The US Treasury Securities Risk Landscape Explained

Treasury securities are considered to be a low-risk investment, but they're not entirely risk-free. The US Treasury Department guarantees the principal and interest payments, but the market value of the securities can fluctuate.

The credit risk associated with Treasury securities is extremely low, as the US government has a strong credit history and a low default rate. In fact, the US Treasury has never defaulted on a payment in its history.

However, Treasury securities are not immune to market risk, which can cause their value to decrease if interest rates rise. This can happen when the Federal Reserve raises interest rates to control inflation or boost economic growth.

Investors should also be aware of liquidity risk, which can occur if there's a sudden increase in demand for Treasury securities, causing their prices to rise rapidly.

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The history of Treasury securities is a story of innovation and adaptation. The US government first issued Treasury securities in 1917 to finance World War I, with the War Revenue Act of 1917 increasing income taxes and issuing government debt, called war bonds.

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To raise funding, the Treasury sold $21.5 billion in "Liberty bonds" at par value, with subscriptions open for several weeks depending on demand. This was a new approach at the time, as the government traditionally borrowed from other countries.

In the late 1920s, the system suffered from chronic over-subscription, where interest rates were so attractive that there were more purchasers of debt than required by the government. This led to undervalued debt, allowing purchasers to buy from the government and immediately sell to another market participant at a higher price.

In 1929, the US Treasury shifted to a system of auctioning Treasury bills to the highest bidder, with securities allocated on a pro rata system. This change allowed the market to set the price, rather than the government.

The Treasury's first auction in 1929 was a success, with $224 million three-month bills issued at a price of 99.310, and the lowest bid accepted at 99.152.

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Treasury bills are sold in various maturities, including 4, 8, 13, 17, 26, and 52 weeks, which approximate different numbers of months.

The minimum purchase for Treasury bills is $100, a change from the previous minimum of $1,000 in April 2008.

Banks and financial institutions, especially primary dealers, are the largest purchasers of Treasury bills.

Treasury bonds have the longest maturity, ranging from 20 to 30 years, with coupon payments every six months.

The 30-year Treasury bond was re-introduced in February 2006 and is now issued quarterly.

Savings bonds are not marketable and can only be redeemed by the original purchaser or beneficiary in case of death.

Marketable securities are governed by the Treasury's Uniform Offering Circular, which can be found in 31 CFR 356.

The Treasury's Uniform Offering Circular provides detailed information on the types and procedures for marketable security issues.

The types and procedures for marketable security issues are described in the Treasury's Uniform Offering Circular (31 CFR 356).

Treasury bills are zero-coupon bonds that mature in one year or less. They are bought at a discount of the par value and are eventually redeemed at that par value to create a positive yield to maturity.

The minimum purchase for Treasury bills is $100, a change that occurred in April 2008, making it more accessible to individual investors. Banks and financial institutions, especially primary dealers, are the largest purchasers of T-bills.

Treasury bills are sold through single-price auctions held weekly, with the offering amounts announced in advance for different maturity dates. For example, the 13-week bill issued three months after a 26-week bill is considered a re-opening of the 26-week bill and is given the same CUSIP number.

CUSIP numbers are unique identifiers for individual issues of Treasury bills, allowing for easy tracking and identification. The 26-week bill issued on March 22, 2007, has the same CUSIP number as the 13-week bill issued on June 21, 2007, and as the 4-week bill issued on August 23, 2007.

During periods of low cash balances, the Treasury may sell cash management bills (CMBs), which are sold through a discount auction process like regular bills but are irregular in amount, timing, and maturity term.

Treasury bonds have the longest maturity at twenty or thirty years, with a coupon payment every six months.

The U.S. government used to suspend issuing 30-year Treasury bonds from 2002 to 2006, but they were reintroduced in 2006 and are now issued quarterly.

Savings bonds, on the other hand, are not marketable and can only be redeemed by the original purchaser or beneficiary in case of death.

Savings bonds are currently offered in two forms: Series EE and Series I bonds, with Series EE bonds paying a fixed rate and Series I bonds having a variable interest rate that resets every six months.

T-bonds are backed by the "full faith and credit" of the U.S. government, meaning investors know they'll be paid back even if the Fed's balance sheet is ugly.

Inflation, interest rate risk, and opportunity costs are the main risks to investing in T-bonds, but they're not risks of default.

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The Government Account Series is the principal form of intragovernmental debt holdings. It's essentially a way for the government to manage its finances more efficiently.

The government issues GAS securities to federal departments and federally-established entities that have excess cash. This helps the government to manage its cash flow and meet its financial obligations.

GAS securities are a type of intragovernmental debt, meaning they're held within the government itself. This is different from marketable Treasury securities, which are sold to the public.

The State and Local Government Series (SLGS) is a type of Treasury security issued to government entities below the federal level. These entities typically have excess cash obtained through the sale of tax-exempt bonds.

The federal tax code generally prohibits investment of this cash in securities offering a higher yield than the original bond. However, SLGS securities are exempt from this restriction.

The Treasury issues SLGS securities at its discretion and has suspended sales on several occasions to adhere to the federal debt ceiling.

Investors in U.S. Treasury bonds face risks, but the Treasury Department's "full faith and credit" backing by the Federal Reserve reduces the likelihood of non-payment.

The primary risks associated with T-bonds are opportunity risks, where investors might have earned a better return elsewhere.

Inflation poses a significant threat, as rising prices can erode the purchasing power of the bond's returns.

Interest rate risk is another concern, as rising interest rates can make existing bonds less attractive and reduce their value.

The opportunity costs of investing in T-bonds are also a consideration, where investors might miss out on potentially higher returns in other investments.

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Opportunity costs are a significant risk factor when investing in T-bonds. This is because every financial decision, including investing in T-bonds, carries the risk of missing out on other potential opportunities.

For instance, if you invest $1,000 in a T-bond, you're essentially locking that money away and losing the chance to invest or spend it elsewhere. You might have been better off putting that $1,000 into an exchange-traded fund (ETF) that offered a greater potential for return.

The danger of opportunity costs is that it can be difficult to recover from missed opportunities. As the article points out, if inflation continues at its current pace, that new laptop you could have bought with $1,000 might cost $1,025 a year from now.

Inflation can erode the value of your investment, making it harder to recover from opportunity costs. For example, if you invest $1,000 in a T-bond for one year at 1% interest, you'll get $1,010 back, but if inflation is 2%, the initial investment will have the buying power of a little under $990.

The I-Bond, which carries a fixed rate of interest plus an inflation factor, is an exception to this rule. However, even the I-Bond has a maximum investment amount per year of $10,000 per taxpayer.

Regulatory changes are making it harder for banks to intermediate in Treasury markets, and this is partly due to regulations that aim to make the financial system safer but have inadvertently reduced market-making and liquidity.

In fact, bank and dealer capacity to intermediate has not kept pace with growth, as regulations have come at the expense of market-making and liquidity. Regulatory changes are making intermediation more challenging for banks.

Risk and regulatory changes are causing banks to be more protective of their cash reserves, which is limiting their ability to intermediate in Treasury markets.

The rapid deterioration of the economy in March caught everyone off guard, causing market expectations to shift rapidly and increasing price volatility.

Uncertainty was a major factor, and it's not surprising given how quickly things changed. The size of the leveraged fund industry is hard to calculate precisely, but daily volumes in the overnight repo market have doubled since 2016.

High leverage in the market also played a significant role, exacerbating the dysfunction as large scale deleveraging took place. This triggered waves of heavy selling into an already dysfunctional market, causing a vicious cycle of losses and additional selling.

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Regulations, particularly those imposed after the global financial crisis, made banks and dealers less willing to warehouse assets for long periods. As a result, they faced balance sheet constraints and internal risk limits, leading to higher costs for even modest transactions.

The shift to working from home also impaired market functioning, as some trades require coordination among several counterparties and are thus operationally demanding. Without human traders providing a backstop, market makers and other activities that rely on face-to-face interactions struggled to operate smoothly.

This was a problem for the broader economy because dealers struggled to intermediate the flow in Treasuries, limiting their ability to transact in other markets.

The problem extended beyond Treasuries, affecting corporations and municipal governments who found themselves paying higher rates in disrupted markets.

The spread between futures and cash securities widened, making the cash-futures basis trade attractive to unleveraged investors like asset managers, who might have forsaken other credit markets for these trades.

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This would have made everything worse, as larger funds that normally invest in other debt of companies and municipal governments might have abandoned other credit markets.

Corporations were trying to build cash buffers to ride out the economic storm, but the disruption in Treasury markets sharply limited their ability to borrow in capital markets.

Many companies tapped their bank revolving credit lines, which would have led banks to sell their high-quality liquid assets, including Treasuries, to fund those draws, accelerating a vicious cycle of deleveraging.

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The US Treasury securities market is at an inflection point, where the supply of liquidity is falling and demand for it is rising. This can lead to higher price volatility, elevated longer-term yields, and higher funding costs.

There are already signs of liquidity pressures, as seen in the past September month-end, and funding market spreads and volatility have increased outside of month-end periods. The last episode of these liquidity pressures, in 2019, resulted in the intervention of the Fed to restore liquidity levels and shore up the Treasury financing market's functioning.

Investing in US Treasury securities is generally considered safe, but it's not risk-free. There's a risk that you could have earned better money elsewhere, and accepting a low return is in itself a risky decision. The investor accepts the risk that the borrower will be unable to keep up the interest payments or return the principal invested.

Key factors that might be at play in the market include:

The Treasury market is undergoing significant changes, driven by regulatory efforts to enhance its safety and liquidity. The SEC's mandate for central clearing Treasury market transactions, for example, will require market participants to fundamentally change their trading and operational processes.

This new rule will convert counterparty credit risk into liquidity risk, increasing the demand for liquidity in normal times and exacerbating it during times of stress. The SEC's expansion of central clearing for the Treasury market will have profound implications on how the market operates.

The Treasury market is currently at an inflection point, where the supply of liquidity is falling, and demand for it is rising. This could lead to higher price volatility, elevated longer-term yields, and higher funding costs.

Regulators are taking steps to address these concerns, including changes to how bank liquidity is measured. Some regulators are considering pre-positioning collateral at the Fed's Discount Window to guard against liquidity shocks.

The Fed's actions to stabilize Treasury markets have been significant, including repurchase agreements, security purchases, and easing regulations. These efforts seem to have worked, with Treasury futures pricing in line with their cash deliverables, market depth recovering, and repo rates falling in line with the federal funds rate.

Here are some key statistics on the Fed's actions:

These changes will have a lasting impact on the Treasury market, requiring market participants to adapt and evolve in response.

Primary Dealer Holdings of Government Securities are at an all-time high. This suggests that intermediaries are facing capacity constraints in the market.

The slow drain of the Fed's Overnight Reverse Repo Facility (RRF) could be indicative of dealer capacity limits for funding products such as repo. This is a significant factor to consider in understanding market dynamics.

Primary dealers are holding onto government securities, which could be limiting their ability to participate in other market activities. This is a key dynamic to keep in mind when analyzing market trends.

The high levels of primary dealer holdings of government securities are a sign that the market is facing capacity constraints. This could have implications for the overall health of the market.

The aftermath of the March 2023 banking crisis has made banks more protective of their liquidity.

Banks are now more cautious with their liquidity, which could impact market dynamics. Regulators are set to increase liquidity management expectations, which may lead to changes in how bank liquidity is measured.

Changes to liquidity measurement could involve steps like pre-positioning collateral at the Fed's Discount Window to guard against liquidity shocks. This move could pull collateral and liquidity from private markets.

Regulators are considering pre-positioning collateral at the Fed's Discount Window to mitigate liquidity risks. High-quality liquid assets, such as Treasury securities, are being eyed as potential collateral for this measure.

The market for U.S. Treasury securities is usually deep and highly liquid, but in March, investors rushed out of Treasuries and into cash, causing a surge in Treasury sales that the market couldn't handle.

Uncertainty was a major factor, as the speed at which the economy deteriorated in March caught nearly everyone by surprise, causing market expectations of asset values to shift rapidly and increasing price volatility.

Large-scale deleveraging also exacerbated the dysfunction, with the size of the leveraged fund industry estimated to be around the size of short-term borrowing done in the repo market, which doubled since 2016.

The unwinding of these positions triggered waves of heavy selling, creating a vicious cycle of losses and additional selling. This was further complicated by the fact that banks and dealers were less willing to warehouse assets for long periods due to post-crisis regulations.

Banks and dealers faced balance sheet constraints and internal risk limits amid the elevated volatility, leading to higher costs for even modest transactions and crowding out their ability to intermediate in other asset classes.

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