Open market operations
An investor can participate in the Federal open market operations, which includes buying and selling of the U.S. Treasury securities either through the primary market and/or the secondary market. Retail investors mostly prefer the secondary market for buying Treasuries as it eliminates a lot of paper work and other administrative hassles, which they may face while applying through Treasury Direct, an online portal provided by the U.S. Treasury department to purchase and sell the securities.
The primary market
As of March 2014, there are about 20 securities dealers (as shown in the chart above), also known as primary dealers, who are authorized and obligated to submit competitive tenders at the Treasury auction. Primary dealers act as a market maker of the government securities as they buy government securities (T-bills, T-notes, and T-bonds) directly from a government, with the intention of reselling mainly to individual investors, while also creating a market for themselves. No single buyer is authorized to buy more than 35% of the Treasuries. Primary dealers submit bids using Treasury Automated Auction Processing System (TAAPS) within 30 days prior to the auction.
Retail investors can also make non-competitive bids through the Treasury Direct. If at any point in time, an investor wish to liquidate their Treasuries held in a Treasury Direct account, the Federal Reserve Bank of Chicago would sell the security on behalf of the investor in the secondary market for a fee. When a bill matures, the investor receives the face value. The difference between the purchase price and the face value equals the interest earned. The prices for new Treasury securities are set by private market demand and supply conditions through Treasury auctions.
The secondary market
The secondary market is an over-the-counter market where the average investor can buy the bonds more readily—through mutual funds or exchange-traded funds that hold Treasury securities.
When buying Treasury securities in the secondary market, an investor may or may not have to bear the commission. Most of the time, the dealers (see the list above) earn a return on the T-bills (BIL), T-notes (SHY) and T-bonds (TLT) by selling the security at a slightly higher price than what was paid in the Treasury auction in the primary market.
Issuers always prefer to quote high ask prices, so that issuers can close the auction at a lower discount, that is, low cost of debt. If the discount is lower, the issuers will have less difference to pay between the face value and the discount given at the time of the maturity. In the secondary market, an investor who makes the bid for lowest yield wins the bid. The lowest yield means the highest price for the bill, which is the lowest return for an investor and a low cost of debt for the issuer.
Since T-bills do not pay coupon (or interest), the interest earned is the difference between the price paid to the issuer at the time of buying the security and the face value received at maturity. Whereas, in case of Treasury notes and bonds, investors receive a coupon payment also known as interest payment (mostly paid in six-month intervals).
Changes in the market interest rates are based on the economic environment, inflation expectations, Federal Reserve policy, and simple forces of supply and demand. The interest rates in the long-term Treasury securities are more affected by changing market interest rates, as more cash flows get affected with higher duration.
Some of the major ETFs that track the Treasury market include SPDR Barclays 1-3 Month T-Bill (BIL), iShares 1-3 Year Treasury Bond (SHV), iShares 1-3 Year Treasury Bond (SHY), The iShares Barclays 20+ Year Treasury Bond (TLT) and ProShares Ultra Short Barclays 20+ Year Treasury (TBT).
In the subsequent series, we will discuss in details these ETFs and will assess the performance of short-term and long-term Treasury bills and bonds issued last week.