What is the U.S. Treasury market?

The single most important financial market across the globe is the U.S. financial market. Pricing and inflation, the major economic stats of the U.S. economy are fundamentally based on the U.S. treasury market. The confidence in the U.S. economy and the accompanying efficient operation of the global economy led to the surge in U.S. treasury dealings. The U.S. markets act as the support system during periods of resilience. Over $7 trillion U.S. treasury bonds are held by other countries.

The U.S. Treasury securities are the fixed-income securities backed and issued by the United States Department of the treasury to finance its public expenditure and debt over the tax revenues. These are low-yielding but highly stable securities that the market participants include in their respective portfolios.

The indulgence in dealer-to-client has seen exploding volumes over the dealer-to-dealer trade volumes in the past decades. These dealers are neither regulated nor registered with the banks and can be referred to as the principal trading firms. These transactions are settled without any central clearance, safeguards, margin requirements. This has led to a highly interconnected arbitrage with the U.S. treasury markets. The working of the U.S. Federal Reserve System, its features, and the effect of a single decision by the Fed, off-the-run, on-the-run, recent developments in the U.S. treasury market is discussed in this article.

Key features of the Federal Reserve System of the United States

The Federal Reserve System is the central bank of the United States and implements monetary policies in the United States. It functions as an enabler for the economic growth and stability of the U.S. as well as abroad. The key features of the world's biggest financial system are:

1. The Federal Reserve Bank acts as the agent of the treasury. It manages the book entries and conducts foreign exchange transactions on behalf of the department.
2. The federal reserve open market committee decides upon the U.S. government debt rates and allows open market operations.
3. The governors of the Federal Reserve System act as the supervisor of the financial system and overlook the discount rate and reserve requirements.
4. The treasury international capital (TIC) system is the status holder of the worldwide distribution of treasury securities.
5. The treasury borrowing advisory committee holds quarterly meetings attended by the major market participants and analyses the debt management policies and issues quarterly refunding statements based on the discussions of the meeting.    

The U.S. Treasury market is comprised of securities divided into two classes as marketable and non-marketable securities. 

Marketable securities

Marketable securities are issued through regularly scheduled auctions in the primary market. These securities can be traded in the secondary market as well. The Federal Reserve banks especially The Federal Reserve Bank of New York (FRBNY) acts as the conduits at the auctions by competitive bidding. These auctions are mainly populated by the primary dealers who are registered and authorized by the Securities and Exchange Commission. The various types of marketable securities are explained below:

1. Treasury bill (T-bill) 

• These are short-term debt securities in the resemblance of zero-coupon bonds.
• Their investment term ranges from 4 weeks to a maximum of 52 weeks.
• They are issued at discounts. 
• They do not yield any coupons but are matured at par value.

2. Treasury notes (T-notes) 

• Treasury notes are medium-term securities having maturities ranging from 1 year to 10 years.
• Semi-annual coupon payments.
• Sold in increments of $100.
• Capture the largest volume in the treasury market depth.

3. Treasury bonds (T-bonds) 

• Long-term bonds have maturities ranging from 10 years to 30 years.
• Semi-annual coupon payments.
• Mainly used for pension funds and long-term institutional investment.
• Most reliable and almost risk-free investment bonds as per the investors.

4. Treasury Inflation-Protected Securities (TIPS)

• TIPS are inflation-protected securities issued by the U.S. treasury for the inflation-protected yield.
• Pays semi-annual coupons at a constant interest rate adjusted for inflation at the rate of NSA-CPI (consumer price index).
• The investment term ranges from 5 years to 30 years.

5. Floating rate notes (FRNs)

• The investment term is 2 years.
• Pays interest quarterly with the weekly reset.
• Treasury yields are determined based on the 13-week treasury bills auction results.
• Used by the investors for forecasting the market's long-term yield.

Non-marketable Securities

The non-marketable securities are the non-bearable ones that can't be traded on a stock exchange but have to be bought from or sold to the U.S. treasury because it is rare to find any broker-dealers in the over-the-counter market where the off-the-run securities can be easily sold or purchased without a bid-ask spread. The various non-marketable securities issued by the U.S. treasury are:

1. U.S. savings bonds

• They are also known as war bonds.
• These are issued in Series EE and Series I bonds.
• Series EE is a fixed-rate bond that pays a fixed rate of interest and almost doubles the purchase price on minimum holding for 20 years by the investor.
• Series I bonds offer a semi-variable interest rate adjusted for inflation every 6 months.

2. Zero-Percent Certificate of Indebtedness

• Issued by the Treasury Direct System
• Have automatic renewal and daily maturity.
• Denominations of $1,000 with no interest.
• The investor can use these savings to accumulate the balance in the treasury direct account to save for buying interest-bearing securities.

3. Government account series

• These are the intra-governmental securities to balance cash.

4. State and local government series

• The cash obtained from the sale of tax-exempt bonds by the government entities is used to buy these series.

On-the-run and off-the-run securities

On-the-run securities are the most recently issued securities in the market depth and are therefore traded at some premium. The off-the-run securities are the ones issued just before the most recent ones. The on-the-run securities have a lower yield to the investor than the off-the-run securities.

Recent developments in the U.S. treasury market

• The 11th March 2020 marked the official declaration of the coronavirus disease 2019 (COVID-19) as a pandemic by the World Health Organization (WHO). This embarked on a fragile state of dysfunction due to heavy demands for the liquidation of the treasury securities.
• The inter-dealer market saw a drastic fall in the market depth in the wake of coronavirus disease 2019 of on-the-run 10 years quoted liquidity from $300 million to $25 million.
• For weeks on setting 3 weeks 16th March 2020, the treasury settlement failures amounted to $1.50 trillion.
• On 16th March 2020, the difference between the General Collateral Financing (GCF) rate and the Federal interest rate reached 76 basis points.
• The Fed enacted a $1.6 trillion repo market operation of buying the treasuries to curb the impinging losses on balance sheets and smoothing out the disrupting state of liquidity from March to June 2020.
• On 1 April 2020, the Fed exempted the treasuries and bank holdings from the SLR requirements simultaneously exempting bank subsidiaries from the SLR requirements from May 15 onward.
• The U.S. treasury observed the strained situation of the global economy. The group of thirty recommended steps to the U.S. treasury in the wake of massive disruption caused by coronavirus disease 2019 in July 2021 towards increased resilience.

Until recently in the last week of September 2021, the yield of the 10-year Treasury note rose to 1.489%, and the inflation is expected to reach up to 2% by the quarter-end, meanwhile, investors have been eyeing the $1 trillion infrastructure bill in Washington. However, the next big crisis is increasingly threatening to underlie the climate change havoc.

Context and Applications

This topic is significant in undergraduate, postgraduate, and professional exams, especially for:

• Chartered Financial Analyst (CFA)
• Financial Risk Management (FRM)
• Masters of Science in Finance
• Financial Analyst

Practice Problems

Question 1: Which of the following is the non-marketable security?

1. 1. U.S. Saving Bonds
   2. Treasury Inflation-Protected Securities (TIPS)
   3. Treasury Bill (T-bill)
   4. Equity Stocks of Apple Inc.

Answer: a)

Explanation: The U.S. saving bonds are non-marketable securities because they are restricted from being sold except to the treasury.

Question 2: Who keeps a record of the worldwide holdings of the U.S. treasury securities?

1. 1. The Treasury International Capital System (TIC)
   2. The Office of the Official Secretary-General of the United States
   3. The New York Stock Exchange
   4. The Securities and Exchange Commission

Answer: a)

Explanation: The Treasury International Capital System (TIC) maintains a record of worldwide holdings.

Question 3: What is the maturity value of T-bills in the U.S.?

1. 1. Redeemed at double the purchase price
   2. Par value
   3. Face Value + Premium @ 6.50%
   4. None of the above

Answer: b)

Explanation: The T-bills are always redeemed at par value.

Question 4: What is the frequency of interest rate adjustment @ NSA-CPI of TIPS?

1. 1. Annually
   2. Quarterly
   3. Semi-annually
   4. Fortnightly

Answer: c)

Explanation: The variable portion of the interest rate is adjusted for inflation 2 times every year.

Question 5: What is the relation between on-the-run and off-the-run securities?

1. 1. Both are highly liquid.
   2. On-the-run security becomes off-the-run on a new issue.
   3. On-the-run securities trade at a premium while off-the-run do not.
   4. All of the above

Answer: d)

Explanation: On-the-run and off-the-run securities are related to all the points explained above.

Common Mistakes

The students often fail to understand the difference between marketable and non-marketable securities. It is necessary to pay attention to the relevance of the U.S. treasury rate on the world economy since the USD (U.S. Dollar) is one of the strongest currencies and it acts as a benchmark for the world economy. It is important to understand the key features of the different securities and relate them to derive the capital asset pricing equation.

Related Concepts

While studying this topic, it is recommended to read the following topics to get a better knowledge:

• Treasury Debt
• The U.S. Financial System
• Treasury Management
• Financing Operations
• Capital Asset Pricing Model (CAPM)