Primary and Secondary Markets for U.S. Treasury Securities

The debt of the United States government consists of both marketable and non-marketable securities, in near equal proportions. Marketable securities consists of bills, notes, bonds, Treasury Inflation Protected Securities (TIPS), and STRIPS. Non-marketable securities consists of United States Savings Bonds, Domestic, Foreign, REA, SLGS, GAS and Other securities. These securities include special securities issued only to state and local governments and Federal trust funds such as Social Security. Non-marketable securities are non-transferable securities issued by the government and registered to the owner, and are payable only to the person(s) or entities to whom they are registered. They cannot be sold in the financial market, but they can be redeemed at any time after they've been held for one year.

Primary Market

Marketable Treasury securities are sold in the primary market through sealed-bid single price auctions (aka uniform-price auctions), sometimes called Dutch auctions, which are announced several days in advance of the auction by Department of the Treasury press releases, detailing the offering amount, type of security, and its term. Most bids — both competitive and noncompetitive — are submitted electronically to a Federal Reserve Bank or an authorized financial institution, or to the Bureau of the Public Debt.

Treasury auctions consists of competitive bids placed by primary dealers, that include HSBC, J.P. Morgan, and Citigroup, and noncompetitive bids, which are bids submitted by everyone else. Primary dealers are required to bid at Treasury auctions.

The yield is set by the competitive bidding to the lowest level, known as the stopout yield that allows the entire offering of marketable securities, minus the noncompetitive bids, to be sold. Competitive bidders that bid higher than the stopout price only have to pay the stopout price, but competitive bidders who bid below the stopout price are not filled. Noncompetitive bidders always pay the stopout price and are always filled.

TreasuryDirect

TreasuryDirect is the best way for individuals to buy and hold marketable Treasury securities.

Marketable securities are those securities that can be bought and sold in the secondary market at prevailing market prices after original issue. The following marketable securities are available in TreasuryDirect:

• T-bills
• T-notes
• Treasury-Inflation Protected Securities (TIPS)
• Treasury bonds

The mix of securities offered may change, as the Treasury's borrowing needs change.

Purchases of marketable issues in TreasuryDirect are allowed on a noncompetitive basis in increments of $100. Purchasers receive their securities at the same price and yield awarded to competitive bidders in the auctions. Recurring purchases of Treasury securities can also be set up to 5 years in advance.

Treasury Automated Auction Processing System (TAAPS)

The Treasury Automated Auction Processing System (TAAPS) is an electronic trading platform for financial institutions that provides direct access to U.S. Treasury auctions. This system electronically receives and processes tenders sent to U.S. Treasury auctions, thus allowing institutions to purchase marketable securities directly from the desktop.

Primary Dealers

A large part of the Treasury offerings is sold to authorized primary government securities dealers, which have a special account with the Federal Reserve Bank of New York, and include major financial institutions and domestic and foreign securities dealers. They are required to maintain a minimum of capital, and to participate significantly in the auctions, and to provide market information to the Fed.

No one, even the primary dealers, are permitted to buy more than 35% of any issue.

Reopenings

On some of its securities, the Treasury has reopenings where additional amounts of a previously issued security are sold. The securities have the same coupon interest rate and maturity, but different issue dates and prices. Accrued interest may have to be paid, but is paid back on the 1^st interest payment. The following table shows the current reopening schedule.

Buybacks

Sometimes the Treasury, during budget surpluses, buys back some of its securities through a reverse auction on the secondary market to limit the average maturity of its debt and to increase the liquidity of the Treasury market. The 1^st debt buyback program was in the 1920s, to use the tax surpluses during the booming economic times to pay off the debt from World War I. The current debt buyback program was initiated in January 2000, again using the surpluses of the booming economy. The last was in April 2002, using the surplus tax receipts.

Buybacks can increase the liquidity of new issues when deficits are declining by allowing Treasury officials to continue a series without shrinking new-issue sizes and can smooth week-to-week fluctuations in Treasury bill offerings. Buybacks actively promote the liquidity of the new-issue markets by regularly repurchasing outstanding debt and funding the purchases with new debt offerings. Buybacks also limit the accumulation of large Treasury cash balances, which usually occurs in late April and early May, when most taxpayers pay their income taxes.

Liquidity also provides current market information about the risk-free rate, which is used in many investment decisions.

Secondary Market

The trading of already issued securities by investors and primary market participants constitutes the secondary market, which is the largest security market in the world, with very narrow bid-ask spreads.

Central banks, both the Federal Reserve and foreign central banks, hold large reserves and trade actively. The main trading centers are in New York, London, and Tokyo. Although trading can occur 24 hours, most of it is done during the New York business day, since the Federal Reserve of New York is the largest holder and trader of Treasury securities.

The primary dealers act as market makers in the secondary market, with standing bid/offer quotes, in the over-the-counter market (OTC).

Interdealer Brokers

Primary dealers trade among themselves by using an electronic platform provided by an interdealer broker, which lists the best bid/ask prices and the quantity. The minimum bid or offer is $5 million for T-bills and $1 million for notes and bonds.

Interdealer brokers provide anonymity for the traders, some of which are non-primary dealers, and provide the latest transaction prices and quantities on their trading platform.

Some interbroker dealers include:

• BrokerTec (acquired by ICAP)
• Cantor Fitzgerald/eSpeed
• Garban-Intercapital
• Hilliard Farber
• Tullett Liberty.

Federal Reserve

The Federal Reserve buys and sells large amounts of securities through its open market operations to fulfill the monetary policies of the Federal Open Market Committee (FOMC). The money supply is expanded when the Federal Reserve buys Treasury securities on the secondary market, and contracted when the central bank sells them.

On-The-Run, Off-The-Run, and When-Issued Treasury Securities

Although Treasury securities trading is the most active and liquid market, less than 200 recent issues constitute most of the trading activity. The most recent issues of a given maturity are called on-the-run securities, in contrast to the older, much more numerous, but less actively traded off-the-run securities.

When-issued securities are securities announced for auction, but not yet issued . Dealers often take orders for when-issued securities to gauge the yield of the new issues and to be able to bid with lesser risk. Although most trades for Treasuries settle the following day, when-issued securities settle on the day of issue.

Treasury Buybacks

The U.S. Treasury often buys back its own debt as a way to save money using excess cash and to buy higher yielding debt and replacing it with lower yielding debt. New securities can then be issued with a more appropriate size and maturity that would better suit the needs of the US government.

Only primary dealers can participate in buybacks. The U.S. Treasury announces the buyback, then interested primary dealers submit offers. The Federal Reserve Bank of New York evaluates the offers and notifies participating dealers what offers were accepted. The Treasury then publishes the results and pays for the securities.

Each announcement includes:

• the desired securities with certain maturity dates
• date, start time, and closing time for the operation
• settlement date
• other relevant information.

The trade is settled 1 business day after the operation with payment = the par amount of the securities.

Quoting Conventions

Treasury prices are quoted according to a convention.

Treasury Bills

Bills are sold at a discount from their face value. When a bill matures, the investor receives the face value. The difference between the purchase price and the face value equals the interest earned. The purchase price can be determined from the following formula:

For example, if a $1,000 26-week bill sells at auction for a 3.80% discount rate, the purchase price would be $980.79, a discount of $19.21.

The discount rate differs from usual calculation of an investment return because it is based on the face value of the security rather than the actual amount invested, and yields are calculated using a 360-day year— a banker's year.

Applying the equation to the above example:

P = 1000 (1- (.0380 × 182)/360) = $ 980.79

T-bills are usually quoted to 2 decimal places in the secondary market, or, for more active issues, to 3 decimal places, if the last digit is a 5.

Treasury Bill Yields: the Discount Yield and the Investment Yield

Shortly after the auction, the U.S. Treasury reports the high, low, and average prices of the T-bills sold. It also reports the yield, which is annualized so that it can be easily compared to other investments.

There are 2 methods for determining the annualized yield on T-bills, both of which are reported by the U.S. Treasury:

1. The discount yield is the annualized yield on the face value of the T-bill, which allows its yields to be more easily compared to coupon Treasuries. The discount yield uses a banker's year of 360 days to calculate its yield.
   • Discount Yield = (Face Value - Price Paid)/Face Value × 360/(Term Length in Days)
2. The investment yield is the annualized yield of the actual investment, which is the discounted price paid for the T-bill. Because this yield is based on a lower price than the discount yield and is based on the calendar year of 365 days (366 for a leap year), which is the actual number of days in the year rather the banker's year, the investment yield will always be slightly higher. Investment yield is the term used by the Treasury, but it is called the bond equivalent yield (BEY).

Note that neither the discount yield or the investment yield is compounded. The following example shows how to find the compounded interest rate of a T-bill. The following solution shows yet another way of calculating the interest rate per term of a T-bill.

Notes and Bonds

No commission is charged when buying or selling treasury securities in the secondary market. A bond dealer makes money through the spread — the difference between the bid price, which is what the dealer is willing to pay for a security, and the ask price, which is what the dealer is selling it for. To keep the spread further apart, prices are generally listed in 1/32 increments of a point, or a higher multiple, although some Treasuries have price differentials as low as 1/64. (Another reason for this convention is that a point is not equal to a dollar, but a decimal base would still be more convenient.) The pricing convention is to list the point after a dash. Thus, a price listed as 102-04 = 102 + 4/32 = 102 + 1/8 = 102.125% of par value. If this listed price were for a $1,000 face-value Treasury note, then this price would be equal to $1,021.25. The integer point value, in this case 102, is known as the handle. When traders negotiate, the handle is usually known and not expressed. So a trader might say that he'll offer 2 for the security, meaning the handle + 1/16 (= 2/32).

Because the trading volume in Treasuries greatly exceeds that for other bonds, Treasuries sometimes trade in 1/64 increments. A 1/64 increment is denoted by a plus next to the listed price. So a U.S. Treasury note with a $1,000 face value that is listed as 101-1+ = 101 + 1/32 + 1/64 = 101 + 3/64 = 101.04875, so the note's price = 101.04875% × 1,000 = $1010.49 (rounded). 1,000 of these securities would cost $1,010,487.50.

Investment Yields on Treasury Notes and Bonds

Calculating investment yields is more complicated for Treasury notes and bonds, but, if the security is held till maturity, the investment yield can be approximated by the following formula:

Microsoft Excel Functions for T-Bills: TBILLEQ, TBILLPRICE, and TBILLYIELD

Microsoft Office Excel offers several functions specifically for T-bills. The function TBILLEQ converts the discount yield of a T-bill to its investment yield (bond equivalent yield). TBILLPRICE calculates the price of a T-bill if the discount yield is known, and TBILLYIELD calculates the discount yield if the T-bill price is known. All of these functions use the Date function with format Date(year,month,day), since the MS Excel Help states that there may be problems if entered as text. Cell references that contain valid dates can also be used for the date arguments.