Marketable government securities, as the term implies, are government bonds that can be bought and sold through standard market channels. Major commercial banks and securities dealers maintain markets in these government debt securities.
In addition, almost all other securities firms and commercial banks, large and small, help their customers buy and sell government bonds by routing orders to institutions that maintain markets in these securities.
Investments in federal bonds by institutional investors and large retail investors are concentrated almost exclusively on marketable issues.
Treasury auctions are held for the initial issuance of bills, notes, and bonds, and for the sale of inflation-linked securities and floating-rate bonds. Although the maturity of a bond shortens during its life, the bond continues to be listed under its original designation. For example, a 20-year Treasury bond continues to be referred to as a bond in the price sheets throughout its term.
Treasury bills are issued with maturities of up to one year, making them the shortest maturities of government securities. They are usually issued with a maturity of 91 days, although some issues have a maturity of 182 days.
Treasury bills with maturities of one year are also issued at auction every four weeks. The Treasury offers new Treasury bills each week to repay the portion of the total that matures. Thus, the 91-day Treasury bills mature and roll over in 13 weeks. Each week, about 1/13 of the total volume of these bills is redeemed.
If Treasury cash receipts are insufficient to meet spending needs, additional bills are issued.
During periods of the year when revenues exceed expenditures, Treasury bills mature without being refunded. Treasury bills thus provide the Treasury with a convenient financing mechanism to compensate for the lack of a regular revenue flow into the Treasury.
The volume of Treasury bills can also be increased or decreased from year to year in response to general surpluses or deficits in the federal budget.
Treasury bills are issued on a discount basis and are payable at par. Each week, Treasury bills to be sold are awarded to the highest bidders. Dealers and other investors submit sealed bids. At the opening, these bids are sorted in order from highest to lowest.
Those bidders who ask for the lowest discount (and bid the highest price) are placed at the top of the line. Bids are then accepted in order of position in the row until all bills are awarded. Bidders who demand a higher discount (and bid a lower price) may not receive bills that week.
Investors wishing to purchase small quantities of Treasury bills ($10,000 to $500,000) may place their orders based on an average competitive price. The Treasury subtracts these small orders from the total quantity of bills to be sold. The remaining bills are allocated on the competitive basis described above. Then, these small orders are executed at a discount equal to the average of the winning bids for large orders.
Investors are not limited to purchasing Treasury bills at their initial issuance. Since Treasury bills are issued weekly, a wide range of maturities is available in the over-the-counter market. Bid and ask prices are quoted in terms of annual yield equivalents.
The prices of the various issues obtained from a dealer would reflect a discount based on these yields. Because of their short maturities and lack of risk, Treasury bills offer the lowest yield available on taxable domestic debt securities.
Although some corporations and individuals invest in Treasury bills, commercial banks are by far the most important holders of these debt securities.
Treasury notes are issued at specified interest rates for maturities ranging from two to 10 years. The Treasury currently issues 2-year, 3-year, 5-year, 7-year, and 10-year notes. These intermediate-term government securities are also held largely by commercial banks.
Treasury bonds have original maturities ranging from 11 to 30 years, with the current focus being on issuing bonds with 30-year maturities. These bonds bear interest at stated rates. Many issues of these bonds are callable, or paid off, by the government several years before their maturity.
For example, a 30-year bond issued in 2015 may be described as having a maturity of 2040–2045. This issue may be called for redemption at par as early as 2040 but in no event later than 2045. Dealers maintain active markets for the purchase and sale of Treasury bonds and the other marketable securities of the government.
All marketable obligations of the federal government, with the exception of Treasury bills, are offered to the public through the Federal Reserve banks at prices and yields set in advance. Investors place their orders for new issues, and these orders are filled from the available supply of the new issue. If orders are larger than the available supply, investors may be allotted only a part of the amount they requested.
Treasury bonds, because of at least initial long-term maturities, are subject to maturity or interest rate risk.
Treasury notes with shorter maturities are affected to a lesser extent. For illustrative purposes, let’s assume that the market interest rate on 30-year Treasury bonds is currently 4 percent and, given their marketability, there is no liquidity premium.
Let’s further assume that investors expect the inflation rate will average 2 percent over the next 30 years and they expect a real rate of return of 1 percent annually. By applying equation we can find the maturity risk premium to be,
4% = RR + IP + DRP + MRP + LP
4% = 1% + 2% + 0% + MRP + 0%
MRP = 4% – 1% – 2% – 0% – 0% = 1%
Our interpretation is that the holders, or investors, require a 1 percent maturity risk premium to compensate them for the possibility of volatility in the price of their Treasury bonds over the next 30 years. If market-determined interest rates rise and investors are forced to sell before maturity, the bonds will be sold at a loss.
Furthermore, even if these investors hold their bonds to maturity and redeem them with the government at the original purchase price, the investors would have lost the opportunity of the higher interest rates being paid in the marketplace.
This is what is meant by interest rate risk. Of course, if market-determined interest rates decline after the bonds are purchased, bond prices will rise above the original purchase price.
The dealer system for marketable U.S. government securities occupies a central position in the nation’s financial markets.
The smooth operation of the money markets depends on a closely linked network of dealers and brokers. Bank and nonbank dealers report their daily activity in U.S. government securities to the Federal Reserve Bank of New York.
New dealers are added only when they can demonstrate a satisfactory level of responsibility and volume of activity. The dealers buy and sell securities for their own accounts, arrange transactions with both their customers and other dealers, and also purchase debt directly from the Treasury for resale to investors.
Dealers do not typically charge commissions on their trades. Rather, they hope to sell securities at prices above the levels at which they were bought.
The dealers’ capacity to handle large Treasury financing has expanded enough in recent years to handle the substantial growth in the government securities market. In addition to the dealers’ markets, new issues of federal government securities may be purchased directly at the Federal Reserve banks.
Tax Status of Federal Obligations
Until March 1941, interest on all obligations of the federal government was exempt from all taxes. The interest on all federal obligations is now subject to federal income taxes and tax rates.
The Public Debt Act of 1941 terminated the issuance of tax-free federal obligations. Since that time, all issues previously sold to the public have matured or have been called for redemption. Income from the obligations of the federal government is exempt from all state and local taxes. Federal obligations, however, are subject to federal and state inheritance, estate, or gift taxes.
Ownership of Public Debt Securities
The U.S. national debt must be financed and refinanced through the issuance of government securities, both marketable and nonmarketable.
Nonmarketable government securities are securities that cannot be transferred to other persons or institutions and can be redeemed only by being turned in to the U.S. government.
In fact, the United States must rely on the willingness of foreign and international investors to hold a substantial portion of the outstanding, interest-bearing public debt securities issued to finance the national debt.
During the last half of the 1980s, the annual increase in foreign ownership was due primarily to the flow of Japanese capital to this country. Japanese investment in real estate and corporate securities has been well-publicized.
However, as the dollar declined relative to the Japanese yen and other major foreign currencies, investment in U.S. assets became less attractive after interest and other returns were converted back into foreign currencies.
In recent years, interest on the part of Europeans and Chinese has increased. The large trade surpluses China has had with the United States have resulted in the Chinese holding ever-increasing amounts of U.S. financial assets.
Maturity Distribution of Marketable Debt Securities
The various types of marketable securities of the federal government have already been described in this section. However, the terms of bills, notes, and bonds describe the general maturity ranges only at the time of issue. To determine the maturity distribution of all obligations, therefore, it is necessary to observe the remaining life of each issue, regardless of its class.
The heavy concentration of short-term maturities will not necessarily change by simply issuing a larger number of long-term obligations. Like all institutions that seek funds in the financial markets, the Treasury has to offer securities that will be readily accepted by the investing public.
Furthermore, the magnitude of federal financing is such that radical changes in maturity distributions can upset the financial markets and the economy in general. The management of the federal debt has become an especially challenging financial problem, and much time and energy are spent on meeting the challenge.
If the Treasury refunds maturing issues with new short-term securities, the average maturity of the total debt is reduced. As time passes, longer-term issues are brought into shorter-dated categories. Net cash borrowing, which results from budgetary deficits, must take the form of maturities that are at least as long as the average of the marketable debt if the average maturity is not to be reduced.
The average length of the marketable debt reached a low level of two years and five months in late 1975. Since that time, progress has been made in raising the average length of maturities to about five years by selling longer-term securities.
One of the new debt management techniques used to extend the average maturity of the marketable debt without disturbing the financial markets is advance refunding. This occurs when the Treasury offers owners of a given issue the opportunity to exchange their holdings well in advance of the holdings’ regular maturity for new securities of longer maturity.
In summary, the Treasury is the largest and most active borrower in the financial markets. The Treasury is continuously in the process of borrowing and refinancing. Its financial actions are tremendous in contrast with all other forms of financing, including those of the largest business corporations.
Yet, the financial system of the nation is well adapted to accommodate its needs smoothly. Indeed, the very existence of public debt of this magnitude is predicated on the existence of a highly refined monetary and credit system.