Chapter 6 Government Bonds

1
Chapter 6Government Bonds

• How are Treasury bonds and notes sold in the
  primary market? In the secondary market?
• How do we adjust bond prices to reflect accrued
  interest?
• What are agency bonds?
• What types of individuals would be interested in
  municipal bonds?

2
Some US Treasury facts

• US Dept of Treasury is the largest debt issuer in
  the world
• Treasury securities about 3 trillion while all
  corporate issues are about 1½ trillion
• Debt from years of running a federal budget
  deficit
• Recall difference between T-bills, T-notes, and
  T-bonds
• Weve already discussed T-bills

3
Primary MarketT-bonds and T-notes

• T-bonds and T-notes use auction procedure
• Coupon rate is set based on the results of the
  stop bid yield of the auction
• Rounded down to the nearest eighth
• Typical auction schedule
• 2-year notes once a month
• 5- and 10-year quarterly
• 30-year semi-annually
• The Federal Reserve acts as agent for US Treasury

4
Competitive vs. Non-Competitive Bids

• Why are you not shut out if you bid
  non-competitively (quantity bid)?
• Which is better?
• By making a competitive bid you are setting the
  maximum price (minimum yield) that you will accept

5
Primary dealers

• Approximately 25 dealers are designated as
  primary dealers
• Only ones that deal directly with the Fed
• They submit bids for yields based on
  noncompetitive (quantity) or competitive basis
• They must participate

6
When issued market

• After the Treasury officially announces the
  auction, but before the securities are actually
  issued, trading begins on the securities in the
  when issued market
• When issued market trading ends when the
  securities are issued
• Helps primary dealers determine the best price to
  offer in the upcoming auction

7
Short squeeze

• When trades in the when issued market exceed the
  actual amount available in the auction, prices
  can be volatile
• Salomon tried to corner the market by owning a
  majority of a particular issue
• They tried to exploit short sellers who would
  have to close out their position
• Few bonds were available so price rose
• There are limits that are supposed to prevent
  this so Salomon got in trouble

8
Sources of dealer profits

• Bid-ask spread
• Sell at high price and buy at the low price
• Price appreciation of securities held
• Carry
• Dealers typically finance their securities
  inventories using repurchase agreements (the
  T-notes, T-bonds are highly liquid collateral)
• In a normal yield curve environment, what is the
  net yield of such a position?

9
T-note and T-bond price quotes

• Although bids are based on yields, reported price
  quotes are based on dollars assuming a 100 face
  value
• Basically prices are in percentage terms
• Quotes are in 32nds (or 64ths)
• 10020 means 100 and 20/32
• Prices are listed by maturity month and year
• All T-notes and T-bonds mature on the 15th
• n signifies that the issue is a note (see p.212)

10
Accrued interest

• Recall that one of the principles of accounting
  is accrual basis
• Recognize income when earned not when cash is
  received
• If a bond is sold between coupons, shouldnt the
  seller get part of the coupon?

11
An Example

• Suppose that a 5, 1,000 bond matures on
  December 15 and today is March 19
• Kurt sells the bond to Belinda

Last Dec 15
Dec 15
June 15
Coupon 25
Coupon 25
Coupon 25 FV 1,000
Kurt
Belinda
12
Dividing the coupon
Last Dec 15
June 15
March 19
Coupon 25
Coupon 25
Kurt
Belinda
Belinda owns for (31-19)303115 88 days
Kurt owns for 313128(19-15) 94 days
13
Dividing the coupon p.2

• Rather than waiting for June 15 coupon, Belinda
  will pay Kurt on the sale date for fraction of
  coupon
• Total price paid to Kurt on the sale date is the
  invoice price which equals the base (quoted)
  price plus the accrued interest
• Invoice price is the PV of cash flows
• This is different from quote in WSJ

14
Example continued

• Suppose the yield on the above bond is 6
• We can discount the cash flows to get a bond
  price of 1005.67
• Since Kurt owned the bond for 94 out of 182 days,
  the accrued interest portion of the price is

15
The Same Example with less work

• Use the calculator
• The base price becomes a plug between the present
  value of the cash flows and the accrued interest
• See book for another example

16
The call feature

• Details will come in corporate bond chapter
• If a bond is callable, it can be redeemed by the
  issuer prior to maturity
• Why call a bond?
• Some Treasuries used to be issued as callable
• But callable Treasuries still exist in the market

17
A little review

• Recall that a bond can be viewed as a portfolio
  of zero coupon bonds
• Example of a 1½ year bond

Coupon Face Value
Coupon
Coupon
Time
½
1
1½
18
Stripping Treasuries

• Converting coupon T-notes or T-bonds to zero
  coupon bonds is called stripping
• Why do this?
• Investors may be interested in tailoring their
  portfolios to have specific cash flows
• Use the STRIPS program approved by the US
  Treasury Separate Trading of Registered
  Interest and Principal Securities

19
Strip example in book p. 216

• 5 year, 1 million, 5 coupon T-note
• Why is the value of the stripped securities
  different from the original bond price?
• In column 3, the value of the coupons is from
  discounting by the YTM of the bond
• In column 6, coupons are discounted by spot rate
• Note that the values of zero coupon bonds (using
  spot rates) should equal the bond price or else
  arbitrage will take place

20
Federal Agency Debt

• Federal government sets up fiscal agents to
  promote credit availability
• Agencies borrow from capital markets and use
  money to make loans
• Loans offered in sectors of the economy to
  promote credit availability such as housing,
  education, farming
• Although not explicitly backed by the full faith
  and credit of the US Government, agency
  securities are regarded as safe

21
Some federal agencies

• Federal National Mortgage Association (FNMA) or
  Fannie Mae
• Federal Home Loan Mortgage Corporation (FHLMC) or
  Freddie Mac
• Student Loan Marketing Association (SLMA) or
  Sallie Mae

22
A note about agency debt

• Investors in agency bonds are not secured by any
  assets underlying the agencys loans
• The issues are debentures
• Debentures are unsecured debt and is backed only
  by the general credit of issuer

23
Municipal bonds

• Aside from the federal government, state and
  local governments also issue bonds
• Can be counties, school districts, townships
• Bonds issued by governments other than the
  federal government are called municipal bonds or
  munis

24
Issuers

• States
• State GO bonds have little default risk since
  default would impair future issues
• Local governments such as cities and counties
• Issuer may buy default protection
• Special districts such as school districts,
  sanitary district

25
Types of munis

• General obligation (GO) bonds are backed by
  full faith and credit of issuer
• Ability to raise taxes determines default risk
• Revenue bonds fund specific projects and
  bond cash flows are derived from
  revenues of the project
• Highways may have tolls
• Industrial development bonds help fund new
  construction of industrial sites for businesses
  at favorable rates

26
Tax treatment

• Munis are interesting because of tax status
• Government (or federal) securities are exempt
  from state tax and municipal securities are
  exempt from federal taxation
• Usually state of issue will exempt their own
  securities from tax
• Exemption applies to interest, not price
  appreciation

27
Effect on yields

• Tax exemption of munis allows them to yield less
  on a pre-tax basis

• The equivalent municipal yield is given by

28
A new risk

• Weve talked about default risk and call risk
• The tax exemption of munis introduces the risk
  that the tax status of the bond will change
• Marginal tax rate
• Exempt status

29
Muni markets

• Munis are underwritten for sale in the primary
  market
• See article distorting the primary market
• The secondary market is OTC
• Generally larger denominations than (federal)
  government debt

30
Summary of Chapter 6

• Federal government sells T-bonds and notes
• Accrual accounting pays bond sellers a portion of
  the coupon income
• Municipal bonds are issued by governments other
  than the federal government and have special tax
  treatment