The Debt Markets (part C)
by
Charles Lamson
The Treasury Bond Market
U.S. governrment bonds, or Treasury bonds, are issued in the primary market by the Bureau of the Public Debt in minimum amounts of $1,000. Treasury bonds are sold in regularly scheduled competitive auctions that have historically been conducted during February, August, and November by the Federal Reserve System. Treasury notes and T-bills are sold in other regularly scheduled auctions. The Treasury decides the maturity structure and the amount of the various offerings.
Information regarding Treasuries securities can be found on the Fed's Internet site at www.federalreserve.gov.
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Treasury bonds are a full faith and credit obligation of the U.S. government. Consequently, investors view securities as being free from default risk. The federal government, with its power to tax or issue currency, will definitely pay back the principal and interest as scheduled. Because they are so highly liquid and free of default risk, interest rates on Treasury securities serve as a benchmark to judge the riskiness and liquidity of other securities.
However, Treasury bonds are not free of interest rate risk. If the interest rate goes up after the bonds are issued and before their maturity, the value of the bonds will go down. If the bonds are sold before maturity, the investor will receive less than the face value of the bonds and experience a capital loss.
The secondary market in treasury bonds is an over-the-counter market where a group of U.S. government securities dealers stands ready to buy or sell various issues of outstanding securities over the counter. Today Treasury securities are sold in secondary markets somewhere in the world 24 hours a day. An extensive and very active secondary market makes treasury bonds highly liquid. The dealers' profits stem from the spread between the bid (buying) and ask (selling) prices.
A desirable feature of treasury bonds is that the interest earned is exempt from state income taxes. Not all states have state income taxes and this feature is particularly beneficial in states with high income tax rates.
Treasury STRIPS are a type of government security first offered in 1984 and sold through depository institutions and government securities dealers. All newly issued treasury notes and bonds with maturities of 10 years or longer are eligible for the STRIPS program. STRIPS allow investors to register and trade ownership of the interest (coupon) payments and the principal amount of the security. The advantage of STRIPS is that the coupon and principal payments can be sold separately at a discount. STRIPS are sold in book entry form, meaning that the security is issued and accounted for electronically. The investor pays less today for the future payment than he or she will receive when the security matures. The interest the investor earns is the difference between what is paid today and what is received at maturity. Because the future payments are sold at a discount, the investor avoids uncertainty that coupon payments may have to be reinvested at a lower interest rate because rates have fallen since the security was issued. The future payments of the STRIPS securities are direct obligations of the U.S. government.
Inflation-indexed bonds are a more recent hybrid, first offered for sale by the Treasury in 1997. An inflation-indexed bond is one in which the principal amount is adjusted for inflation at the time when an interest (coupon) payment is made, usually every six months. Although the interest rate does not change, the interest payments are based on the inflation-adjusted principal, and the inflation-adjusted principal is received at maturity. Inflation-indexed bonds protect the investor from the ravages of inflation.
Recap
Treasury securities are sold in competitive auctions. They are considered to be free of default risk, and their interest rate serves as a benchmark to judge the risk and liquidity of other financial assets. The secondary market for government securities is a highly developed over-the-counter market. STRIPS are a government security that allows the investor to register and trade ownership of the coupon payments and the principal separately. The principal of inflation-indexed bonds is adjusted for inflation every six months. Although the interest rate does not change, the coupon rate is based on the inflation-adjusted principal at maturity.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 410-412*
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