In this post, you will find how exactly bonds issued by US treasury work. You will see information about the auction process, the bidding process and other relevant aspects regarding the bonds. You will see how you can buy or invest through primary and secondary markets.
Note: Buying from primary market means buying directly from the department of treasury. On the contrary, investing through secondary market means, buying through a bank or a dealer.
To start with, you should be clear on what exactly is a US Treasury Bond. Treasury bonds are one of the four popular marketable securities issued by the US Department of Treasury. The other three are treasury bills, notes, and TIPS. TIPS stands for Treasury Inflation Protected Securities. Treasury bonds are the longest maturing securities among the four.
How Bonds are Different From Bills & Notes
A primary factor by which the Treasury securities can be categorized is there maturing period. In the case of bonds, the maturing period is typically 30 years or slightly lesser (, but not lesser than 10 years.)
How US Treasury Bonds Work
Now you are going to see the working of the treasury bonds. The various stages in the life cycle of a bond are the following.
- Auction & Bidding
- Secondary Market Investing
Usually, a week before awarding bonds, the treasury announces the offering amount and other details pertaining to a bond issue.
US Treasury conducts auctions for treasury bonds on a schedule. You can get to know the upcoming dates from the government website, TreasuryDirect.
Difference Between Original and Reopened Issues
For illustration purposes, let us consider a tentative schedule of 2016. If you look at the PDF document showing the tentative dates, you will see an “R” appearing to the right side of mentions of “30-Year Bonds” in few cases. “R” denotes a reopening. For example, assume a bond originally issued in January is reopened in February. This means an additional amount of January bonds are issued again in February. The reopened securities will have the same maturity date as the original ones. (Thus a reopened bond will have a maturity lesser than 30 years.)
You can also say that a bond issue is original or reopened by looking at the announcement. For example, this document announces a reopening of a 30-year bond. If a bond is new, the “outstanding amount” field will $0. This means, there are no outstanding bond amounts previously issued. If the bond is a reopened one, the “outstanding amount” will reflect the amount already been issued in previous auctions.
How Advance Notice Helps Investors
The advanced announcement gives ample time for the potential investors to decide and bid a favorable yield or rate or discount margin from the face value.
If you are unsure of the parameters – yield, rate and discount margin here is a brief explanation. (In fact, these three parameters are related to each other. You will see how.)
Yield, Rate & Discount Margin
Let us assume an investor is willing to buy $2000 worth (face value) of a bond. (Face value is nothing but the principal one will receive at the end of maturity term.) One may want a discount from the margin to turn the investment profitable or at least better than his investments elsewhere. A discount from the face value is called the “discount margin“. For example, assume an investor XYZ is willing to pay $1800 for $2,000 worth of bonds. In this case, the discount margin will be
($2,000 - $1800) / $2000 x 100% = 10%.
Interest rate is nothing but the amount of annual payment per $100 face value of the bond. An important point to note is that the treasury bonds pay interest semi-annually.
Note: To determine the semi-annual rate just divide the per-annum interest by 2.
Yield refers to the annual income for $100 real investment (not the face value.) For example, if you paid $900 for $1000 worth of bonds and let us assume you receive $20 annually. For the above example, the yield and interest rate can be calculated as shown below.
Interest Rate = $20/$1000 x $100 = 2%
Yield = $20/$900 x $100 = 2.22%
When face value is greater than the purchase price, the yield will be greater than the interest rate. The opposite is also true.
2 Auction and Bidding
Two types of investors can buy bonds directly from the US Treasury.
- Individual investors
- Institutional investors like banks, brokers or foreign country entities
There are two types of bidding. One is competitive and the other is noncompetitive.
Competitive bidding is for large-scale purchases of bonds and a preferred method for institutional investors. In competitive bidding, there is no guarantee that the bidder will receive bonds for the quoted amount in the tender.
Non-competitive bidding is a preferred method for individual investors. The investors are guaranteed to receive bonds for the entire amount quoted. Treasury limits the worth of bonds given to non-competitive bidders. The cap is $5 million worth fo bonds per investor. This cap prevents investors from exhausting the guaranteed bidding scheme.
The proportion of bonds offered through non-competitive bidding is usually much lesser compared to those issued via competitive mode. As a real-life example. consider the auction results for a bond that was issued during November 15th, 2017.
Let us now calculate the proportion of offered amounts for the bidding types.
Ratio between offered bonds for competitive vs non-competitive
$14,995,116,000 / $4,884,700
= 3069.81 : 1
In other words, for every $1 awarded through non-competitive bidding, $3069.81 worth of bonds is issued through competitive mode.
Now let us discuss how the winning bids are determined in non-competitive bidding. Higher rate or yield is beneficial for those who purchase while a lower rate is good for the Government. (So that the Government has to pay less.) Based on the bids received, the treasury finds a middle-ground. The process the treasury follows is called a single price auction system You know the reason in a while.
Single Price Auction System
The bids are worked in the ascending order of the rates. That is the bidder who has expressed willingness for lowest rate will be given the topmost priority. The bids are worked down till the total amount expressed in the tenders equals the amount that can be allocated through competitive bidding.
Before auction process, the total offered amount through non-competitive bidding will be subtracted from the offering amount. For example, in the case of November 15th Bond (that we saw earlier), the total amount offered through non-competitive bidding system was $4,884,700. This would be subtracted from the total offered amount ($16,823,982,700) before deciding competitive bid winners.
Note: You will find a field “SOMA” in auction results. SOMA stands for System Open Market Account, an account held by Federal Reserve.
In our Nov 15th auction example, After SOMA and offering for non-competitive bidders, the amount available for non-competitive bidders was $14,995,116,000.
The bidders will be awarded bonds in the ascending order of the rates till the total offering is exhausted. Therefore, not all competitive bidders will be getting the bonds. Some will be left out. Some on the border will receive a fraction of the total amount expressed in the tender.
Cap exists for competitive bidders just like in the case of non-competitive bidders. No one investor can buy more than 35% available worth of bonds.
Now comes the interesting part. You will now learn the reason why the system is called a single price system. Even though bidders have expressed their willingness for different rates, the bonds will be awarded to everyone only for the lowest rate. Based on Netcial’s observation, this mechanism ensures two things.
- Everyone gets a fair price.
- No one single bidder can raise the bond prices for all others.
4 Secondary Market Investing
Once the bonds are offered, the institutional investors like banks and brokers have the liberty to sell the ones on the secondary market. The units sold in the secondary market may assume different forms. One popular way of selling in the secondary market is through investment products called STRIPS.
What are STRIPS? How do They Work?
STRIPS stands for Separate Trading of Registered Interest and Principal of Securities.
STRIPS are nothing but broken down components of the bonds. They are marketed in the secondary market by the primary buyers (banks, brokers, etc.) of bonds.
To see how exactly the process works, let us see a simple example. Consider a bond that matures in 30 years from now.
The total number of payments one will receive by holding the bond from inception to maturity can be calculated as shown below.
No of semi-annual interest payments =
30 years x 2 = 60 payments
Principal payment on maturity
= 1 payment
total number of payments = 60 interest payments + 1 face value or principal payment = 61 payments.
Now, from a 30-Year Bond, potentially 61 individual products can be formed. These products are called STRIPs.
Apart from STRIPS, another popular product created out of bonds are the bond mutual funds. These funds invest in one or more bonds.
Summary: How You Can Benefit From Treasury Bonds
You may be an individual looking for safe investment options for objectives like retirement, vacation, education fee, etc. Or you may represent an institution like a bank or broker or an outside US organization. Either way, treasury bonds are amongst the lowest risk investment vehicles available.
If you have any queries on the treasury bonds, kindly use the comments section.