L4. Treasury Securities

TOC

1. Chinese Treasury Bonds 1.1 Symbols and Markets 1.2 Treasury tender offer 2. U.S. Treasury Securities 2.1 Classes of Treasury Securities 2.2 Treasury Auction 2.3 When-issued trading (WI)

1. Chinese Treasury Bonds

1.1 Symbols and Markets

In China, Treasury bonds are the liabilities of the central government issued by the Ministry of Finance. There are two types treasury bonds:

1. book-entry Treasury bonds;

2. savings Treasury bonds.

Book-entry Treasury bonds are issued to institutional and a limited number of individual investors, tradable in the secondary market.

Coupon-bearing bonds have maturities of one year or longer (1, 2, 3, 5, 7, 10, 15, 20, 30 and 50 years)

Discount bonds have maturities of 28, 69, 91, 182, and 273 days

Savings Treasury bonds, in electronic or certificate form, are issued to individual investors, not tradable.

Maturities include 3 years and 5 years.

Treasury bond markets

Primary market:

Tender offer book-entry Treasury bonds to members of the Treasury bond underwritting syndicate.

Members of the Underwriting Syndicate

Issue savings Treasury bond via underwriters (banks).

Issue targeted Treasury bonds to targeted social security institutions and insurance companies.

Secondary market:

Exchanges: the Shanghai Stock Exchange (SSE) and the Shenzhen Stock Exchange (SZSE).

Over-the-Counter (OTC) markets: the interbank market and bank counter.

1.2 Treasury tender offer

Tender offer may involve competitive and noncompetitive bids

A competitive bid expresses both price (interest rate) and quantity demands

A noncompetitive bid, also called additional bid, only involves quantity demand; it unconditionally accepts the price (interest rate) determined by the competitive bids.

Noncompetitive bids are typically available for Class-A members and for coupon-bearing bonds with maturities less than 10 years (inclusive). Quantity restrictions apply.

Bid subject is interest rate or price. Typically, initial issues of coupon-bearing bonds apply interest rate while issue of discount bonds and re-opening issues of coupon-bearing bonds use price.

Bid positions

Each issue notice stipulates the unit of change in bid position. The unit tells the minimal difference in price/interest rate between two adjacent bid positions

In an interest rate auction, the unit of change in the bid position is 1 basis point.

In a price auction, the unit of change in the bid position is stipulated in the notice. The unit typically increases with bond maturity. For example, 0.001 yuan for the 2023 28-day and 63-day discount bonds; 0.002 yuan for the 2023 91-day discount bonds.

Bidding restrictions

There are bidding restrictions expressed in the unit of change in bidding position:

The difference between the highest and lowest bids of a member cannot exceed the limit stipulated in the issue notice, for example, 45 units.

Bids with prices / interest rates deviating from the weighted average bidding price / interest rate of all bids over a certain limit, e.g. 100 units, will be disqualified.

Winning bids with prices / interest rates deviating from the weighted average bidding price / interest rate of all winning bids over a certain limit, e.g., 40 units, will be disqualified.

Bidding and underwriting amount requirements

Maximum bidding amount: 35% of the auction (competitive bidding) amount for a Class-A member; 25% for a Class-B member.

Minimum bidding amount: 4% of the auction amount for a Class-A member; 1.5% for a Class-B member.

Minimum underwriting amount: 1% of the auction amount for a Class-A member; 0.2% for a Class-B member.

Notice Example

Notice of MoF on the Issuance of 2023 Book-entry Coupon-bearing Treasury Bonds

Winning Bids

Ministry of Finance accounts each effective bid, giving priority to bids for lower interest rates or higher prices, until the market is cleared or all bids are accounted.

Rank the bids

Thus, at 3.25%, the highest winning interest rate, also called stop-out-yield (SOY)

Bidder A receives 4.66 (), round up to 0.01 billion yuan;

Bidder B receives 2.33 (), round up to 0.01 billion yuan;

Bidder B receives the rest 0.01 (7-4.66-2.33) as it bided early

Overall, A receives 14.66 billion yuan; B receives 12.34 billion yuan and C receives 18 billion yuan.

Pricing Mechanism

Multiple price / discriminatory auctions: each winning bid receives the interest rate it expresses to receive.

Uniform price auctions: All winning bids receive the same highest interest rate at which the market clears.

Modified multiple price auctions: For above example,

Winning bids for interest rates equal to or below the coupon rate pay the par price;

Winning bids for interest rates higher than the coupon rate pay discount prices, calculated with the interest rates expressed to receive respectively; for example,

Secondary Market Market-Making Support Operation

Ministry of Finance (MoF) uses buy-and-sell tools to support market-making in the interbank market:

When market supply exceeds demand, MoF buys Treasury bonds from market makers, called the buy operation

When demand exceeds supply, MoF sells Treasury bonds to market makers, called the sell operation

Participating institutions are simultaneously Class-A members of the Treasury underwriting syndicate and market makers in the interbank market.

2. U.S. Treasury Securities

Objective: Fund the government at the least cost to the taxpayer over time.

2.1 Classes of Treasury Securities

There are two categories of treasury securities:

Marketable Securities:

Can be traded in the secondary market

Sold at auction, rates set via competitive bidding

e.g., Bills, Notes, Bonds, TIPS and FRNs. Note that Zero coupon bonds are created by market participants and are not issued directly by Treasury.

Non-Marketable Securities:

Can not be traded and can be sold only to Treasury

Sold to investors by subscription, rates set administratively

e.g., Savings Bonds, State and Local Government Series

Marketable Treasury Securities

Bills: Maturities less than 1-year, sold at competitive auction at a discount to par. Returns par at maturity

Notes: Maturities from 1-year to 10-years, sold at competitive auction, semi-annual coupon payments

Bonds: Maturities > 10-years, sold at competitive auction, semi-annual coupon payments

Treasury Inflation-Protected Securities (TIPS): Maturities of 5-, 10- and 30- years. Sold at competitive auction. Semi-annual coupon payments. TIPS have a “Real Rate Coupon”. Principal is indexed to NSA-CPI

Floating Rate Notes (FRN): 2-year maturity. Sold at competitive auction; quarterly interest payments with weekly reset. Indexed to the 13-week T-bill auction result

Treasury issuance calendar

2.2 Treasury Auction

An example is shown as below

The auction procedure is as following

Only players designated as primary dealers have direct access to the auctions. The pricing mechanism is uniform price auction.

2.3 When-issued trading (WI)

WI is a transaction or trade in securities that are not yet issued, on the understanding that the trade will be settled once the securities are issued. When-issued trading occurs between the announcement date and the issue date. Dealers and investors can take significant long or short positions that do not require financing. WI trading thus constitutes a special kind of forward market for non-existent securities. Active WI markets exist for US Treasury securities and sometimes Freddie Mac Securities issued by auction, e.g. reference bills.

Benefits of WI trading

Information discovery: Recall that the US Treasury market is an OTC market — lower transparency about demand schedules. A dealer that will subsequently bid in an auction faces uncertainty about customers’ quantity and price demands. WI trading allows some of the uncertainty to be resolved.

By shorting as a commitment in the WI market, a dealer can meet customer demands and obtain a benchmark of required prices and quantities.

Downsides of WI trading

Short squeeze: squeezing the market means a dealer/market participant corners most or all available supply in security to engineer an artificial price rise; It may refer specifically to the futures or repo markets when the supply of loanable or deliverable securities is reduced by such cornering activity.

Repo specialness:

refers to repo transcations in specific securities, where only the special securities can be delivered back to close out the transaction.
substitution of similar collateral, such as other securities of the same issuer, are not accepted for transaction closure.

Taking advantage of the specialness:

Suppose there is a shortage of security required to cover a short WI trading position (or to deliver on a forward or futures contract). We can take advantage of this specialness with following steps:

Enter into a repo: sell our security and agree to repurchase it later

Since the security is scarce, we will obtain a high price relative to the “forward” price. That means we can borrow at a specially low repo rate

Invest the cash in a standard “non-special” investment and earn the difference between the prevailing market rate and the special repo rate

There exists an incentive to create such “specialness”, e.g. the Salomon Brothers scandal in 1991.