Finance

US Treasury Market: How does it Work

US Treasury Market: How does it Work?

U.S. Treasury Market is the largest and the most active debt market in the world. Despite its complex nature, the U.S. Treasury market is not just limited to financing the U.S. Federal government. It forms the basis for the U.S. dollar’s status as the global reserve currency, provides the transmission mechanism for the US monetary policy, and providing a low- risk hedging instrument for global investors and savers. It is considered one of the world’s efficient and most liquid markets, serving as a global risk-free benchmark for millions of securities and transactions around the world. U.S. Treasury securities are backed by the “full faith and credit” of the U.S. government. They are extensively owned and actively traded by institutional investors, central banks, companies, individuals, and number of other private and public institutions.

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Market Structure:

To begin with, the participants in the U.S. Treasury Market are the U.S. Department of the Treasury, the Federal Reserve System, government securities dealers and brokers, and other holders of Treasury securities. The U.S. Department of the Treasury issues debt through the primary market, in order to finance the federal government efficiently and to pay off the obligations which are due. This is done by issuing various types of Treasury securities ranging from different maturities like the T- Bills, T- Notes, Bonds, Treasury Inflation Index Securities (TIPS), Floating Rate Notes (FRN) and  STRIPS, or Separate Trading of Registered Interest and Principal of Securities, are a special kind of Treasury bond created by a process called “coupon stripping.” Principal and interest are separated and sold individually at a discount from their par value.

Trading:

Once these Treasury instruments are issued in the Primary market; they are further resold in the secondary market by the primary dealers. The trading activity in the secondary market largely takes place on the over-the-counter market rather than organized exchanges. The secondary market is an informal network of banks and traders linked by telephones, fax machines, and computers. There is no structured exchange (such as the New York Stock Exchange) as there is for the equity markets.

Types of securities traded in the Treasury Market.

  • Treasury bills (T-bills): They are short-term investments with a maturity of one year or less. They do not have coupon rates, since they are usually issued at a discount but pay the maximum par value at maturity.
  • Treasury notes: These are intermediate to long-term bonds, typically issued with an initial maturity of 2, 3, 5, 7, or 10 years. However, as time passes, Treasury notes can be purchased and sold on the secondary market with varying maturities of less than 10 years.
  • Treasury Inflation-Protected Securities (TIPS): Treasury Inflation-Protected Securities, are notes and bonds intended to provide inflation protection. They are notes and bonds intended to provide inflation protection. The principal is modified every six months to reflect adjustments in the Consumer Price Index ( CPI). TIPS are issued with an initial maturity of 5, 10, or 30 years and, at maturity, are redeemable at either the face value or the inflation-adjusted principal, whichever is higher.
  • Treasury bonds: These are long-term securities with a maturity of 30 years. They pay interest on a semi-annual basis which can be used for additional earnings, retirement, and financial planning.

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Risk Involved: The securities in the U.S. Treasury Market are exposed to the following risk types:

  • Interest rate: As result of change in interest rates,  the value of fixed-income security could decline.
  • Reinvestment: If the interest rate is low as the bond hits its maturity date or the issuer calls the bond, the investor will be faced with lower return opportunities for reinvestment and a potential decrease in cash flow.
  • Inflation (purchasing power): If prices increase at a faster pace than the return on investment, your cash will buy less in the future. The uncertainty is highest if the bond has been in maturity for a long time.
  • Market and event: External circumstances that have an effect on the economy may have a negative impact on the price or valuation of your investments.

Significance:

Treasuries are typically the most liquid forms of fixed-income investments. A wide, active secondary market provides enough opportunities to sell your Treasures till around maturity. To encourage liquidity in the market, the Treasury issues securities consistently and predictably through a regular schedule of sell-offs. Treasury releases the details out of the upcoming issue, including the amount to be auctioned and the maturity. The securities are also critical to short-term lending. Prominently also work as collateral. Transactions in this market are nothing but the agreements to exchange securities and funds on the day the new security is issued. Treasury securities can be traded almost round the clock. Investors use the Treasury market for investing and hedging purposes. For the pricing of other debt securities, yields on the securities are widely considered as benchmarks and are further analyzed for market participants’ expectations with reference to the future path of the economy, outlook, and monetary policy.

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Bottom Line:

Overall, the U.S. Treasury Market is extraordinarily liquid. Enormous amounts of securities are traded every day. The market for Treasury securities is extensive and serves important functions for numerous investors. The value of the entire stock of marketable Treasury debt would turn over completely in about weeks’ time. The considerable trading volume allows market participants to move in and out of large Treasury positions rapidly with little impact on the prices of those securities.

Author: Deepika Shenolikar

About the Author:  Deepika Shenolikar is professionally qualified as CFA (ICFAI). Her primary interest lies in analyzing the market trends, investments, and aims for continual professional growth through learning.

 

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