CHAPTER 6

TREASURY AND FEDERAL AGENCY SECURITIES

CHAPTER SUMMARY
The second largest sector of the bond market (after the mortgage market) is the market for U.S.
Treasury securities. One of the smallest sector is the U.S. government agency securities market.
We discuss these two sectors together in this chapter. As explained in a later chapter, a majority
of the securities backed by a pool of mortgages are guaranteed by a federally sponsored agency
of the U.S. government. These securities are classified as part of the mortgage-backed securities
market rather than as U.S. government agency securities.

TREASURY SECURITIES

Two factors account for the prominent role of U.S. Treasury securities: volume (in terms of
dollars outstanding) and liquidity. The Department of the Treasury is the largest single issuer of
debt in the world. The large volume of total debt and the large size of any single issue have
contributed to making the Treasury market the most active and hence the most liquid market in
the world. The dealer spread between bid and ask price is considerably narrower than in other
sectors of the bond market.

All Treasury securities are noncallable. Therefore, investors in Treasury securities are not subject
to call risk.

Types of Treasury Securities

The Treasury issues marketable and nonmarketable securities. Our focus here is on marketable
securities. Marketable Treasury securities are categorized as fixed-principal securities or
inflation-indexed securities.

Fixed-income principal securities include Treasury bills, Treasury notes, and Treasury bonds.

Treasury bills are issued at a discount to par value, have no coupon rate, and mature at par
value. The current practice of the Treasury is to issue all securities with a maturity of one year or
less as discount securities. As discount securities, Treasury bills do not pay coupon interest.
Instead, Treasury bills are issued at a discount from their maturity value; the return to the
investor is the difference between the maturity value and the purchase price.

All securities with initial maturities of two years or more are issued as coupon securities. Coupon
securities are issued at approximately par and, in the case of fixed-principal securities, mature at
par value. Treasury coupon securities issued with original maturities of more than one year and
no more than 10 years are called Treasury notes. Treasury coupon securities with original
maturities greater than 10 years are called Treasury bonds.

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During 2014, the U.S. Department of the Treasury first began issuing notes on both a fixed-rate
and floating-rate basis. Floating-rate notes are referred to as FRNs by the Treasury as well as
market participants, with the understanding that the F means floating. Unlike a fixed-rate
note which pays interest semiannually, a floating-rate note makes quarterly payments.

The U.S. Department of the Treasury issues Treasury securities that adjust for inflation. These
securities are popularly referred to as Treasury inflation protection securities, or TIPS. The
principal that the Treasury Department will base both the dollar amount of the coupon payment
and the maturity value on is adjusted semiannually. This is called the inflation-adjusted
principal.

The Treasury Auction Process

Treasury securities are sold in the primary market through sealed-bid auctions. Each auction is
announced several days in advance by means of a Treasury Department press release or press
conference. The announcement provides details of the offering, including the offering amount
and the term and type of security being offered, and describes some of the auction rules and
procedures. Treasury auctions are open to all entities.

The auction for Treasury securities is conducted on a competitive bid basis. There are actually
two types of bids that may be submitted by a bidder: noncompetitive bids and competitive bids.
A noncompetitive bid is submitted by an entity that is willing to purchase the auctioned security
at the yield that is determined by the auction process.

When a noncompetitive bid is submitted, the bidder only specifies the quantity sought. The
quantity in a noncompetitive bid may not exceed $5 million. A competitive bid specifies both
the quantity sought and the yield at which the bidder is willing to purchase the auctioned
security. The competitive bids are then arranged from the lowest yield bid to the highest yield
bid submitted. The highest yield accepted by the Treasury is referred to as the stop-out yield
(or high yield).

Bidders whose bid is higher than the stop-out yield are not distributed any of the new issue
(i.e., they are unsuccessful bidders). Bidders whose bid was the stop-out yield (i.e., the highest
yield accepted by the Treasury) are awarded a proportionate amount for which they bid.

Secondary Market

The secondary market for Treasury securities is an over-the-counter market where a group of
U.S. government securities dealers offer continuous bid and ask prices on outstanding
Treasuries. There is virtual 24-hour trading of Treasury securities. The three primary trading
locations are New York, London, and Tokyo. The normal settlement period for Treasury
securities is the business day after the transaction day (next day settlement).

The most recently auctioned issue is referred to as the on-the-run issue or the current issue.
Securities that are replaced by the on-the-run issue are called off-the-run issues. At a given point
in time there may be more than one off-the-run issue with approximately the same remaining

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maturity as the on-the-run issue. Treasury securities are traded prior to the time they are issued
by the Treasury. This component of the Treasury secondary market is called the when-issued
market, or wi market. When-issued trading for both bills and coupon securities extends from
the day the auction is announced until the issue day.

Government dealers trade with the investing public and with other dealer firms. When they trade
with each other, it is through intermediaries known as interdealer brokers. Dealers leave firm
bids and offers with interdealer brokers who display the highest bid and lowest offer in
a computer network tied to each trading desk and displayed on a monitor. Dealers use interdealer
brokers because of the speed and efficiency with which trades can be accomplished.

Price Quotes for Treasury Bills

The convention for quoting bids and offers is different for Treasury bills and Treasury coupon
securities. Bids and offers on Treasury bills are quoted in a special way. Unlike bonds that pay
coupon interest, Treasury bill values are quoted on a bank discount basis, not on a price basis.

The quoted yield on a bank discount basis is not a meaningful measure of the return from
holding a Treasury bill. There are two reasons for this. First, the measure is based on a face-value
investment rather than on the actual dollar amount invested. Second, the yield is annualized
according to a 360-day rather than a 365-day year, making it difficult to compare Treasury bill
yields with Treasury notes and bonds, which pay interest on a 365-day basis.

The measure that seeks to make the Treasury bill quote comparable to Treasury notes and bonds
is called the bond equivalent yield. The CD equivalent yield (also called the money market
equivalent yield) makes the quoted yield on a Treasury bill more comparable to yield quotations
on other money market instruments that pay interest on a 360-day basis. It does this by taking
into consideration the price of the Treasury bill rather than its face value.

Quotes on Treasury Coupon Securities

Treasury coupon securities are quoted in a different manner than Treasury billson a price basis
in points where one point equals 1% of par. The points are split into units of 32nds, so that
a price of 9614, for example, refers to a price of 96 and 14 32nds, or 96.4375 per 100 of par
value. The 32nds are themselves often split by the addition of a plus sign or a number. In
addition to price, the yield to maturity is typically reported alongside the price.

When an investor purchases a bond between coupon payments, if the issuer is not in default, the
investor must compensate the seller of the bond for the coupon interest earned from the time of
the last coupon payment to the settlement date of the bond. This amount is called accrued
interest. When calculating accrued interest, three pieces of information are needed: (i) the
number of days in the accrued interest period, (ii) the number of days in the coupon period, and
(iii) the dollar amount of the coupon payment. The number of days in the accrued interest period
represents the number of days over which the investor has earned interest.

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The calculation of the number of days in the accrued interest period and the number of days in
the coupon period begins with the determination of three key dates: the trade date, settlement
date, and date of previous coupon payment. The trade date is the date on which the transaction
is executed. The settlement date is the date a transaction is completed. For Treasury securities,
settlement is the next business day after the trade date. Interest accrues on a Treasury coupon
security from and including the date of the previous coupon payment up to but excluding the
settlement date.

The number of days in the accrued interest period and the number of days in the coupon period
may not be simply the actual number of calendar days between two dates. For Treasury coupon
securities, the day count convention used is to determine the actual number of days between two
dates. This is referred to as the actual/actual day count convention.

STRIPPED TREASURY SECURITIES

The Treasury does not issue zero-coupon notes or bonds. However, because of the demand for
zero-coupon instruments with no credit risk, the private sector has created such securities.

In August 1982, both Merrill Lynch and Salomon Brothers created synthetic zero-coupon
Treasury receipts. Merrill Lynch marketed its Treasury receipts as Treasury Income Growth
Receipts (TIGRs), and Salomon Brothers marketed its receipts as Certificates of Accrual on
Treasury Securities (CATS). The procedure was to purchase Treasury bonds and deposit them
in a bank custody account. The firms then issued receipts representing an ownership interest in
each coupon payment on the underlying Treasury bond in the account and a receipt for
ownership of the underlying Treasury bonds maturity value. This process of separating each
coupon payment, as well as the principal (called the corpus), and selling securities against them
is referred to as coupon stripping.

Other investment banking firms followed suit by creating their own receipts. They all are
referred to as trademark zero-coupon Treasury securities because they are associated with
particular firms.

In February 1985, the Treasury announced its Separate Trading of Registered Interest and
Principal of Securities (STRIPS) program to facilitate the stripping of designated Treasury
securities. Today, all Treasury notes and bonds (fixed-principal and inflation indexed) are
eligible for stripping. The zero-coupon Treasury securities created under the STRIPS program
are direct obligations of the U.S. government. Moreover, the securities clear through the Federal
Reserves book-entry system. Creation of the STRIPS program ended the origination of
trademarks and generic receipts.

On dealer quote sheets and vendor screens STRIPS are identified by whether the cash flow is
created from the coupon (denoted ci), principal from a Treasury bond (denoted bp), or principal
from a Treasury note (denoted np). Strips created from the coupon are called coupon strips and
strips created from the principal are called principal strips. The reason why a distinction is
made between coupon strips and principal strips has to do with the tax treatment by non-U.S.
entities.

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Tax Treatment

A disadvantage of a taxable entity investing in stripped Treasury securities is that accrued

interest is taxed each year even though interest is not paid. Thus these instruments are negative
cash flow instruments until the maturity date. They have negative cash flow because tax
payments on interest earned but not received in cash must be made.

Reconstituting a Bond

Reconstitution is the process of coupon stripping and reconstituting that will prevent the actual
spot rate curve observed on zero-coupon Treasuries from departing significantly from the
theoretical spot rate curve. As more stripping and reconstituting occurs, forces of demand and
supply will cause rates to return to their theoretical spot rate levels.

FEDERAL AGENCY SECURITIES

Federal agency securities are securities issued by government-chartered entities. These entities
are either federally related institutions or government-sponsored enterprises. Federally related
institutions are agencies of the federal government. Government-sponsored enterprises (GSEs)
are privately owned, publicly chartered entities. They are instrumentalities (not agencies) of the
U.S. government that like federally related institutions provide them privileges that granted to
private sector corporations. Despite this difference, we refer to GSEs as agencies.

An important issue associated with federal agency securities is their credit quality. A commonly
shared view is that although any agency issue may not carry the explicit guarantee of the U.S.
government, there is an implicit guarantee due to their ability to borrow from the U.S. Treasury.

Because of the credit risk, federal agency securities trade at a higher yield in the market than
U.S. Treasury securities. As with Treasury securities, these securities trade in a multiple-dealer
over-the-counter secondary market but with trading volume significantly less than that in the
Treasury market.

There are two types of securities that can be issued. The first are the typical bond used by other
issuers in the bond market. This type of debt obligation is referred to as a debenture. The other
type, and the one that is probably the best known by bond market participants, is a security
backed by a pool of residential mortgage loans. This type of debt obligation is called a mortgage-
backed security.

Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac are the two major suppliers of funds to the residential mortgage
market. They issue similar debt instruments and currently face the same legal constraint.

Due to the major downturn in the housing and credit markets beginning in 2007, in September
2008 the entity that regulates Fannie Mae and Freddie Mac, the Federal Housing Finance

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Agency (FHFA), placed these two GSEs in conservatorship. This meant that the FHFA had
complete control over the operations and assets of these two GSEs.

Federal Farm Credit Bank System

The Federal Farm Credit Bank System (FFCBS) was established by Congress is to facilitate the
supply of credit the agricultural sector of the economy. The Farm Credit System consists of three
entities: the Federal Land Banks, Federal Intermediate Credit Banks, and Banks for
Cooperatives. The FFCBFC or simply Farm Credit issues debt with a broad range of structures
and maturities. Farm Credit Discount Notes are similar to U.S. Treasury bills with maturities
from one day to 365 days. Farm Credit Designated Bonds can have a non-callable or callable
structure that generally has 2- to 10-year maturities at issuance. The callable Designated Bonds
have a one-time only redemption feature. Farm Credit Bonds can be customized for institutional
investors as structured notes. Farm Credit Master Notes are debt obligations whose coupon rate
is indexed to some reference rate.

Federal Agricultural Mortgage Corporation

The purpose of the Federal Agricultural Mortgage Corporation (Farmer Mac) is to provide
a secondary market for first mortgage agricultural real estate loans. Farmer Mac raises funds by
selling debentures and mortgage-backed securities backed by the loans purchased. The latter
securities are called agricultural mortgage-backed securities (AMBSs).

Federal Home Loan Bank System

The Federal Home Loan Bank System (FHL Banks) consists of the 12 district Federal Home
Loan Banks and their member banks. Each member bank issues consolidated debt obligations,
which are joint and several obligations of the 12 member banks.

Tennessee Valley Authority

The Tennessee Valley Authority (TVA) was established by Congress in 1933 primarily to
provide flood control, navigation, and agricultural and industrial development. Created to
promote the use of electric power in the Tennessee Valley region, the TVA is the largest public
power system in the United States.

The debt obligations issues bonds with a wide range of maturities and targeting individual (retail)
and institutional investors. The TVA Discount Notes have a maturity of one year or less. They are
offered to on continuing basis to investors via investment dealers and dealer banks. The bonds
issued, referred to as TVA Power Bonds can have a final maturity of up to 50 years and have
a variety of bond structures issued in two programs.

KEY POINTS
The U.S. Treasury market is closely watched by all participants in the financial markets
because interest rates on Treasury securities are the benchmark interest rates throughout the
world.

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 The Treasury issues three types of securities: bills, notes, and bonds. Treasury bills have
a maturity of one year or less, are sold at a discount from par, and do not make periodic
interest payments. Treasury notes and bonds are coupon securities.
Treasury notes are available as fixed-rate securities and floating-rate securities.
The Treasury issues coupon securities with a fixed principal and an inflation-protected
principal. The coupon payment for the latter is tied to the Consumer Price Index and the
securities are popularly referred to as Treasury Inflation Protection Securities (TIPS).
Treasury securities are issued on a competitive bid auction basis, according to a regular
auction cycle. The secondary market for Treasury securities is an over-the-counter market,
where dealers trade with the general investing public and with other dealers.
In the secondary market, Treasury bills are quoted on a bank discount basis; Treasury coupon
securities are quoted on a price basis.
Although the Treasury does not issue zero-coupon Treasury securities, government dealers have
created these instruments synthetically by a process called coupon stripping. Zero-coupon
Treasury securities are created via the STRIPS program.
The federal agency securities market is the market for the debt instruments issued by federally
related institutions and government-sponsored enterprises. Unless otherwise specified, the
securities issued by these entities are not explicitly or implicitly guaranteed by the full faith
and credit of the U.S. government.

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 ANSWERS TO QUESTIONS FOR CHAPTER 6
(Questions are in bold print followed by answers.)

1. What are the differences among a Treasury bill, Treasury note, and Treasury bond?

Fixed-Principal Treasury Securities are fixed-income principal securities that include Treasury
bills, Treasury notes, and Treasury bonds. As discussed below the main differences involve
maturity and how earnings are received over time.

Treasury bills are issued at a discount to par value, have no coupon rate, and mature at par value.
The current practice of the Treasury is to issue all securities with a maturity of one year or less as
discount securities. As discount securities, Treasury bills do not pay coupon interest. Instead,
Treasury bills are issued at a discount from their maturity value; the dollar return to investors is
the difference between the maturity value and the purchase price.

All securities with initial maturities of two years or more are issued as coupon securities.
Coupon securities are issued at approximately par and, in the case of fixed-principal
securities, mature at par value. Treasury coupon securities issued with original maturities of
more than one year and no more than 10 years are called Treasury notes. Treasury coupon
securities with original maturities greater than 10 years are called Treasury bonds. (On quote
sheets, an n is used to denote a Treasury note. No notation typically follows an issue to
identify it as a bond.)

2. The following questions are about Treasury Inflation Protected Securities (TIPS).

(a) What is meant by the real rate?

In terms of TIPS, the real rate is the coupon rate. This is discussed below.

The U.S. Department of the Treasury issues Treasury securities that adjust for inflation. These
securities are popularly referred to as Treasury inflation protection securities, or TIPS.

TIPS work as follows. The coupon rate on an issue is set at a fixed rate. That rate is determined
via the auction process. The coupon rate is called the real rate since it is the rate that the
investor ultimately earns above the inflation rate. The inflation index that the government has
decided to use for the inflation adjustment is the non-seasonally adjusted U.S. City Average All
Items Consumer Price Index for All Urban Consumers (CPI-U)

(b) What is meant by the inflation-adjusted principal?

For TIPS, the inflation-adjusted principal is the principal that the Treasury Department will base
both the dollar amount of the coupon payment and the maturity value on. It is adjusted
semiannually. Part of the adjustment for inflation comes in the coupon payment since it is based
on the inflation-adjusted principal. However, the U.S. government has decided to tax the

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adjustment each year. This feature reduces the attractiveness of TIPS as investments in accounts
of tax-paying entities.
Because of the possibility of disinflation (i.e., price declines), the inflation-adjusted principal at
maturity may turn out to be less than the initial par value. However, the Treasury has structured
TIPS so that they are redeemed at the greater of the inflation adjusted principal and the initial par
value.

An inflation-adjusted principal must be calculated for a settlement date. The inflation-adjusted

principal is defined in terms of an index ratio, which is the ratio of the reference CPI for the
settlement date to the reference CPI for the issue date. The reference CPI is calculated with
a three-month lag. For example, the reference CPI for May 1 is the CPI-U reported in February.
The U.S. Department of the Treasury publishes and makes available on its website
(www.publicdebt.treas.gov) a daily index ratio for an issue.

(c) Suppose that the coupon rate for a TIPS is 3%. Suppose further that an investor
purchases $10,000 of par value (initial principal) of this issue today and that the semiannual
inflation rate is 1%.

Answer the below questions.

(1) What is the dollar coupon interest that will be paid in cash at the end of the first six
months?

In our example, the coupon rate for a TIPS is 3%, the annual inflation rate is 2%, and an investor
purchases today $10,000 par value (principal) of this issue. The semiannual inflation rate is 1%
(2% divided by 2). The inflation-adjusted principal at the end of the first six-month period is found
by multiplying the original par value by one plus the semiannual inflation rate. In our example,
the inflation adjusted principal at the end of the first six-month period is (1.01)$10,000 = $10,100.
It is this inflation adjusted principal that is the basis for computing the coupon interest for the first
six-month period. The coupon payment is then 1.5% (one-half the real rate of 3%) multiplied by
the inflation-adjusted principal at the coupon payment date ($10,100). The coupon payment is
therefore 0.015($10,100) = $151.50.

(2) What is the inflation-adjusted principal at the end of six months?

As seen in part (1) when computing the coupon payment, we find that the inflation adjusted
principal at the end of the first six-month period is (1.01)$10,000 = $10,100. Given the
semiannual inflation rate for the next six months we could compute the inflation-adjusted
principal at years end. Assuming the semiannual inflation rate remains at 1%, then we
would get: (1.01)$10,100 = $10,201. The coupon payment would be 0.015($10,201) =
$153.015.

(d) Suppose that an investor buys a five-year TIP and there is deflation for the entire
period. What is the principal that will be paid by the Department of the Treasury at the
maturity date?

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With deflation, the inflation-adjusted principal would fall. However, the Treasury has structured
TIPS so that they are redeemed at the greater of the inflation adjusted principal and the initial par
value. Thus, the investor who buys a five-year TIP is promised the original principle amount at
the maturity date.

(e) What is the purpose of the daily index ratio?

The purpose of the daily index ratio is to help compute an inflation-adjusted principal for
a settlement date. The inflation-adjusted principal is defined in terms of an index ratio, which is
the ratio of the reference CPI for the settlement date to the reference CPI for the issue date. The
reference CPI is calculated with a three-month lag. For example, the reference CPI for May 1 is
the CPI-U reported in February. The U.S. Department of the Treasury publishes and makes
available on its Web site (www.publicdebt.treas.gov) a daily index ratio for an issue.

(f) How is interest income on TIPS treated at the federal income tax level?

For TIPS, the coupon payment is based on the inflation-adjusted principal. The U.S. government
taxes the adjustment each year. This feature reduces the attractiveness of TIPS as investments in
accounts of tax-paying entities.

3. What is the when-issued market?

Treasury securities are traded prior to the time they are issued by the Treasury. This component
of the Treasury secondary market is called the when-issued market, or wi market. When-issued
trading for both bills and coupon securities extends from the day the auction is announced until
the issue day.

4. Why do government dealers use government brokers?

When government dealers trade with each other, it is through intermediaries known as
interdealer brokers. They use interdealer brokers because of the speed and efficiency with which
trades can be accomplished. Also, interdealer brokers keep the names of the dealers involved in
trades confidential. The quotes provided on the government dealer screens represent prices in the
inside or interdealer market.

5. Suppose that the price of a Treasury bill with 90 days to maturity and a $1 million face
value is $980,000. What is the yield on a bank discount basis?

The convention for quoting bids and offers is different for Treasury bills and Treasury coupon
securities. Bids and offers on Treasury bills are quoted in a special way. Unlike bonds that pay
coupon interest, Treasury bill values are quoted on a bank discount basis, not on a price basis.
The yield on a bank discount basis is computed as follows:

D 360
Yd
F t

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where Yd = annualized yield on a bank discount basis (expressed as a decimal), D = dollar
discount, which is equal to the difference between the face value and the price, F = face value
and t = number of days remaining to maturity.

For our problem, a Treasury bill with 90 days to maturity, a face value of $1,000,000, and selling
for $980,000 would be selling with a dollar discount of D = F P = $1,000,000 $980,000 =
$20,000. Given D = $20,000, F = $1,000,000 and t = 90, the Treasury bill would be quoted at the
following yield:

$20,000 360
Yd = = 0.02(4) = 0.0800 or 8.00%.
$1,000,000 90

6. The bid and ask yields for a Treasury bill were quoted by a dealer as 5.91% and 5.89%,
respectively. Shouldnt the bid yield be less than the ask yield, because the bid yield
indicates how much the dealer is willing to pay and the ask yield is what the dealer is
willing to sell the Treasury bill for?

The higher bid means a lower price. So the dealer is willing to pay less than would be paid for
the lower ask price. We illustrate this below.

Given the yield on a bank discount basis (Yd), the price of a Treasury bill is found by first solving
the formula for the dollar discount (D), as follows:

t
D = Yd (F) . The price is then price = F D.
360

For the 100-day Treasury bill with a face value (F) of $100,000, if the yield on a bank discount
basis (Yd) is quoted as 5.91%, D is equal to:

t 100
D = Yd (F) = 0.0591($100,000) = $1,641.67.
360 360

Therefore, price = $100,000 $1,641.67 = $98,358.33.

For the 100-day Treasury bill with a face value (F) of $100,000, if the yield on a bank discount
basis (Yd) is quoted as 5.89%, D is equal to:

t 100
D = Yd (F) = 0.0589($100,000 = $1,636.11.
360 360

Therefore, price is: P = F D = $100,000 $1,636.11 = $98,363.89.

Thus, the higher bid quote of 5.91% (compared to lower ask quote 5.89%) gives a lower selling
price of $98,358.33 (compared to $98,363.89). The 0.02% higher yield translates into a selling
price that is $5.56 lower.

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In general, the quoted yield on a bank discount basis is not a meaningful measure of the return
from holding a Treasury bill, for two reasons. First, the measure is based on a face-value
investment rather than on the actual dollar amount invested.

Second, the yield is annualized according to a 360-day rather than a 365-day year, making it
difficult to compare Treasury bill yields with Treasury notes and bonds, which pay interest on a
365-day basis. The use of 360 days for a year is a money market convention for some money
market instruments, however. Despite its shortcomings as a measure of return, this is the method
that dealers have adopted to quote Treasury bills. Many dealer quote sheets, and some reporting
services, provide two other yield measures that attempt to make the quoted yield comparable to
that for a coupon bond and other money market instruments.

7. Assuming a $100,000 par value, calculate the dollar price for the following Treasury
coupon securities given the quoted price.

(a) The quoted price for a $100,000 par value Treasury coupon security is 84.14. What is
the dollar price?

Treasury coupon securities are quoted in a different manner than Treasury billson a price basis
in points where one point equals 1% of par. (Notes and bonds are quoted in yield terms in
when-issued trading because coupon rates for new notes and bonds are not set until after these
securities are auctioned.)

The points are split into units of 32nds, so that a price of 9614, for example, refers to a price of
96 and 14 32nds, or 96.4375 per 100 of par value (96 + 14/32 = 96 + 0.4375 = 96.4375). The
32nds are themselves often split by the addition of a plus sign or a number. A plus sign indicates
that half a 32nd (or a 64th) is added to the price, and a number indicates how many eighths of
32nds (or 256ths) are added to the price. A price of 9614+, therefore, refers to a price of 96 plus
14 32nds plus 1 64th, or 96.453125 (e.g., 96 + 14/32 + 1/64 = 96 + 0.4375 + 0.0625 =
96.453125), and a price of 96142 refers to a price of 96 plus 14 32nds plus 2 256ths, or
96.4453125 (96 + 14/32 + 2/256 = 96 + 0.4375 + 0.0078125 = 96.4453125).

Thus, assuming a $100,000 par value Treasury coupon security with a quoted price of 8414, the
dollar price is: 84 + 14/32 = 84 + 0.4375 = 84.4375 per 100 of par value. The dollar price is:
84.4375 ($100,000 / 100) = $84,437.50.

(b) The quoted price for a $100,000 par value Treasury coupon security is 84.14+. What is
the dollar price?

Thus, assuming a $100,000 par value Treasury coupon security with a quoted price of 8414+,
the dollar price is: 84 + 14/32 + 1/64 = 84 + 0.4375 + 0.015625 = 84.453125 per 100 of par
value. The dollar price is: 84.453125 ($100,000 / 100) = $84,453.13.

(c) The quoted price for a $100,000 par value Treasury coupon security is 103.284. What is
the dollar price?

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Thus, assuming a $100,000 par value Treasury coupon security with a quoted price of 103284
the dollar price is: 103 + 28/32 + 4/256 = 103 + 0.875 + 0.015625 = 103.89063 per 100 of par
value. The dollar price is: 103.89063 ($100,000 / 100) = $103,890.63.

(d) The quoted price for a $100,000 par value Treasury coupon security is 105.059. What is
the dollar price?

Thus, assuming a $100,000 par value Treasury coupon security with a quoted price of 105059
the dollar price is: 103 + 5/32 + 9/256 = 103 + 0.15625 + 0.0351562 = 103.19141 per 100 of par
value. The dollar price is: 103.19141($100,000 / 100) = $103,191.41.

8. Answer the below questions for a treasury auction.

(a) For a Treasury auction what is meant by a noncompetitive bidder?

A noncompetitive bidder is a bidder is who is willing to purchase the auctioned security at the
yield that is determined by the auction process. More details are supplied below.

The auction for Treasury securities is said to be conducted on a competitive bid basis. However,
there are actually two types of bids that may be submitted by a bidder: noncompetitive bid and
competitive bid. A noncompetitive bid is submitted by an entity that is willing to purchase the
auctioned security at the yield that is determined by the auction process.

When a noncompetitive bid is submitted, the bidder only specifies the quantity sought. The
quantity in a noncompetitive bid may not exceed $1 million for Treasury bills and $5 million for
Treasury coupon securities. A competitive bid specifies both the quantity sought and the yield at
which the bidder is willing to purchase the auctioned security.

(b) For a Treasury auction what is meant by the high yield?

In a Treasury auction, the results are determined by first deducting the total noncompetitive
tenders and nonpublic purchases (such as purchases by the Federal Reserve) from the total
securities being auctioned. The remainder is the amount to be awarded to the competitive
bidders. The competitive bids are then arranged from the lowest yield bid to the highest
yield bid submitted. (This is equivalent to arranging the bids from the highest price to the
lowest price that bidders are willing to pay.) Starting from the lowest yield bid (or highest
price bid), all competitive bids are accepted until the amount to be distributed to the
competitive bidders is completely allocated. The highest yield accepted by the Treasury is
referred to as the high yield (or stop-out yield). Bidders whose bid is higher than the high
yield are not distributed any of the new issue (i.e., they are unsuccessful bidders). Bidders
whose bid was the high yield (i.e., the highest yield accepted by the Treasury) are awarded
a proportionate amount for which they bid. For example, suppose that $4 billion was
tendered for at the high yield but only $3 billion remains to be allocated after allocating to
all bidders who bid lower than the high yield. Then each bidder who bid the high yield will
receive $3 billion / $4 billion = 0.75 = 75% of the amount for which they tendered. So, if

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an entity tendered for $5 million, then that entity would be awarded only 0.75($5 million) =
$3.75 million.

9. In a Treasury auction, how is the price that a competitive bidder must pay determined in
a single-price auction format?

The competitive bidder pays the price associated with the high yield. However, the price can
differ slightly from par to reflect adjustments to make the yield equal to the high yield. More
details are supplied below.

All bidders that bid less than the high yield are awarded the amount that they bid. The Treasury
will report what percentage someone will receive if their bid is equal to the high yield. For
example, the Treasury might report: Tenders at the high yield were allotted 50%. This means
that if an entity bid for $10 million at the high yield that entity was awarded $5 million.

Now that the winning bidders are determined along with their allotment, the price can be set
following the conventions of a single-price auction (because all U.S. Treasury auctions are
single-price auctions). In a single-price auction, all bidders are awarded securities at the highest
yield of accepted competitive tenders (i.e., the high yield). This type of auction is called a Dutch
auction. Thus, all bidders (competitive and noncompetitive) are awarded securities at the high
yield.

The Treasury does not actually offer securities with a coupon rate equal to the high yield because
it adjusts the coupon rate and the price so that the yield offered on the security is equal to the
high yield. This makes the yield a more common number (e.g., 3.025 becomes 3.000 and price
can differ slightly from par.

10. In a Treasury auction, how is the price that a noncompetitive bidder must pay determined
in a single-price auction format?

A noncompetitive bidder is a bidder is who is willing to purchase the auctioned security at the
yield that is determined by the auction process. This yield is the high yield. However, the price
can differ slightly from par to reflect adjustments to make the yield equal to the high yield. More
details are supplied below.

Once the winning bidders are determined along with their allotment, the price can be set following
the conventions of a single-price auction (because all U.S. Treasury auctions are single-price
auctions). In a single-price auction, all bidders are awarded securities at the highest yield of
accepted competitive tenders (i.e., the high yield). This type of auction is called a Dutch auction.
Thus, all bidders (competitive and noncompetitive) are awarded securities at the high yield.

The Treasury does not actually offer securities with a coupon rate equal to the high yield because
it adjusts the coupon rate and the price so that the yield offered on the security is equal to the
high yield. This makes the yield a more common number (e.g., 3.025 becomes 3.000 and price
can differ slightly from par.

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11. Suppose that a Treasury coupon security is purchased on April 8 and that the last
coupon payment was on February 15. Assume that the year in which this security is
purchased is not a leap year.

Answer the below questions.

(a) How many days are in the accrued interest period?

The calculation of the number of days in the accrued interest period and the number of days in
the coupon period begins with the determination of three key dates: the trade date, settlement
date, and date of previous coupon payment.

The trade date is the date on which the transaction is executed. The settlement date is the date a
transaction is completed. For Treasury securities, settlement is the next business day after the
trade date. Interest accrues on a Treasury coupon security from and including the date of the
previous coupon payment up to but excluding the settlement date. In our problem, the settlement
day of February 15th will be excluded when determining the accrued interest period.

The number of days in the accrued interest period and the number of days in the coupon period
may not be simply the actual number of calendar days between two dates. The reason is that
there is a market convention for each type of security that specifies how to determine the number
of days between two dates. These conventions are called day count conventions. There are
different day count conventions for Treasury securities than for government agency securities,
municipal bonds, and corporate bonds.

The day count convention used for Treasury coupon securities involves determining the actual
number of days between two dates. This is referred to as the actual/actual day count convention.
In our problem, we consider a Treasury coupon security whose previous coupon payment was
February 15. The next coupon payment would be on August 15. The Treasury security is
purchased with a settlement date of April 8.

In the Figure below, we show the actual number of days between February 15 (the previous
coupon date) and April 8 (the settlement date):

February 15 to February 28 (count Feb. 15) 14 days

March (31 days in March) 31 days
April 1 to April 8 (dont count April 8) 7 days

Actual number of days 52 days

The number of days in the accrued interest period represents the number of days over which
the investor has earned interest. For February, we have 14 remaining days (e.g., the 13 days
from February 15 up to February 28 and the additional day of February 15 th (since by
convention we count the day that the day on which the last coupon was paid). We have 31 days
for March. For April, we have 7 days up to April 7 (by convention we do not count April 8 th as

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a day since that is the settlement day). Thus, the accrued interest period is 14 + 31 + 7 = 52
days.

[NOTE. The number of days in the coupon period is the actual number of days between February
15 and August 15, which is 182 days. The number of days between the settlement date (April 8)
and the next coupon date (August 15) is therefore 182 days 52 days = 130 days. Notice that in
computing the number of days from February 15 to February 28, February 15 is counted in
determining the number of days in the accrued interest period; however, the settlement date
(April 8) is not included.]

(b) If the coupon rate for this Treasury security is 7% and the par value of the issue
purchased is $1 million, what is the accrued interest?

When an investor purchases a bond between coupon payments, if the issuer is not in default, the
investor must compensate the seller of the bond for the coupon interest earned from the time of
the last coupon payment to the settlement date of the bond. This amount is called accrued
interest.

When calculating accrued interest, three pieces of information are needed: (i) the number of days
in the accrued interest period, (ii) the number of days in the coupon period, and (iii) the dollar
amount of the coupon payment. The number of days in the accrued interest period represents the
number of days over which the investor has earned interest. Given these values, the accrued
interest (AI) assuming semiannual payment is calculated as follows:

annual dollar coupon days in AI period

AI = .
2 days in coupon period

In our problem, we have 52 days in the accrued interest period, 182 days in a coupon period from
February 15 through August 15, and the annual dollar coupon per $100 of par value is $7. The
accrued interest is:

annual dollar coupon days in AI period $7 52

AI = = = $1.00.
2 days in coupon period 2 182

12. Answer the below questions.

(a) What is meant by coupon stripping in the Treasury market?

Coupon stripping, in general, refers to detaching the coupons from a bond and trading the
principal repayment and the coupon amounts separately, thereby creating zero coupon bonds.
The Treasury does not issue zero-coupon notes or bonds. However, because of the demand for
zero-coupon instruments with no credit risk, the private sector has created such securities.

The profit potential for a government dealer who strips a Treasury security lies in arbitrage
resulting from the mispricing of the security.

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(b) What is created as a result of coupon stripping in the Treasury market?

As discussed below, a zero-coupon Treasury security results from the coupon stripping in the
Treasury market.

To illustrate the process of coupon stripping and what is created, suppose that $500 million of
a 10-year fixed-principal Treasury note with a coupon rate of 5% is purchased by a dealer firm to
create zero-coupon Treasury securities. The cash flow from this Treasury note is 20 semiannual
payments of $12.5 million each ($500 million times 0.05 divided by 2) and the repayment of
principal (also called the corpus) of $500 million 10 years from now. As there are 11 different
payments to be made by the Treasury, a security representing a single payment claim on each
payment is issued, which is effectively a zero-coupon Treasury security. The amount of the
maturity value for a security backed by a particular payment, whether coupon or corpus, depends
on the amount of the payment to be made by the Treasury on the underlying Treasury note. In
our example, 20 zero-coupon Treasury securities each have a maturity value of $12.5 million,
and one zero-coupon Treasury security, backed by the corpus, has a maturity value of $500
million. The maturity dates for the zero-coupon Treasury securities coincide with the
corresponding payment dates by the Treasury.

13. Why is a stripped Treasury security identified by whether it is created from the coupon
or the principal?

On dealer quote sheets and vendor screens STRIPS are identified by whether the cash flow is
created from the coupon (denoted ci), principal from a Treasury bond (denoted bp), or
principal from a Treasury note (denoted np). Strips created from the coupon are called coupon
strips and strips created from the principal are called principal strips.

The reason why a distinction is made between coupon strips and principal strips has to do wit h
the tax treatment by non-U.S. entities where some foreign buyers have a preference for
principal strips. This preference is due to the tax treatment of the interest in their home
country. The tax laws of some countries treat the interest as a capital gain, which receives a
preferential tax treatment (i.e., lower tax rate) compared with ordinary interest income if the
stripped security was created from the principal.

14. What is the federal income tax treatment of accrued interest income on stripped
Treasury securities?

Interest income from Treasury securities is subject to federal income taxes but is exempt from state
and local income taxes. A disadvantage of a taxable entity investing in stripped Treasury securities
is that accrued interest is taxed each year even though interest is not paid. Thus these instruments
are negative cash flow instruments until the maturity date. In brief, they have negative cash flow
because tax payments on interest earned but not received in cash must be made.

15. What is a government-sponsored enterprise?

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A government-sponsored enterprise (GSE) is a one of several types of government-chartered
entities. GSEs are divided into two types. The first is a publicly owned shareholder corporation.
There are three such GSEs: the Federal National Mortgage Association (Fannie Mae), the
Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Agricultural
Mortgage Corporation (Farmer Mac). The other type of GSE is a funding entity of a federally
chartered bank lending system. These GSEs include the Federal Home Loan Banks and the Federal
Farm Credit Banks. The GSEs issue two types of securities: debentures and mortgage-backed
securities. Because of credit risk and liquidity, GSEs trade in the market at a yield premium to (i.e.,
yield greater than) comparable-maturity Treasury securities.

16. Explain why you agree or disagree with the following statement: The debt of
government-owned corporations is guaranteed by the full faith and credit of the U.S.
government, but that is not the case for the debt of government-sponsored
enterprises.

One would not agree with this statement because both government-owned corporations and also
government-sponsored enterprises are not backed by the full faith and credit of the U.S.
government.

A government-owned corporation (GOC) is one of several types of government-chartered

entities. Two examples of a government-owned corporation are the Tennessee Valley
Authority (TVA) and the U.S. Postal Service. However, the only government-owned
corporation that is a frequent issuer of debt in the market is the TVA. TVA debt obligations
are not guaranteed by the U.S. government. However, the securities are rated triple A by
Moodys and Standard and Poors. The rating is based on the TVAs status as a wholly owned
corporate agency of the U.S. government and the view of the rating agencies of the TVAs
financial strengths.

Another type of government-chartered entity is a government-sponsored enterprise (GSE).

Like GOCs, GSEs are not backed by the U.S. government. GSEs are divided into two types.
The first is a publicly owned shareholder corporation. There are three such GSEs: the Federal
National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage
Corporation (Freddie Mac), and the Federal Agricultural Mortgage Corporati on (Farmer
Mac). The other type of GSE is a funding entity of a federally chartered bank lending
system. These GSEs include the Federal Home Loan Banks and the Federal Farm Credit
Banks.

17. In the fall of 2010, the author of this book received an offering sheet for very short-term
Treasury bills from a broker. The offering price for a few of the issues exceeded the
maturity value of the Treasury bill. When the author inquired if this was an error, the
broker stated that it was not and that there were institutional investors who were buying
very short-term Treasury bills above the maturity value. What does that mean in terms of
the yield such investors were willing to receive at that time?

As show in our illustration below, paying above the maturity value means that investors are
ceteris paribus willing to earn a negative rate of return.

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To begin with, T-bills are sold at a discount, and prices are quoted as a percentage of the
maturity value. The discount is the difference between the face value and the purchase price, and
represents the interest earned on the investment. Unlike Treasuries with longer maturities, T-bills
don't pay periodic interest payments; the full value of the interest is factored into the discount
and earned if the bill is held to maturity.

The discount rate, also called the discount yield, on T-bills is established by the competitively
determined purchase price and may be calculated on a bank discount basis as:

D 360
Yd
F t

where Yd = annualized yield on a bank discount basis (expressed as a decimal), D = dollar

discount, which is equal to the difference between the face value and the price, F = face value
and t = number of days remaining to maturity.

For our problem, let us assume a Treasury bill with 90 days to maturity, a face value of
$1,000,000, and selling for $1,001,000 (which in this case selling means what some
institutional buyers are willing to pay). The dollar discount (which is not really a discount)
when investors will pay more than face value is: D = F P = $1,000,000 $1,001,000 =
$1,000.

Given D = $1,000, F = $1,000,000 and t = 90, the Treasury bill would, by its traditional
formula, be quoted at the following yield:

$1, 000 360

Yd = = 0.0010(4) = 0.0040 or 0.40%.
$1, 000, 000 90

Even if Yd was its normal positive quoted yield on a bank discount basis, it is not a
meaningful measure of the return from holding a Treasury bill for two reasons. First, the
measure is based on a face value investment rather than on the actual dollar amount invested.
Second, the yield is annualized according to a 360-day rather than a 365-day year, making it
difficult to compare Treasury bill yields with Treasury notes and bonds, which pay interest
on a 365-day basis.

The measure that seeks to make the Treasury bill quote comparable to Treasury notes and bonds
is called the bond equivalent yield. The CD equivalent yield (also called the money market
equivalent yield ) makes the quoted yield on a Treasury bill more comparable to yield quotations
on other money market instruments that pay interest on a 360-day basis. It does this by taking
into consideration the price of the Treasury bill rather than its face value.

The formula for the CD equivalent yield is

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 360Yd
CD equivalent yield
360 t (Yd )

Considering out hypothetical 90-day Treasury bill with a face value of $1,000,000, selling for
$1,000,100, and offering a yield on a bank discount basis of 0.40%, we get:

360( 0.004)
CD equivalent yield = 0.0036 or about 0.36%.
360 90( 0.004)

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