FixedIncome Securities
Foundedin1807,JohnWiley&Sonsistheoldestindependentpublishing companyintheUnitedStates.WithofficesinNorthAmerica,Europe,AustraliaandAsia,Wileyisgloballycommittedtodevelopingandmarketing printandelectronicproductsandservicesforourcustomers’professional andpersonalknowledgeandunderstanding.
TheWileyFinanceseriescontainsbookswrittenspecificallyforfinance andinvestmentprofessionalsaswellassophisticatedindividualinvestors andtheirfinancialadvisors.Booktopicsrangefromportfoliomanagement toe-commerce,riskmanagement,financialengineering,valuation,and financialinstrumentanalysis,aswellasmuchmore.
Foralistofavailabletitles,visitourwebsiteatwww.WileyFinance.com.
Copyright©2022byBruceTuckmanandAngelSerrat.Allrightsreserved.
PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada.
Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,ortransmittedin anyformorbyanymeans,electronic,mechanical,photocopying,recording,scanning,or otherwise,exceptaspermittedunderSection107or108ofthe1976UnitedStatesCopyright Act,withouteitherthepriorwrittenpermissionofthePublisher,orauthorizationthrough paymentoftheappropriateper-copyfeetotheCopyrightClearanceCenter,Inc.,222 RosewoodDrive,Danvers,MA01923,(978)750-8400,fax(978)750-4470,orontheweb atwww.copyright.com.RequeststothePublisherforpermissionshouldbeaddressedtothe PermissionsDepartment,JohnWiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030, (201)748-6011,fax(201)748-6008,oronlineathttp://www.wiley.com/go/permission.
LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveusedtheirbest effortsinpreparingthisbook,theymakenorepresentationsorwarrantieswithrespecttothe accuracyorcompletenessofthecontentsofthisbookandspecificallydisclaimanyimplied warrantiesofmerchantabilityorfitnessforaparticularpurpose.Nowarrantymaybecreated orextendedbysalesrepresentativesorwrittensalesmaterials.Theadviceandstrategies containedhereinmaynotbesuitableforyoursituation.Youshouldconsultwitha professionalwhereappropriate.Further,readersshouldbeawarethatwebsiteslistedinthis workmayhavechangedordisappearedbetweenwhenthisworkwaswrittenandwhenitis read.Neitherthepublishernorauthorsshallbeliableforanylossofprofitoranyother commercialdamages,includingbutnotlimitedtospecial,incidental,consequential,orother damages.
Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport,please contactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974,outside theUnitedStatesat(317)572-3993orfax(317)572-4002.
Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthatappearsin printmaynotbeavailableinelectronicformats.FormoreinformationaboutWileyproducts, visitourwebsiteatwww.wiley.com.
LibraryofCongressCataloging-in-PublicationDataisAvailable:
ISBN9781119835554(Hardback)
ISBN9781119835608(ePDF)
ISBN9781119835592(ePub)
ISBN9781119835622(oBook)
CoverDesign:Wiley
CoverImage:©MF3d/GettyImages
Preface
Thegoalofthisbookistoconveytheinstitutional,conceptual,andquantitativeframeworksusedbysophisticatedfixedincomemarketpractitioners.Theoverviewchapterisabroadsurveyofmarkets,marketparticipants,andsomeintermediate-termtrends(monetarypolicyinaregimeof abundantreserves;negativeratesinEuropeandJapan;andthechanging natureofliquidity).Chapters1through6presentthebasiclanguageand toolboxofthefixedincomecosmos:arbitragepricing;ratesandspreads; DV01,duration,andconvexity;andmulti-factorandempiricalhedging. Chapters7through9explainhowtermstructuremodelsareusedforbetter understandingtheshapeofthetermstructureofinterestrates;forpricing fixedincomederivatives;andforrelativevalueandevenmacro-styletrading.Chapters10through16thendelveintothedetailsofseverallargeand importantmarkets:repurchaseagreementsorrepo;noteandbondfutures; short-termratesandtheirderivatives;interestrateswaps;corporatebonds andcreditdefaultswaps;mortgagesandmortgage-backedsecurities;and fixedincomeoptions.
Whilefixedincomeisaninherentlyquantitativesubject,thisbooktakes averyappliedapproach.Allideasarepresentedthroughexamples,using marketprices,events,ormeaningfulapplicationswheneverpossible.(Alist ofparticularlyextensiveapplicationsisgivenonthenextpage.)Thereisa lotofemphasisonordersofmagnitude(e.g.,“Abouthowbigistheinterest rateswapmarket?”or“ApproximatelywhatistheDV01ordurationofa 10-yearparTreasury?)andonfundamentalconcepts(e.g.,“Whatdoesit meanforapositiontobenegativelyconvex?”or“Whatsortsoftradesand positionshavefinancingrisk?).
Thisfourtheditionisacomprehensiverevision.Alldataonmarkets andmarketparticipantshavebeenupdated;allexamplesandapplications updated;andallofthein-depthmarketpresentationsrewrittentoreflect contemporaryissues(e.g.,variationmarginofclearedinterestrateswaps changedto“settled-to-market”).Thetimingoftheeditionisdeliberatewith respecttothetransitionawayfromLIBOR.WhileSOFRandotherreplacementsarerelativelyyoung,itistimeforatextbooktreatmentofthesenew referenceratesandtheirassociatedderivatives.
WewouldliketothankBillFalloon,whohasenthusiasticallysupportedthistextbookfortwodecades,andPurviPatel,forherpatientand
expertshepherdingofthiseditionthroughtheproductionprocess;Judy DiClemente,forherdeeplythoughtfuleditingofthemanuscript;Sienna SihanZhuforexcellentandcarefulresearchassistance;KristiBennettfor diligentcopyediting;andthepeoplewhokindlyandgenerouslygaveof theirexpertiseandtimetoenrichthecontentsofthisbook:ViralAcharya, AmitabhArora,RichardCantor,JonathanCooper,RichardHaynes,David Lohuis,LihongMcPhail,GregPerez,DavidSayles,JamesStreit,andRegis VanSteenkiste.
EXTENDEDEXAMPLES,APPLICATIONS,ANDCASES
■ IdiosyncraticPricingofUSTreasurySTRIPS(Section1.5)
■ RelativeValueSpreadsofHigh-CouponTreasuries(Section3.6)
■ P&LAttributionforanOutrightLonginaHigh-CouponTreasury (Section3.8)
■ HedgingaCenturyBond(Sections4.3and4.6)
■ HedgingStylizedPensionLiabilities(Sections4.8and5.4)
■ RegressionHedgeoftheJohnson&Johnson2.45sof09/01/2060with a30-YearUSTreasury(Section6.1)
■ EstimationoftheGauss+ ModeloverthePeriodJanuary2014to January2022(Section9.2)
■ MFGlobal’sRepo-to-MaturityTrades(Section10.7)
■ USTreasuryFuturesBasisTradesinMarch2020(Section11.13)
■ ExtractinganImpliedPathofShort-TermRatesfromFedFundFutures, October2021 versus January2022(Section12.3)
■ TrancheStructureofaCLOIssuedinMay2019(Section14.1)
■ HertzCDSSettlementAuction,June2020(Section14.11)
■ TheLondonWhale(Section14.13)
■ Three30-YearFNMAPools,2018–2021(Sections15.5through15.7)
■ StructureofaCreditRiskTransferSecurityIssuedin2020 (Section15.12)
■ PricingaCallableBankofAmericaBondwithBlack-Scholes-Merton, August2021(Section16.1)
ListofAcronyms
ABSAsset-backedsecurities
ADVAveragedailyvolume
AFXAmericanFinancialExchange
AmeriborAmericanInterbankOfferedRate
APAuthorizedparticipant
ARMAdjustable-ratemortgage
ATMAt-the-money
AUDAustraliandollar
AXIAcross-the-CurveCreditSpreadIndex
BISBankforInternationalSettlements
BOJBankofJapan
BRLBrazilianreal
BSBYBloombergShort-TermBankYieldIndex
BSMBlack-Scholes-Merton
CADCanadiandollar
CCPCentralcounterparty
CDSCreditdefaultswaps
CHFSwissfranc
CLOCollateralizedloanobligation
CLOBCentrallimitorderbook
CMOCollateralizedmortgageobligation
CMTConstant-maturityTreasury
CPCommercialpaper
CPRConditionalorconstantprepaymentrate
CRTCreditrisktransfer
CTDCheapest-to-deliver
CTMCollateralized-to-market
CVACreditvalueadjustment
DTSDurationtimesspread
DVPDeliveryversuspayment
DV01Dollarvalueofan’01
ECEuropeanCommission
ECBEuropeanCentralBank
EFFREffectivefedfundsrate
ENNsEntity-nettednotionals
EONIAEuroOvernightIndexAverage
ESGEnvironmental,social,andgovernance
ESTEREuroShort-TermRate
ETFExchange-tradedfund
EUREuro
EURIBOREuroInterbankOfferedRate
FCMFuturescommissionmerchant
FHLMCFredditMacorFederalHomeLoanMortgageCorporation
FICCFixedIncomeClearingCorporation
FNMAFannieMaeorFederalNationalMortageAssociation
FOMCFederalOpenMarketCommittee
FRAForwardrateagreement
FRNFloating-ratenote
FVAFundingvalueadjustment
GBPBritishpound
GCGeneralcollateral
GCFGeneralcollateralfinance
GSEGovernment-sponsoredenterprise
HFThigh-frequencytrading
HQLAHigh-qualityliquidassets
HQMHigh-qualitymarket-weighted
IDBInterdealerbroker
IMInitialmargin
IMMInsidemarketmidpoint
IMMInternationalmoneymarket
IOInterestonly
IOERInterestonexcessreserves
IORBInterestonreservebalances
IRSInterestrateswap
JPYJapaneseyen
LCHLondonClearingHouse
LCRLiquiditycoverageratio
LIBORLondonInterbankOfferedRate
LTROLong-termrefinancingoperations
LTVLoan-to-value
MACMarketagreedcoupon
MBSMortgage-backedsecurities
MPORMarginperiodofrisk
MROMainrefinancingoperations
MTNMedium-ternnote
NAVNetassetvalue
NOINetopeninterest
NPVNetpresentvalue
NSFRNetstablefundingratio
ListofAcronyms
LSOCLegallyseparatedoperationallycomingled
OADOption-adjustedduration
OASOption-adjustedspread
OISOvernightindexswap
ONOvernight
OTCOver-the-counter
OTROn-the-run
PACPlannedamortizationclass
PCAPrincipalcomponentanalysis
POPrincipalonly
PTFPrincipaltradingfirm
P&LProfitandloss
REMICRealestatemortgageinvestmentconduit
RFQRequestforquote
RRPReverserepo
RSATReplicationsyntheticassettransaction
RTMrepo-to-maturity
SARONSwissaveragerateovernight
SATOSpreadatorigination
SDRSwapdatarepositories
SEFSwapsexecutionfacility
SEKSwedishkrona
SEQSequentialpayclass
SIMMStandardinitialmarginmodel
SLUGsStateandlocalgovernmentseries
SMMSinglemonthlymortality
SOFRSecuredOvernightFinancingRate
SONIASterlingOvernightInterbankAverage
STMSettled-to-market
STRIPSSeparateTradingofRegisteredInterestandPrincipal ofSecurities
TACTargetedamortizationclass
TIBORTokyoInterbankOfferedRate
TIPSTreasuryInflationProtectedSecurities
TLTROTargetedlong-termrefinancingoperations
TONARTokyoOvernightAverageRate
UMBSUniformmortgage-backedsecurities
USDUnitedStatesdollar
VMVariationmargin
WACWeighted-averagecoupon
WALAWeighted-averageloanage
WAMWeighted-averagematurity
O.1GLOBALFIXEDINCOMEMARKETS
Fixedincomemarketsarelargeandglobal.FigureO.1showstheoutstandingamountsofdebtsecurities,byresidenceofissuer.Debtsecuritiesare instrumentsdesignedtobetraded,likebondsissuedbycorporationsorby governments.Groupingbyresidenceofissuermeans,forexample,thatUS TreasurybondsheldbyChina’scentralbankareincludedinthetotalfor theUnitedStates.AsofMarch2021,theglobaltotalofoutstandingdebt securitieswasabout$123trillion.Forreference,thetotalcapitalizationof globalequitymarketsatthetimewas$110trillion,althoughstockmarket valuesaresignificantlymorevolatile.
FigureO.1showsthatthefivelargestissuers,intermsofamountsoutstanding,areintheUnitedStates,theEurozone,China,Japan,andthe UnitedKingdom,whichtogethercomprisenearly90%ofthetotal.The EurozoneincludescountriesthatbothbelongtotheEuropeanUnion(EU) andusetheeuroasanationalcurrency.Someindividualmembersofthe Eurozone,indicatedwithasterisksinthefigure,aresignificantissuersof debtsecuritiesontheirown.Notethatthefiguredisplaystheiramounts outstandingwithgraybars,buttheircontributionstothecumulativetotal areincludedonce,withtheEurozonetotal.
FigureO.2decomposesdebtoutstandinginthefivelargestregionsby sector.ThelargefractionofgovernmentdebtinJapanreflectsdecadesof governmentborrowingandspendingintendedtostimulatetheeconomy. ThefractionofgovernmentdebtintheUnitedStates,theEurozone,and theUnitedKingdomislower,atabout50%,buthasincreasedsignificantly sincethefinancialcrisisof2007–2009.CorporationsintheUnitedStates arerelativelymorelikelytoissuebondsdirectlytothepublic,whilecorporationsintheEurozone,Japan,andtheUnitedKingdomarerelatively morelikelytoborrowfundsfromintermediaries,likebanks,which,inturn, raisemoneyfromthepublic.WhileFigureO.2includesthebreakdownfor debtinChina,therelativelylargeroleofthegovernmentinfinancialand nonfinancialenterprisesmakescomparisonsacrosssectorsandregionsless meaningful.
Outstanding, $Trillions (left)
Total Global Outstanding: $123.1 Trillion UnitedStatesEurozoneChinaJapan
Cumulative % of Global Outstanding (right)
FIGUREO.1 GlobalDebtSecuritiesOutstanding,byResidenceofIssuer,asof March2021.CountrieswithanAsteriskAreintheEurozone.
Sources: BIS;andAuthorCalculations.
FIGUREO.2 GlobalDebtSecuritiesOutstanding,bySector,asofMarch2021. Sources: BIS;andAuthorCalculations.
TableO.1andFigureO.3showthe notional amountsofoutstanding interestratederivativesacrosstheglobe.Thesederivativesaredescribed inlaterchapters,butderivativesessentiallyallowmarketparticipantsto takepositionsoninterestrates,whetherforhedging,investment,orspeculativepurposes.Thenotionalamountofaderivativeisusedtocalculatethe cashflowsthatoneofthederivative’scounterpartiespaystheother.Adding togetherallnotionalamounts,however,cansignificantlyoverstatemarket size.First,thelargestmarketparticipants,namelydealers,tendtobesimultaneouslylongandshortnearlyidenticalderivatives.Second,optionsareactuallyequivalenttoonlyfractionsofthenotionalamountsoftheirunderlying securities.Laterchapterselaborateonthesepoints,but,forthepurposesof thisoverview,thistableandfigurearereportedinnotionalamounts.
Whilederivativesmaytradeinaparticularlocality,thereisnosensein whichderivativesareissuedinoneplaceoranother:localregulationsaside, anyentity,residinganywhere,canenterintothesederivativescontracts. Atypicalclassification,therefore,isthecurrencyinwhichthecashflows ofthederivativearedenominated.ThefirsttwocolumnsofTableO.1show notionalamountsforswaps,options,andforwardrateagreements.Most oftheoutstandingamountsaredenominatedinUSDollars(USD)andEuro (EUR).Thequantitiesinthetablehintattheoverstatementofmarketsize bynotionalamount:ifthesizesofthemarketsfortheseUSDderivatives werereally$150trillion,theywouldbelargerthanthecombinedsizeofall globaldebtsecuritiesmarkets.Thesecondtwocolumnsofthetableshow thenotionalamountsofstandardized,exchange-tradedinterestratefutures
TABLEO.1 NotionalAmountsofInterestRate
Derivatives.Swaps,Options,andFRAs,asofJune2020; FuturesandFuturesOptions,asofDecember2020. Entriesin$Trillions.
Swaps,Options,FRAsFuturesandFuturesOptions CurrencyAmountCurrencyAmount
USD152.1USD41.5 EUR132.6GBP10.4 Other67.1EUR9.5 GBP54.3BRL1.6 JPY37.1CAD1.0 CAD14.3AUD0.9 SEK5.3Other0.6 CHF3.6
USD:UnitedStatesDollar;EUR:Euro;GBP:BritishPound; JPY:JapaneseYen;CAD:CanadianDollar;SEK:Swedish Krona;CHF:SwissFranc;BRL:BrazilianReal;AUD: AustralianDollar.
Source: BIS.
FIGUREO.3 CreditDefaultSwaps,NotionalAmountsOutstanding,bySectorand Type,asofJune2020.
Source: BIS.
andoptions.AmountsoutstandingofUSD-denominatedcontractsareby farthegreatest,withthosedenominatedinBritishPounds(GBP)andEUR makingupmostoftherestoftheoverallmarket.
Finally,FigureO.3givesthenotionalamountofcreditdefaultswaps (CDS)outstanding.ThesearediscussedindetailinChapter14,but,roughly speaking,CDSallowinvestorstotakepositionsthatareequivalenttoleveragedlongorshortpositionsinbondswithcreditrisk.Thefiguredivides themarketintocreditsectors:CDScanbewrittenonnonfinancialcompanies,financialcompanies,sovereigns,asset-backedsecurities(ABS),and mortgage-backedsecurities(MBS).Withineachsector,asingle-nameCDS referencesasinglecredit(e.g.,thegovernmentofSpain),whileanindex CDSreferencesaportfolioofcredits(e.g.,25Europeanfinancialcompanies).NotethattheCDSmarketismuchsmallerinnotionalamountthan thederivativesmarketsdepictedinTableO.1.
O.2USMARKETS
ThissectiondescribesdebtandloaninstrumentsintheUnitedStates,categorizedasinFigureO.4.Thetotalamountoutstandingacrossallinstruments, asofJune2021,was$76.4trillion.1 Bywayofcomparison,themarket
1 Thedatasourcesaredifferent,buttheinclusionofnontradedinstrumentshereis themaindiscrepancybetweenthis$76.4trilliontotalandthe$48trilliontotalof
FIGUREO.4 DebtSecuritiesandLoansintheUnitedStates,AmountsOutstanding, asofJune2021.GSE:Government-SponsoredEnterprise.
Sources: FinancialAccountsoftheUnitedStates,BoardofGovernorsoftheFederal ReserveSystem;andAuthorCalculations.
capitalizationofUSequitiesatthesametimewasabout$45trillion.Treasurysecuritiesandmunicipalsecuritiesarediscussedinthissectioninsome detail,whilesectorsdiscussedinlaterchaptersofthebookaretreatedvery brieflyhere.
TreasurySecurities
Inlessthanadecade,Treasurysecuritieshavegrownfromthethirdlargest category,behindmortgagesandcorporateandforeignbonds,tothelargest category,at$24.3trillion.WhentheUSgovernmentspendsmorethan itcollectsintaxesandfees,whichhasbeenthecaseformostofthelast 50years,itneedstoborrowmoneytofunditsdeficitspending.Itdoesso throughthearrayofinstrumentsshowninFigureO.5.Treasury bills or T-bills matureinoneyearorlessandare discount securities,whichmeans thattheysellforlessthan,oratadiscountfrom,theirpromisedpayment atmaturity.Treasury notes and bonds are coupon-bearing securities;that is,theyearnafixedcouponorinterestrateontheir principal, face,or par amountsthroughmaturity,andthenrepaythatprincipalamountat
USdebtsecuritiesinFiguresO.1andO.2.Inparticular,addingtothat$48trillion the$6.8trillionofnonmarketableTreasurysecurities,$7.8trillionofnonsecuritized mortgages,$9.0trillionofloansandadvances,and$4.3trillionofconsumercredit givesatotalofabout$76trillion.
FIGUREO.5 USTreasuryObligations,AmountsOutstanding,asofJune2021.
Source: USTreasuryBulletin.
maturity.Strictlyspeaking,andintheaccountsofthegovernment,notesare issuedwith10orfeweryearstomaturity,whilebondsareissuedwithmore than10yearstomaturity.Thedistinctionhadmoremeaninghistorically, whenbondsweresubjecttoamaximum,statutoryrateofinterest.In commonparlancetoday,however,thewords“notes”and“bonds”areused interchangeably.Inanycase,Chapter1describesthecashflowsofTreasury notesandbondsinmoredetail.
TreasuryInflationProtectedSecurities (TIPS)protectinvestorsagainst inflationwithprincipalamountsthatincreaseordecreasewithchanges intheconsumerpriceindex(CPI).Consider,forexample,aTIPSwitha principalamountof$100andacouponrateof1%peryear.IfCPIhas increasedby10%,theprincipalamountoftheTIPSwillhaveincreased to$110,andtheinvestorearns1%onthathigherprincipalamount.This investorisjustaswelloffhaving$100andearning$1peryearatthe originalpricelevelashaving$110andearning1%× $110or$1.10per yearatapricelevelthatis10%higher.Hence,TIPSearnafixed real or inflation-adjustedreturn,whilecoupon-bearingTreasuriesearnafixed nominal ordollarreturn.2 Forthisreason,bytheway,indiscussionsthat includebothTIPSandTreasurybonds,thelatterareoftenreferredtoas nominalbonds.Inanycase,whilecomprisingonly5.6%ofthetotalin
2 Overaperiodofdeflation,TIPSprincipalamountmayfallbeloworiginalprincipal forthepurposesofcalculatinginterest,but,atmaturity,TIPSreturnatleastthe originalprincipalamount.
FigureO.5,TIPShaveanoutsizedimportanceasmeasuringthemarket’s perceptionofinflationandthepriceofinflationrisk.AsofJanuary2022, forexample,therateonfive-yearnominalTreasurybondswasabout2.8% higherthantherateonfive-yearTIPS.Roughlyexpressed,therefore,the marketexpectsanaverageinflationrateof2.8%overthesubsequent fiveyears.Morepreciselyexpressed,giveninflationexpectationsandrisk preferences,investorsrequireapremiumof2.8%tobuyfive-yearnominal bondsandtoassumeinflationriskoverthathorizon.
FigureO.5nextlists floating-ratenotes (FRNs).Thesearerelatively new,havingbeenfirstissuedinJanuary2014.FRNsaresoldwithtwoyears tomaturity,andtheypayavariablerateofinterestequaltothegoingrateon 13-weekT-billsplusafixedspread.Thisspreadenticessomeinvestors,who mightotherwiserollinvestmentsofshort-termT-bills,tosacrificesome liquidityandbuytwo-yearFRNsinstead.Fromtheperspectiveofthe Treasury,FRNslockinfundingfortwoyears,butatacostonlyslightly abovethatofshort-termbills.3 Infact,over2021,FRNsweresoldata spreadoflessthanfivebasispoints.4 Inaddition,somewhatcynically,FRNs seemtocostlessthantwo-yearnotes,becausegovernmentaccountingof interestratecostdoesnotpenalizetheriskofratesincreasinginthefuture. Inanycase,theissuanceofFRNshasremainedlimited,comprisingabout 2%ofthetotalinFigureO.5.
USTreasuryissuesareamongthemostactivelytradedsecuritiesinthe world.Thisisdue,ingoodpart,tothesignificantroleoftheUSdollarin internationalmarketsandtotheperceptionofUSgovernmentdebtasamong thebeststoresofvalueavailable.Anadditionalexplanation,however,is thecarefulmanagementofTreasurydebtissuance.Morespecifically,theUS Treasurysetsaregular auctionschedule thatletsinvestorsknow,inadvance, whichsecuritieswillbesoldwhenandinwhatquantities.Furthermore,the Treasuryhasgraduallymodulatedthisscheduleovermanyyearstosuitboth theborrowingneedsofthegovernmentandchangingmarketconditions. Toappreciatethesepoints,TableO.2describestheauctionscheduleasof January2022.
“Issuefrequency”describeshowoftennewsecuritiesofeachtypeare issued.TheTreasuryhassettled,forexample,onissuingnewnoteswith two,three,five,andsevenyearstomaturityeverymonth,whileissuingnew
3 Whiletherewouldseemtobenoparticularneedtolockinlonger-termfunding, becausetheUSTreasuryhasneverhadaproblemrollingoveritsshort-termborrowings,prudentdebtmanagementavoidsscenariosinwhichtoomuchdebtmatures andneedstoberefinancedoverarelativelyshortperiodoftime.
4 Abasispointis0.01%.Thedifferencebetweenarateof1.01%and1.00%isone basispoint,andarateof1%mightbereferredtoasarateof100basispoints.The spreadoffivebasispointsinthetext,therefore,isaspreadof0.05%.
TABLEO.2 USTreasuryAuctionSchedule,asofJanuary2022.
SecurityIssueFrequencyReopenings
4-,8-,13-,and26-weekbillsWeekly 52-weekbillsEvery4weeks 2-,3-,5-,and7-yearnotesMonthly 10-,20-and30-yearnotes/bondsQuarterlyMonthly 5-yearTIPSSemiannually2monthsafterissuance 10-yearTIPSSemiannuallyEvery2months 30-yearTIPSAnnuallySemiannually 2-yearFRNsQuarterlyMonthly
TIPS:TreasuryInflationProtectedSecurities;FRNs:FloatingRateNotes. Source: USDepartmentoftheTreasury.
10-yearnotes,alongwithnew20-and30-yearbonds,everyquarter.Both thesetofissuesandtheirfrequencyhavechangedovertime,however.For example,issuanceofthe20-yearbondwaseliminatedin1986andbrought backinMay2020,whileissuanceof30-yearbondswasstoppedafterAugust 2001andresumedinFebruary2006.Andin2000,theUSTreasuryintroducedtheconceptof reopenings,whichmeansauctioningorsellingmore ofanexistingissue.Forexample,TableO.2reportsthat10-yearnotesare issuedquarterlyandreopenedmonthly.InAugust2021,theTreasurysold about$59billionofanew1.25%10-yearnote,thatis,anotethathad notbeenissuedbefore,thatpaysinterestonprincipalatanannualrate of1.25%,andthatmaturesonAugust15,2031.Thefollowingmonth,in September2021,theTreasurysoldanother$42billionofthatsameissue, thatis,morenoteswithacouponof1.25%thatmatureonAugust15, 2031.Andagainthenextmonth,inOctober2021,theTreasurysoldanother $41billionofthatsameissue.InNovember2021,however,aquarterafter thefirstissuanceofthe1.25%10-yearnotes,theTreasurysold$62billion ofanew10-yearnote,withacouponof1.365%andamaturitydateof November15,2031.
Oneresultoftheauctionscheduleisthatthemostrecentlyissuedbonds ofeachtypeandmaturitytendtobetheonesmostactivelytraded.Inthe previousexample,asofNovember15,2021,thejust-issued1.365%notes maturingonNovember15,2031,arecalledthe10-year on-the-run notes andarelikelytobecomethemostactivelytradedofnoteswithapproximately10yearstomaturity.The1.25%notesmaturingonAugust15,2031, whichhadbeenthe10-yearon-the-runnotes,becomethe old notes,andover time,asevennewer10-yearnotesareissued,becomethe double-old notes, the triple-old notes,etc.
ReturningtoFigureO.5, nonmarketable securitiesisanothersmallcategoryofTreasuryissuance.Includedinthiscategoryareabout$140billion
ofsavingsbonds,whicharediscountsecuritiessolddirectlytoindividual investors,andabout$120billionof StateandLocalGovernmentSeries bonds,commonlyknownas SLUGs,whicharementionedlaterinthecontextofmunicipalbonds.
ThefinalcategoryinFigureO.5referstoTreasurybondssoldinto governmentaccounts.Thesebondsarealsononmarketableandrepresent debtthattheUSgovernmentowesitself.Thesocialsecuritytrustfunds,for example,attheendof2020,heldabout$3trillioninTreasurybonds.Most peoplearguethatthesebondsdonotrepresentanyadditionalTreasury indebtedness,or,inotherwords,thatthereisnodifferencebetweensocial securitybenefitsbeingpaidbytheTreasurydirectlyorbeingpaidindirectly throughthepaymentofinterestandprincipalonbondsinthesocialsecurity trustfunds.Bythislogic,Treasurybondsheldingovernmentaccounts areexcludedfrommostdescriptionsofgovernmentindebtedness.More specifically,intermsofFigureO.5,USgovernmentdebtisusuallyequated to“TotalDebtHeldbythePublic,”or$22.3trillion,ratherthanto“Public DebtSecurities,”whichaddsthe$6.2trillionheldingovernmentaccounts, foragrandtotalof$28.5trillion.
Indiscussingthemagnitudeofgovernmentdebt,andincomparinggovernmentindebtednessacrosscountries,debtheldbythepublicisusually normalizedby grossdomesticproduct (GDP),whichmeasuresthevalueof thegoodsandservicesproducedinacountryinasingleyear.Theideahereis thatcountrieswithgreaterGDPscansafelycarrygreaterlevelsofdebt.With USGDPatabout$22trillionasofJune2021,theratioofdebttoGDPin theUnitedStatesisabout100%,whichisextremelyhighbyhistoricalstandards.Theratiowasover100%duringWorldWarII;subsequentlydeclined tobetween20%and50%;climbedtoabout80%intheaftermathofthe financialcrisisof2007–2009;andthenshotuptoabove100%inthewake oftheCOVIDpandemicandeconomicshutdowns.Forcomparisonpurposes,theratioofdebttoGDPinJapaniscurrentlyover230%;inGreece about175%;inFranceabout100%;intheUnitedKingdomabout85%;in GermanyandChina,lessthan60%;andinSwitzerland,lessthan40%.
DespitethehistoricallyhighratioofUSdebttoGDP,foreigninvestors continuetofindUSTreasuriesattractiveandholdalargefractionofthe amountoutstanding.AsofJune2021,investorsoutsidetheUnitedStates held$7.2trillionTreasuries,or33%ofthe$21.8trillionmarketablesecuritiesshowninFigureO.5.Theseholdingsinclude$1.28trillion(5.9%) inJapan,$1.06trillioninChina(4.9%),and$0.53trillion(2.4%)inthe UnitedKingdom.
MunicipalSecurities
The$4trillionmunicipalsecuritiesmarketincludesmorethan50,000 issuersandapproximatelyonemillionindividualbondissues.Municipal
bonds,sometimescalled municipals orsimply munis,areissuedbystates andlocalgovernmentstofundtheirexpenditures.Unlikemostfixedincome markets,themunimarketisdominatedbyretailinvestors:asofJune 2021,over70%ofprincipaloutstandingwashelddirectlybyindividuals, orindirectlybyindividualsthroughmutualfundsandotherinvestment vehicles.
Interestpaymentsfrommunisareexemptfromfederaltaxsolongas fundsraisedfromsellingthosemunisareusedforpublicprojects.Therefore, investorswhopayfederaltaxesarewillingtoacceptlowerratesofinterestfrommunisthantheywouldfrombondswhoseinterestistaxedatthe federallevel,likecorporatesandTreasuries,controlling,ofcourse,fordifferencesincreditquality.Andmunicipalissuerscanraisefundsatratesbelow whattheywouldotherwisehavetopay.Thestoryissomewhatmorecomplicated,however,becausecapitalgainsonpriceappreciationfrommunisisnot exemptfromfederaltax.Toavoidthistax,however,themarkethasevolved tominimizetheproportionofreturnintheformof(taxed)priceappreciationratherthan(untaxed)interest.Morespecifically,mostmunis–inthe currentlow-rateenvironment–areissuedatacouponrateof5%and,consequently,atapremiumtopar,thatis,atapricegreaterthanfaceamount.In thisway,thesemunisareunlikelytotradeatadiscountandthussubjectsubsequentbuy-and-holdpurchaserstotaxesoncapitalgains.Withrespectto statetaxes,thetreatmentofmunicipalinterestvariesbystate.Moststates taxbondsissuedinotherstatesandexempttheirownbonds,whilesome statestaxboththeirownandotherstates’bonds.Washington,D.C.,does nottaxanymunicipalbondinterest,andUtahexemptsmunicipalsissuedin statesthatexemptUtah’sbonds!Utah’sexemptionismoresignificantthanit mayseem,becausestateswithnoincometaxautomaticallyqualify.Thefinal pieceofthetaxstoryisthatabout$500billionofmunicipalsdonotqualify forthefederaltaxexemption,becausetheirproceedsareusedforworking capital,forfundingprivatebusinessdevelopment,orforrefinancingexistingdebtthroughparticularkindsoftransactions.5 These taxablemunis pay interestatratescomparabletothoseinthecorporateandTreasurymarkets, againcontrollingfordifferencesincreditquality.
Munibondscanbedividedintothreebroadgroups. Generalobligation(GO)bonds,whichconstituteabout25%ofthemarket,arebackedby thetaxingpoweroftheissuingmunicipality. Revenuebonds,whichconstituteabouttwothirdsofthemarket,arebackedbyrevenuesfromparticular
5 Historically,municipalitieshadbeenallowedtorefinanceexistingtax-exemptdebt inadvanceofmaturityoranycalloptionwiththeproceedsofnew,tax-exemptdebt, butthispracticewasoutlawedin2017.Forafulltreatmentofthisandotherrelated issues,seeKalotay,A.(2021), InterestRateRiskManagementofMunicipalBonds, AndrewKalotayAssociates,Inc.
projects,liketollsfromabridgeorhighway.Andwithinrevenuebondsisa $600billionsubsetof industrialrevenuebonds,throughwhichmunicipalitiesissue(tax-exempt)debttoraisefundsforprivateenterprisesengaged inqualifyingprojects.Thethirdgroupconsistsof prerefunded or defeased bonds.Amuniinthiscategoryhasbeencanceledasamunicipalliability bythesettingasideofsufficientcashandTreasurysecuritiestofundallof itsremainingpaymentobligations.Theseprerefundedordefeasedbonds continuetoexistandtrade,butwiththeircreditriskimprovedtothatof Treasuries.6
Defaultratesonmunicipalsecuritieshavebeenverylow.From1970 to2020,Moody’sreportsafive-yearcumulativedefaultrateforthesector of0.08%,whichismuchlowerthantheequivalentforcorporatebonds, asdiscussedinChapter14.Nevertheless,creditriskisanimportant considerationforinvestorsinthemunimarket,withunderfundedpension obligationsaparticularlysignificantandperennialcauseforconcern. Historically,GObonds,whicharebackedbytheissuer’staxingpower, wereperceivedassaferthanrevenuebonds,whicharebackedbyparticular sourcesofrevenuethatcoulddiminishordisappearovertime.Thisperceptionchangedsignificantly,however,withthebankruptcyofDetroitin thesummerof2013.ThesettlementprovisionsthatemergedinNovember 2014wereacombinationoflaw,politicalforces,andnegotiationsacross manyinterestedparties.Theresultscanberoughlysummarizedasfollows. First,whileacourtruledthatstatelawsprotectingpensionbenefitswere trumpedbyfederalbankruptcylaw,Detroitpensionsrecoveredover 95%oftheirvalue,althoughcostoflivingadjustmentswerereducedor eliminated.Healthandlifeinsurancebenefits,however,recoveredonly 10%ofvalue.Second,holdersofwaterandsewerbonds,whichhadstrong legalclaimstotheassociatedrevenuestreams,sufferednolossofprincipal. Third,GObondssufferedsignificantlosses,dependingontheirexact provisions. Unlimitedtax bondscarryapledgebyissuerstoraisetaxes, ifnecessary,topaybondholders.Theunlimitedtaxbondsinvolvedinthe Detroitbankruptcywere,inaddition,backedbyspecific,segregated,and voter-approvedtaxreceipts.Nevertheless,thesebondsrecoveredonly74% ofprincipal,andthisnegotiated,less-than-fullrecoverywasattributedto thedwindlingoftheirdedicatedtaxreceiptsduetodeterioratingeconomic
6 Whenamunicipalitydefeasesatax-exemptbondissue,itneedstopurchaseTreasurysecurities,butisprohibited–topreventtaxarbitrageattheexpenseofthe federalgovernment–frominvestingatahigherratethantherateonthedefeased, tax-exemptissue.ThisproblemissolvedbypurchasingSLUGsdirectlyfromthe Treasury,whicharementionedearlierinthechapter.SLUGsarethesamecreditqualityasotherTreasuriesbutpayalowerinterestratetosuittheneedsoftheparticular defeasance.
conditionsinDetroit.Worseoff,however,wereDetroit’s limitedtax GO bonds,whichhadneitherapledgeofunlimitedtaxincreasesnordedicated taxreceipts.Theyrecoveredonly34%ofprincipal.Therevelationthat GObondscanbetreatedlikeunsecuredclaimschangedcreditanalysisand pricinginthemunimarket.
Beforethefinancialcrisisof2007–2009,amajorityofmunibondswere insuredagainstdefault,forafee,ofcourse,byprivateinsurers.Infact,most ofDetroit’sGObondswereinsured,whichmeantthatinsurers,ratherthan investors,sufferedthelossesdescribedinthepreviousparagraph.Inany case,muniinsurerssufferedmassivelossesduringthefinancialcrisis,not fromtheirmunibusinesses,butfromhavinginsuredmortgage-relatedproducts.Theensuingdamagetotheindustryultimatelyresultedinlessthan5% ofnewmuniissuesbeinginsured.Morerecently,perhapsinpartduetothe Detroitbankruptcy,andperhapsinpartduetotheCOVIDpandemicand shutdowns,therehasbeenaresurgenceofmuniinsurance,risingtoperhaps 10%ofnewissues.7
OtherUSMarkets
Mortgages. ThesecondlargestsectorinFigureO.4containsmortgages, at$17.3trillion.Mortgageloansareusedtopurchasepropertiesandare collateralizedbythosesameproperties.Mortgagebalancesfinancethepurchaseofone-tofour-familyresidences(70%);commercialproperty(18%); multi-familyresidences(10%);andfarms(2%).Aremarkablefeatureabout theUSmortgagemarketisthatonlyabout45%ofmortgageloanbalances areheldbytheoriginallenders.Theremaining55%ofbalancesare securitized,thatis,soldbytheoriginallenders;packagedintosecurities;andthen soldtoinvestors.Chapter15describesthismarketinmuchgreaterdetail.8 CorporateandForeignBonds. ThethirdlargestsectorinFigureO.4 comprisescorporateandforeignbonds,at$14.7trillion,whichincludes bondssoldbyUSnonfinancialcorporations(45%);byUSfinancialcorporations(31%);andbyforeigncorporationstoUSinvestors(24%),allto raisemoneytofundtheiroperationsandcorporatetransactions.Chapter 14describesthismarketindetail.
7 SeeGillers(2020),“BondInsuranceReturnstotheMuniMarketinaBigWay,” The WallStreetJournal,October22;andMoran,D.(2020),“MunicipalBondInsurance BusierThanEverAfterDecade-LongSlump,” InsuranceJournal,June26.
8 BecausemanyoftheMBSissuedbytheFederalNationalMortgageAssociation(FNMA)andtheFederalHomeLoanMortgageCorporation(FHLMC)have beenconsolidatedontotheirbalancesheets,theFinancialAccountsoftheUnited Statesincludetheseaspartofthedebtofgovernment-sponsoredenterprises(GSEs). FigureO.4andthenumbersinthisparagraphexcludetheseMBSfromAgency/GSE debtsoasnottodoublecounttheunderlyingmortgages.
LoansandAdvances. ContinuingcounterclockwiseinFigureO.4,alittlelessthanhalfofthe$9.0trillionofLoansandAdvancesaremadeby banks,andtherestbyanassortmentofnonfinancialandfinancialentities. Animportantfeatureofthissectoristhesecuritizationandtradingofbank loans,whichisdescribedinChapter14.Consumercredit,at$4trillion,is discussedinthenextsection,inthecontextofhouseholdbalancesheets. Agency/GSEDebt. Thepenultimatecategoryofinstrumentsin FigureO.4includes“agencies”or“agencybonds,”whichareissuedby governmentagenciesandGSEs.Theseentitiesspanarangeofassociations withthefederalgovernment,andtheirdebtissuesenjoyvaryinglevelsof supportfromthefederalgovernment.AtoneextremearetheFederalHousingAdministration(FHA),theSmallBusinessAdministration(SBA),and theGovernmentNationalMortgageAssociation(GNMA).Theseagencies arepartofthegovernment,andtheirdebtissuesarebackedbythe“full faithandcredit”oftheUnitedStates.Movingfromthefull-faith-and-credit framework,theTennesseeValleyAuthority(TVA),whichprovideselectricityforlocalpowercompaniesinTennesseeandsurroundingstates,is consideredafederalagency.Formally,however,itisacorporationthatis whollyownedbytheUSgovernment,anditsdebtisbackedbyitsown revenues,not–atleastexplicitly–bythefederalgovernment.Furtheraway fromfull-faith-and-creditaretheFederalNationalMortgageAssociation (FNMA)andtheFederalHomeLoanMortgageCorporation(FHLMC). TheyareknownasGSEs,butareownedbyprivateshareholdersand, havingfailedduringthefinancialcrisisof2007–2009,arenowunder governmentconservatorship.Leadinguptothecrisis,theirdebtwasnot explicitlybackedbythegovernment,butthemarketexpectationsforfull governmentsupportoftheirbondswasfullyrealizedduringandafterthe crisis.ThesetwoentitiesarediscussedingreatdetailinChapter15.
CommercialPaper. ThefinalcategoryinFigureO.4isCommercialPaper (CP),throughwhichthemosthighlyratedcorporationsborrowshort-term fundsfromthepublic.CPisdiscussedfurtherinChapter14.
O.3USMARKETPARTICIPANTS
Thissectiondescribessectorsofmarketparticipants.Thevolumesofdebt securitiesandloansthatappearasassetsonthefinancialbalancesheets ofvarioussectorsareshowninFigureO.6,whilethevolumesthatappear asliabilitiesareshowninFigureO.7.Households,nonfinancialbusiness, andgeneralgovernment(i.e.,federalandmunicipal)holdacombined $10.0trillionofdebtsecuritiesandloansfortheirownsavingsorcash managementpurposes.Banks,variousfundvehicles,insurancecompanies, pensionfunds,andotherfinancialentitiesholddebtsecuritiesandloans asintermediaries,investingandmanagingfundsfortheultimatebenefitof
FIGUREO.6 FinancialAssetsofVariousSectors,asofJune2021.ETF: Exchange-TradedFund;MMF:MoneyMarketFund.
Sources: FinancialAccountsoftheUnitedStates,BoardofGovernorsoftheFederal ReserveSystem;andAuthorCalculations.
FIGUREO.7 FinancialLiabilitiesofVariousSectors,asofJune2021.B/D: Broker-Dealer.
Sources: FinancialAccountsoftheUnitedStates,BoardofGovernorsoftheFederal ReserveSystem;andAuthorCalculations.
