The U.S. Treasury Market is one of the largest and most liquid in the world. U.S. Treasury securities, or Treasuries, are backed by the “full faith and credit” of the U.S. government. They are widely held and actively traded by institutional investors, central banks, corporations, individuals and many other private and public institutions.
Market Size
As of July 2011 (statistics compiled and published by the Securities Industry and Financial Markets Association, “SIFMA”) there were $9.1 trillion in Treasuries outstanding, with an average of over $600 billion traded each day. Over $2.3 trillion in Treasuries were issued in 2010. Both the value of Treasuries outstanding and volume traded have more than tripled over the past 10 years, and continue to grow as the U.S. Treasury issues more debt.
Trading
U.S. Treasury securities are traded “over-the-counter” between counter-parties. There is no formal exchange (such as the New York Stock Exchange) as exists for the equity markets. Instead, Treasuries are traded over the phone or across ElectronicCommerce Networks (ECNs).
A number of market participants trade Treasuries on a regular basis. On Wall Street, the term “buyside” is used generically to describe institutions that typically purchase securities. The buyside comprises money managers, asset managers, portfoliomanagers, pension fund managers, corporations, government agencies, hedge funds and other institutional investors. Similarly, the “sellside” refers to institutions that typically sell securities (primarily banks and dealers).
But buysideand sellsideare only loose designations, which can change depending on the counter-party’s perspective. For example, a small regional bank lacking an in-house Treasury trading operation may use the inventory of a much larger dealer to source Treasuries to sell to its clients. The large dealer may consider the regional bank a buysidecustomer since it regularly buys Treasuries from its trading desk, whereas the regional bank’s local institutional customer views the bank as on the sellside. In effect, the regional bank is an intermediary broker, buying from the large dealer and selling to the local institutional client for a small, add-on fee.
The U.S. Treasury market’s tens of thousands of active participants make it the second largest in the world (behind the enormous, $4 trillion/day foreign exchange market).
Market Makers
Sellside banks and dealers have trading desks that make markets in Treasuries. Their traders place bids or offer to sell specific Treasury securities for the firm’s in-house trading account (“book”). A good trader knows the fair value of the Treasury; he bids a little lower to buy it and offers it for sale at a slightly higher price. If the trader can buy low and sell high, the difference is his trading profit.
The difference between the trader’s bid and offer has many names: the bid/offer spread, the bid/ask spread, or just the spread. With so many active market makers executing hundreds of thousands of trades per day, Treasury markets are extremely competitive. Thus, the bid/offer spreads tend to be very narrow.
For example: the bid/offer spread for a 5-year Treasury is frequently 1/128th of 1 percent. This amounts to $78.125 for a $1 million trade. If the trader is very skilled—and can buy the Treasury at the bid and sell it quickly at the offer, before the markets move—then he has locked in a gross profit of $78.125 for the trade. This gross profit is before back office operations, transaction, clearing, accounting and the many other direct and indirect costs involved in running a trading operation, all of contribute to razor-thin profit margins. If the trader guesses wrong or the market moves against him before he can offset his trade, he can lose money easily, especially taking direct transaction-related expenses and corporate overhead into account.
Market makers commit their firm’s capital and resources to provide markets and liquidity to buyside firms and have been extremely important to the success and growth of the Treasury markets.
Treasury Securities
There are four primary security types issued by the U.S Treasury:
- Treasury Bills (T-Bills)
- Treasury Notes (T-Notes)
- Treasury Bonds (T-Bonds)
- Treasury Inflation-Protected Securities (TIPS)
All of these securities are marketable, meaning they can be sold in the secondary market. In general, Treasury securities are considered a very safe investment, as they are backed by the “full faith and credit of the U.S. government,” making the risk of default very low.
Treasury Bills
Treasury Bills (T-Bills, or just Bills) are short-term securities with maturity dates of less than one year (commonly issued are the 4, 13, 26, and 52 week bills). They are purchased at a discount from the face value (or par amount). For example, a $1000 T-Bill might sell for $980. When the bill matures, its owner will receive the full $1000; the $20 difference between the discounted price and the par amount is the interest on the bill.
Two methods allow us to calculate the yield on Treasury Bills: the discount yield method and the investment yield method. The first equation looks at the yield as a percentage of the face value of the T-Bill; the second looks at yield as a percentage of the purchase price.
Discount Yield (%) = [(Face Value –Purchase Price) / Face Value] x (360/Days to Maturity) x 100 (%)
Investment Yield (%)= [(Face Value – Purchase Price) / Purchase Price] x (365 or 366/Days to Maturity) x 100 (%)
The minimum purchase of Treasury Bills is $100. The interest earned on T-Bills is subject to federal income taxes in the year the Bill matures. This interest is exempt from local and state taxes. (The same is true for Notes, Bonds, and TIPS).
Treasury Notes
Treasury Notes (T-Notes or just Notes) are issued with maturity dates of 2, 3, 5, 7, and 10 years; T-Note holders are paid a fixed rate of interest, or “coupon,” every 6 months until maturity. The term “coupon” is a relic of the time when a Treasury Note was an actual piece of paper; every six months, the holder of the security would remove a physical coupon from the periphery of the document and trade it in for interest.
Formulas used to calculate the return on T-Notes can be very complex. Please refer to thePagetitled“Price Yield Calculations” if you want to know more about this topic.
Treasury Bonds
Treasury Bonds (T-Bonds or Bonds) are identical to treasury notes except that they mature in 30 years. They also pay a coupon every 6 months.
Treasury Inflation-Protected Securities
Treasury Inflation-Protected Securities offer investors protection from inflation (as determined by the Consumer Price Index). Inflation causes an increase in the principal of the TIPS; deflation causes a decrease. When the TIPS reaches its maturity date, the owner receives the inflation-adjusted principal or the original principal (whichever has a higher value).
TIPS pay interest every six months at a fixed rate; however, because the rate is applied to the inflation adjusted principal, the amount of interest paid may fluctuate.
