US Treasury Securities

United States Treasury securities (also called Treasuries) are fixed income instruments issued by the United States Department of Treasury. They are direct obligations of the Federal Government, so they are considered free of credit risk. Interest income from Treasuries is taxed by the Federal Government but not by US state or local governments. Due to their favourable tax treatment, lack of credit risk and the fact that Treasuries are generally not callable, Treasuries offer yields below those of high-quality corporate securities.

At any given time, there are several trillion dollars of Treasuries outstanding. As old debt matures or federal budget deficits create a need for additional funds, the Treasury issues new securities. Accordingly, both the primary and secondary markets for Treasuries are large, active and highly liquid.

Treasuries are issued in various forms. By convention, these are categorized as

• Treasury bills, which are discount instruments with initial maturities of up to a year.
• Treasury notes, which pay semiannual coupons and have initial maturities of more than one year and up to ten years.
• Treasury bonds, which pay semiannual coupons and have initial maturities greater than ten years.

A more recent development is Treasury Inflation-Protected Securities (TIPS), which are coupon paying instruments with a principal amount that is adjusted over time for inflation.

The primary market for Treasuries is conducted as a Dutch auction open to the public and run by the Treasury. About 150 auctions are held a year. Most are for bills. Notes or bonds are auctioned less frequently. The Treasury publishes an informal long-term schedule for auctions. This is modified as the federal government’s funding needs evolve.

Some auctions are called reopenings. At these, the treasury auctions more of a previously issued security. For example, if a 4.25% coupon 30-year bond is issued in a February auction, more of those same 4.25% bonds will be offered in the August reopening. They will have the same maturity date as the previously issued bonds, so they will have just 29.5 years to maturity when issued.

Each auction is formally announced a few days in advance, and the Treasury identifies a specific dollar amount to be raised. That amount cannot change based on bids received. All bids are sealed. They can be placed competitively or non-competitively. Non-competitive orders are specified as an amount of securities, in units of 1,000s of dollars of par value, to be filled at whatever price is determined in the competitive bidding. Competitive orders are also specified as a par amount to be purchased but include a minimum yield the bidder is willing to accept. The Treasury collects all competitive bids, arranges the bided yields in ascending order, and determines the minimum yield at which it can meet the funding requirement specified for the auction. That stop-out yield is converted into a price, which is the price paid by all participants whose orders are filled. Specifically, non-competitive orders and competitive orders bid at yields lower than the stop-out yield are filled entirely. Competitive orders bid at the stop-out yield may be only partially filled. Remaining orders—those bid above the stop-out yield—are not filled.

For newly issued coupon instruments, the coupon rate is set by rounding the stop-out yield down to the nearest eighth of a per cent, so securities are always first issued at or below par. For example, the ten-year note maturing November 15, 2015, was first issued with a stop-out yield of 4.578. Its coupon was set at 4.500, and all bidders paid 99.379727 per 100 dollars of par value. Securities reissued in a reopening have the same coupon as the original issue, so they may be issued above par.

Treasury securities are all held in book-entry form. There is an active OTC market for Treasuries, typically for next-day settlement. Large financial institutions act as dealers, buying from or selling to their clients. Those that the New York Federal Reserve transacts within its open market operations are called primary government securities dealers (or primary dealers). In exchange for the Fed’s business, primary dealers are expected to participate meaningfully in Treasury auctions, provide the Fed a reasonable bid-offer spread on open market transactions, and be a source of market intelligence for the Fed. There are usually about twenty-five primary dealers, and they dominate the secondary market.

Dealers trade with one another through interdealer brokers, including BrokerTec, Cantor Fitzgerald, Garban-Intercapital, Hilliard Farber, and Tullett & Tokyo Liberty. Brokers provide dealers with proprietary screens that indicate best bids and offers available from other dealers as well as recent transaction details. The system is anonymous. A dealer who transacts at one of the displayed bids or offers pays the broker a modest fee.

The majority of secondary transactions are for on-the-run securities. These are Treasuries issued in the most recent auction. Typically, dealers have acquired large holdings in that auction and are selling them to clients. Securities issued in earlier auctions are called off-the-run. There is less liquidity for off-the-run securities, and they trade at modestly lower prices.

Treasuries also trade in the secondary market during the days leading up to their auction. These are called when-issued securities. The trades are forward transactions to be settled the same day the securities are issued. When-issued trading provides price transparency in anticipation of the auction. Also, by allowing dealers to advance-sell securities to clients, it reduces the risk they take in bidding on large blocks of securities in the auction.

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