Fixed Income · Reading 55
Treasury Bonds
CFA Level I · Fixed Income · Reading 55: Fixed-Income Markets for Government Issuers · about 24 min
What you'll learn
- LOS 55.a Describe how sovereign, non-sovereign (regional/local), quasi-government (agency) and supranational issuers fund themselves, including developed vs. emerging market and domestic vs. external sovereign debt.
- LOS 55.b Contrast government and corporate bond issuance and trading: auctions (competitive and noncompetitive bids, cut-off yield, single- vs. multiple-price), primary dealers, on-the-run bonds and noneconomic investors.
Module 55.1
Fixed-Income Markets for Government Issuers
This reading describes how sovereign, non-sovereign, agency and supranational issuers fund themselves, and how government bonds are issued at auction and traded. A candidate must be able to classify a government-related issuer, explain the currency risk in emerging market debt and the maturity choices of a government, and work through an auction to find the cut-off yield and each bidder's allocation.
LOS 55.a — Government issuers and their funding choices
Sovereign debt
National governments borrow to pay for public goods and services and for infrastructure. Sovereign bonds are backed by the power to tax, so they usually carry the highest credit rating in their home market, and the sovereign is usually the largest issuer in that market.
Public-sector accounting standards differ from private-sector ones: they lean on cash transactions more than on accruals such as depreciation and unfunded liabilities. Analysts should therefore think of an economic balance sheet that adds implied assets (expected future tax revenue) and implied liabilities (promised future spending) to the reported financial assets and liabilities.
| Assets side | Liabilities side | |
|---|---|---|
| Financial balance sheet (reported) | Financial assets, such as short-term claims, holdings in state-owned firms and foreign exchange reserves | Debt outstanding (short- and long-term, in domestic or foreign currency) and other recorded obligations |
| Added in the economic balance sheet | Implied asset: expected future tax revenues | Implied liability: promised future expenditures, such as pensions and public services |
| Developed market sovereign | Emerging market sovereign | |
|---|---|---|
| Economy | Stable, diversified | Faster-growing, less stable, more concentrated |
| Public finances | Consistent, transparent fiscal policy | Less stable tax revenue, sometimes tied to one dominant industry or commodity |
| Currency of debt | A reserve currency: a major currency held by central banks worldwide and widely used in trade (e.g., US dollar, Chinese renminbi) | Home currency or a foreign reserve currency |
Emerging market debt often funds investment in economic growth. It can be:
- Domestic debt: issued in the home currency and held by domestic investors. The currency may not be freely convertible, because of illiquidity or capital controls.
- External debt: owed to foreign creditors, in the home currency or in a reserve currency. If it is in a reserve currency, foreign investors avoid direct currency risk. They still bear indirect currency risk, because the government must earn enough of the reserve currency to repay.
A government's debt management policy sets how much debt it will issue and in what form. To forecast issuance, focus on fiscal policy, such as tax cuts and spending increases when the economy is below full employment, and on how cyclical and inflation-sensitive revenues and spending are. Floating-rate or inflation-indexed features and any government guarantees of non-sovereign debt also matter.
Ricardian equivalence says taxpayers expect today's debt to be repaid with future taxes. Under that view a government should be indifferent to the maturity of its debt, but only if taxpayers save more when they expect higher taxes, have rational expectations, can borrow and lend without transaction costs, and pass tax savings on to future generations. These conditions do not hold in practice. Governments therefore issue across the maturity spectrum and keep a fairly stable mix of short- and long-term debt.
- Short-term sovereign debt is seen as safe and highly liquid and can serve as an alternative to bank deposits. That liquidity benefit likely keeps its yields below where they would otherwise be. Relying on it too heavily creates rollover risk.
- Longer-term sovereign debt provides benchmark yields for pricing the credit risk of other borrowers. It is used for interest rate risk management and as repo collateral, and central banks use it to conduct monetary policy.
Other government-related issuers
Key concept
| Issuer type | Who issues | Repayment / key feature |
|---|---|---|
| Non-sovereign government bonds | States, provinces, counties, cities and entities providing public services (hospitals, airports) | See GO vs. revenue bonds below |
| General obligation (GO) bonds | Local or regional governments | General public spending, backed by local taxing power |
| Revenue bonds | Local or regional governments | Fund one project; repaid from fees generated by it (e.g., a toll road or bridge) |
| Agency (quasi-government) bonds | Entities created by a national government for a specific purpose (infrastructure, mortgage finance; e.g., Ginnie Mae) | Repaid from the agency's own revenue (Ginnie Mae: guarantee fees) plus any government backing; if backed by the sovereign, yields and ratings sit close to the government's |
| Supranational bonds | International institutions set up by several sovereign governments (World Bank, IMF, Asian Development Bank) to promote cooperation, trade or growth | Typically high credit quality; some issues very liquid |
Common exam traps
- Calling the bonds of an institution set up by several governments quasi-government bonds. They are supranational bonds; an agency is created by one national government.
- Mixing classification by geography (developed vs. emerging market) with classification by issuer type (sovereign, non-sovereign, agency, supranational).
- Treating reserve-currency external debt as free of currency risk. Only the direct risk is removed.
LOS 55.b — Issuing and trading government vs. corporate bonds
Corporations raise debt financing as they need it. Sovereign issuers use regular public auctions.
How a government bond auction works
Key concept
- Noncompetitive bids are filled first. These bidders are guaranteed their allocation at the price the auction sets, but they do not help set it.
- Competitive bids state a yield (price). They are ranked from the highest price (lowest yield) down.
- Bonds go to competitive bidders from the highest price downward until the offering is filled.
- The yield on the lowest-priced accepted competitive bid is the cut-off yield.
Key concept
| Auction type | Price paid by successful bidders | Consequences |
|---|---|---|
| Single-price auction | Every winner pays the price at the cut-off yield | All bonds issued at one yield, so lower yield volatility. Tends to widen distribution, raise the chance of a successful auction and lower the issuer's funding cost |
| Multiple-price auction | Each winner pays its own bid | Bids tend to cluster close together and be large in size |
Example. A treasury offers 500 million of 7-year notes. It receives 80 million of noncompetitive bids and the competitive bids shown below. Allocation runs down the table, adding up the amounts until the 500 million is used:
| Bid | Yield bid | Amount bid | Cumulative amount | Allocated |
|---|---|---|---|---|
| Noncompetitive | — | 80 | 80 | 80 |
| Competitive | 3.10% | 150 | 230 | 150 |
| Competitive | 3.12% | 120 | 350 | 120 |
| Competitive | 3.15% | 200 | 550 | 150 (partial) |
| Competitive | 3.18% | 100 | 650 | 0 |
The offering runs out within the 3.15% bids, so the cut-off yield is 3.15%. Those bidders receive 150 million of the 200 million they asked for, and the 3.18% bid gets nothing. In a single-price auction every successful bidder pays the price that corresponds to 3.15%. In a multiple-price auction each pays the price of its own bid.
Primary dealers
A sovereign designates certain financial institutions as primary dealers. They must bid competitively in auctions, submit bids for third parties, and act as counterparties when the central bank buys (expansionary) or sells (contractionary) government securities to conduct monetary policy. Fiscal policy, meaning spending and taxation, is run by the government.
Secondary trading and yields
Like corporate bonds, government bonds trade mainly in quote-driven OTC dealer markets. Trading is heaviest and prices most informative for on-the-run bonds, the most recently issued bonds of each maturity. Their yields serve as the default-risk-free benchmark yields used to build yield curves.
Some holders of government bonds have noneconomic objectives. Central banks hold them for monetary policy, foreign governments hold them as reserves, and regulations require some financial institutions to hold them. This extra demand pushes sovereign yields below those of non-sovereign issuers. Lower credit risk also contributes to the lower yields.
Common exam traps
- Filling competitive bids before noncompetitive ones, or starting the competitive bids at the highest yield. In the 500 million example, starting from the 3.18% bid gives a cut-off yield of 3.12%, and filling the competitive bids before the noncompetitive ones gives 3.18%, instead of 3.15%.
- Taking the cut-off yield as the lowest accepted yield. It is the highest accepted yield, which matches the lowest accepted price. In the example that error gives 3.10% instead of 3.15%.
- Assuming a competitive bidder is sure of an allocation. Only noncompetitive bidders are, in either auction format.
Bottom line
- Sovereign bonds are backed by the power to tax, so they usually carry the highest credit rating in their home market, and the sovereign is usually the largest issuer there.
- External debt of an emerging market government in a reserve currency spares foreign investors the direct currency risk but leaves indirect currency risk, because the government must earn enough of that currency to repay.
- Ricardian equivalence would make a government indifferent to the maturity of its debt only if taxpayers save more when they expect higher taxes, have rational expectations, borrow and lend without transaction costs and pass tax savings on to future generations; these conditions do not hold, so governments keep a fairly stable mix of short- and long-term debt.
- Short-term sovereign debt is seen as safe and highly liquid, which likely holds its yields down, but relying on it too heavily creates rollover risk; longer-term sovereign debt supplies the benchmark yields used to price other borrowers' credit risk.
- General obligation bonds are backed by local taxing power, revenue bonds are repaid from the fees of the one project they fund, agency (quasi-government) bonds are issued by entities a national government creates, and supranational bonds are issued by institutions set up by several sovereign governments.
- In a government bond auction, noncompetitive bids are filled first, then competitive bids from the highest price (lowest yield) down until the offering is used up; the cut-off yield is the highest accepted yield, which matches the lowest accepted price.
- In a single-price auction every successful bidder pays the price at the cut-off yield, while in a multiple-price auction each successful competitive bidder pays its own bid.
- On-the-run government bonds, the most recently issued of each maturity, trade most actively and supply the default-risk-free benchmark yields, and demand from holders with noneconomic objectives pushes sovereign yields below non-sovereign yields.
Quick check
A bond analyst wants to group bonds according to the geography of their issuers. Which of the following labels fits that approach?
Show answer and explanation
Correct answer: C
Grouping bonds as developed market or emerging market bonds classifies them by the issuer's geography. The label emerging market bonds belongs to this approach.
Why the other options are wrong
- A. Supranational bonds are a category of issuer: international institutions owned by several governments. The label is not geographic.
- B. Municipal bonds are grouped by type of issuer (local governments), and sometimes by tax status.
Key takeaway Geographic labels are developed market and emerging market. Issuer-type labels are sovereign, municipal, agency, supranational and corporate.
Practice Questions
The central bank of Valdoria conducts much of its policy through a group of designated primary dealers. Which transaction is it most likely to carry out with them?
Show answer and explanation
Correct answer: B
Primary dealers act as counterparties when the central bank buys or sells government securities to carry out monetary policy. When the central bank buys securities, it pays cash into the banking system, which adds reserves and is expansionary.
Why the other options are wrong
- A. Selling government bonds drains reserves from the banking system. That is contractionary.
- C. Government spending and taxation are fiscal policy. The government sets them, and they are not executed through the central bank's primary dealers.
Key takeaway A central bank purchase of securities is expansionary, and a sale is contractionary. Primary dealers are the central bank's counterparties. Fiscal policy is not a central bank tool.
An analyst is building a government yield curve to use as the default-risk-free benchmark. The yields she uses are most likely taken from:
Show answer and explanation
Correct answer: B
Government bonds trade mainly in OTC dealer markets, and trading is most active, with the most informative prices, in the most recently issued (on-the-run) bond of each maturity. Their yields are therefore used as the default-risk-free benchmark yields for building yield curves.
Why the other options are wrong
- A. Older (seasoned) issues trade less actively, so their prices are less informative for benchmark purposes.
- C. Supranational bonds are high quality but are not the sovereign default-risk-free benchmark. Benchmark curves are built from the sovereign's own on-the-run issues.
Key takeaway Benchmark (risk-free) yield curves are built from on-the-run government bonds.
This reading has 11 questions in the full bank. Practice all of them.
Key Takeaways
- Geographic labels are developed market and emerging market. Issuer-type labels are sovereign, municipal, agency, supranational and corporate.
- A central bank purchase of securities is expansionary, and a sale is contractionary. Primary dealers are the central bank's counterparties. Fiscal policy is not a central bank tool.
- Benchmark (risk-free) yield curves are built from on-the-run government bonds.