not One Thing
"Risk" is not a single concept;
It comes in distinct categories.
Objective: Examine these risk categories one at a time.
Implication: Each financial instrument represents a bundle of these risks.
Understanding individual risks aids in evaluating any investment.
Major Risk Types
Credit (Default) Risk:
Definition: The risk that the borrower fails to repay.
Interest Rate Risk:
Definition: The risk that a security's value changes when market rates change.
Inflation Risk:
Definition: The risk that purchasing power erodes over time due to inflation.
Liquidity Risk:
Definition: The risk of not being able to sell an asset quickly at a fair price.
Other Risks:
Maturity Risk: Associated with the length of time until the security matures.
Reinvestment Risk: Risk stemming from reinvesting income at a different interest rate than the original security.
Market Risk: Risk related to changes in the market prices for securities.
Currency Risk: Risk of loss due to exchange rate fluctuations.
Political/Regulatory Risk: Risk associated with changes in laws or regulations that can affect an investment’s value.
The Risk-Return Relationship
Principle: Higher Risk → Higher Required Return
Risk Spectrum (ordered from lowest to highest risk/return):
Treasury Bills: Nearly risk-free, lowest return.
Treasury Notes and Bonds: Very safe, slightly higher return.
Investment-Grade Corporate Bonds: Some credit risk, moderate return.
High-Yield (Junk) Bonds: Significant default risk, higher return.
Stocks and Real Estate: Highest volatility, highest potential return.
Treasuries - Backed by "Full Faith and Credit"
Definition: The U.S. government promises to repay debt by any necessary means, which may include raising funds through taxation or borrowing.
Importance of this backing:
Investor Confidence: Treasuries are considered the safest investment globally.
Market Stability: During financial crises, Treasuries provide a safe haven for investors.
Example: During the crises of 2008 and COVID, demand for Treasuries surged, cementing their status as a trusted asset, even when other investments faltered.
Credit Ratings and Treasury Trust
How Are Treasuries Rated?
Rated by major credit rating agencies to indicate the likelihood of timely repayment.
Why Do Ratings Drop?
Political Impasses: Disagreements concerning debt ceilings or budgets create uncertainty.
Debt Concerns: Worries regarding the government's ability to manage its debt burden.
Why Treasuries Are Treated as Safest
Government backing with full faith and credit provides assurance of repayment.
The U.S. government's ability to raise revenue through taxation.
The capability to print currency exists, although there's an acknowledged concern regarding inflation implications.
Investor Behavior:
Trends showing a "flight to safety" during financial crises.
Global acceptance as reserve assets.
Treasuries consistently offer the lowest yields available in the market.
Treasury Interest Rates as Foundation
Treasury yields serve as the base for most other interest rates in the market.
The Risk-Free Rate: Compensation for foregoing immediate spending by investing the money instead.
How Other Rates Are Priced:
Corporate Bond Rate = Treasury Rate + Credit Spread.
Mortgage Rate = Treasury Rate + Housing Risk Premium.
Bank Loan Rate = Treasury Rate + Default Risk + Operating Costs.
Types of Treasury Securities
Type | Maturities | Issued | Interest Paid | Principal Repaid |
|---|---|---|---|---|
Bills | 4, 8, 13, 17, 26, 52 weeks | Weekly | None (zero-coupon, paid via discount) | At Maturity |
Notes | 2, 3, 5, 7, 10 years | Monthly | Every 6 months | At Maturity |
Bonds | 20, 30 years | Monthly | Every 6 months | At Maturity |
Treasury Bills – Buying at a "Discount"
A Treasury Bill does not pay interest payments.
Purchase Process:
Purchase Bill for less than its face value.
This purchase is referred to as buying at a "discount".
You receive the full face value at maturity.
Definition: The difference between the purchase price and face value represents your interest.
Key takeaway: The lower the purchase price, the higher the yield.
Example of Treasury Bills – Buying at a "Discount"
Example Scenario: Buy a $100 face value T-bill for $95.
At maturity, the government pays $100.
Your calculated "interest" = $100 - $95 = $5.
Rate of return = rac{5}{95} imes 100 = 5.26 ext{%}.
Example: $100 Face Value, Want 5% Return
Objective: Determine the purchase price to achieve a 5% return on a 1-year T-bill.
Formula: Price = Face Value ÷ (1 + Interest Rate)
Plugging in numbers: Price = rac{100}{1.05} = 95.24
Purchase the T-bill for $95.24.
Outcome: At maturity, you receive $100. Interest earned = $4.76, yielding a return = 5%.
Treasury Bills: Key Takeaways
T-bills do not offer coupon payments; instead, the discount constitutes your interest.
T-bills function on the principle: The lower the price paid, the higher the yield.
Treasury Notes and Bonds: Two Parts to Their Returns
Sale at a Discount (or Premium):
The discount contributes to the total return; lower purchase price yields a higher first component of return.
Interest Income:
Treasury notes and bonds pay interest income via coupon payments every six months.
Higher stated coupon rates lead to a larger second component of total return.
Total return analysis: Capital gain + Interest income.
Example: Two Parts to Their Returns
Given: Face value = $1,000; Coupon rate = 4% (therefore generates $40 annually, paid as $20 biannually).
Purchase Scenario: Buy at a price of $950 (a discount).
Coupon Income: $40/year × 5years = $200 total.
Capital Gain: Treasury pays back face value = $1,000; your cost = $950; Capital gain = 1,000 - 950 = 50.
Total Return: Total gain = $200 (coupons) + $50 (price gain) = $250.
Return on Investment: rac{250}{950} ≈ 26.3 ext{%} total over 5 years; Annualized return ≈ 4.8% per year.
Bond Prices and Market Interest Rates
Key Insight: Prices and interest rates move in OPPOSITE directions.
An increase in interest rates results in a decrease in bond prices.
A decrease in interest rates leads to an increase in bond prices.
Treasury Rates as Base for Other Rates
Treasury rates establish a baseline for all other rates in the economy:
Mortgages: 30-year mortgage rates ≈ 10-year Treasury rate + 1.5% to 2.5%.
Corporate Bonds: Corporate bond rates = Treasury rates + credit spread.
Savings Accounts: Bank rates relate to short-term Treasury yields.
Rise in Treasury rates typically causes other rates to rise as well.
The Treasury Yield Curve
Definition: A graph displaying Treasury yields across different maturities.
Short End vs. Long End Analysis:
Short End (bills, 2-year notes): Influenced by Federal Reserve policy and liquidity needs.
Long End (10-year and 30-year bonds): Reflects inflation expectations, growth, and term premium.
Yield Curve Shapes and Interpretation
Normal (Upward-Sloping):
Long-term yields are higher than short-term yields.
Suggests expectations for healthy economic growth.
Flat:
Short and long yields are roughly equal.
Indicates a transition phase with an uncertain economic outlook.
Inverted (Downward-Sloping):
Short-term yields exceed long-term yields.
Often viewed as a predictor of recession.
Deficit vs. Debt
DEFICIT:
Annual flow; the gap between government outlays and revenues for the year.
Example: Spending = $6 trillion; Revenue = $5 trillion; Deficit = $1 trillion.
DEBT:
Cumulative stock; total outstanding Treasury obligations accumulated over time.
Example: Sum of all past deficits (minus any surpluses); Current U.S. debt is approximately $36 trillion.
Why Raw Deficit Dollars Mislead
Factors leading to misleading interpretations of raw deficit numbers:
GDP has grown significantly over time.
Inflation reduces the real value of dollars.
Population and economic expansion are substantial.
Better Measure: Deficit-to-GDP ratio reveals the deficit as a percentage of the economy, permitting meaningful historical comparisons.
Why Treasury Issues So Much Debt
Financing Current Deficits:
Treasury borrows the difference when spending exceeds revenue.
Rolling Over Maturing Debt:
When matured bonds occur, new bonds are issued to repay them.
Cash Management:
Treasury maintains a cash balance to optimize the timing of receipts and payments.
Why Issue Many Maturities?
Cost Management:
Long-term rates usually exceed short-term ones.
Rollover Risk:
Solely issuing short-term debts requires frequent refinancing.
Investor Demand:
Different investors show preferences for varying maturities.
Market Functioning:
A complete yield curve allows for the effective pricing of other securities.
Weighted Average Maturity (WAM)
Definition: The average time until all outstanding Treasury debt matures, weighted according to dollar amounts.
Increasing WAM results from issuing more long-term bonds.
Decreasing WAM results from issuing more short-term bills.
The Treasury Auction
Auction Announcement Includes:
The amount to be sold (e.g., $50 billion).
Type of security and its maturity.
Coupon rate (if applicable).
Goal: Raise the target amount at the lowest possible cost.
Non-Competitive vs. Competitive Bids
NON-COMPETITIVE BIDS:
Who: Retail investors.
Bid amounts only, without specifying yield.
Guaranteed allocation (approximately 10% of the auction).
COMPETITIVE BIDS:
Who: Institutional investors.
Bid amounts and yield specified.
Compete with other bidders for lower yields.
May not receive a full allocation (approximately 90% of the auction).
Competitive Bidding and Stop-Out Yield
Bidders submit yield requests (lower yields correspond to higher prices).
Treasury ranks all bids from lowest to highest yield.
Accept bids starting from the lowest yield until the target amount is reached.
The final accepted yield is termed the "stop-out yield."
Single-Price (Dutch) Auction
All winning bidders receive the same stop-out yield.
Applicable to all competitive bidders whose bids were accepted.
Applies to all non-competitive bidders.
Note: Winners pay the stop-out yield rather than their bid amounts.
The Fed's Role in the Treasury Market
The Fed implements monetary policy through operations involving Treasuries and MBS (Mortgage-Backed Securities).
Restriction: The Fed cannot directly purchase from the Treasury.
Must trade in the secondary market instead.
Standard Open Market Operations (OMO)
Purpose: To maintain the federal funds rate near the Fed's target.
Involves small, frequent transactions in short- and medium-term Treasuries.
Includes repurchase agreements (repos) to add or drain liquidity as required.
Quantitative Easing (QE)
Context for Use: Implemented when the federal policy rate is close to zero, and additional economic stimulus is sought.
Difference from Standard OMO:
Involves large-scale purchases of medium- and long-term Treasuries and MBS.
Aims to reduce longer-term yields and grows the Fed's balance sheet significantly.
Quantitative Tightening (QT)
Definition: The Fed allows maturing Treasuries and MBS to run off without reinvestment.
Implementation: Restricted by monthly caps to prevent market disruption.
Strategy: No aggressive selling of holdings, leading to a gradual shrink of the balance sheet.
Key Takeaways
Treasuries benefit from full faith and credit, rendering them near risk-free.
Treasury yields form the foundation for all other interest rates in the economic landscape.
The shape of the yield curve reflects market expectations regarding economic growth and inflation rates.
Treasury issues debt for a range of reasons including financing deficits, rolling over maturing debt, and cash management strategies.
Auctions adopt a single-price method to effectively sell securities, ensuring market efficiency.
The Fed's treasury operations are pivotal in executing monetary policy effectively.