Radical Guide to Bonds: A Quick Introduction to the Treasury Market and U.S. Agencies

All told, Treasury and U.S. agency bonds comprise fewer than 10% of all U.S. households’ bond holdings.  Investors buy these bonds for their safe features and their governmental support.  When looking for the ultimate safe assets, investors turn to these markets.

Retail investors do not drive this market; institutions do.  To start with, the Federal Reserve engineers short Treasury rates.  Foreign central banks --- especially the Bank of Japan --- have propped up this market with their large dollar reserve purchases.  Another large buyer group, commercial banks, receives capital benefits from holding Treasuries and U.S. agency bonds.  Retail investors’ flows are insignificant in these two markets.

We lump Treasuries and U.S. agencies together here.  By default and design, U.S. agency bonds are like pseudo-Treasury paper.  We think of the large U.S. agencies as mammoth government-sponsored entities (or “GSEs”) supporting a public purpose.  Fannie Mae, Freddie Mac and the Federal Home Loan Bank are large housing GSEs.  Tennessee Valley Authority is a GSE supporting power delivery.  Farm Credit Bank is another GSE providing subsidized agricultural loans. 

Bear in mind that the government does not officially back U.S. agency bonds.  Still, investors assume the government will support their bonds in a crisis.  That support was tested recently, as bond investors largely remained in Fannie Mae and Freddie Mac bonds despite their accounting and governance scandals.   

As always, we approach this market from the cost perspective.  Despite the liquidity and activity in Treasuries and U.S. agency bonds, they can be costly to trade for retail investors.  We’ll write more about the specific costs in later chapters, but here are some upfront pointers.

  • Buy Treasuries at auction in your brokerage account. You can setup a Treasury Direct account to buy Treasuries in the regular auctions.  (There is a small annual account maintenance fee of $25 for account balances over $100K).  The auction calendar is on the Bureau of Public Debt website, www.publicdebt.treas.gov.  The Treasury will flow the interest and principal payments to your bank account.   

That’s fine, but you will get more benefit by purchasing the auctioned Treasuries through a brokerage account.  By doing so, your portfolio holdings are consolidated into one account.  The bonds can be traded.  Your broker may also give you buy power and margin on the Treasuries in your account.

  • Save trading costs through auctions. Online bond brokers should charge you no more than a flat $50 ticket charge for an auction purchase.  If you buy Treasuries from your online broker in a regular (non-auction) broker trade, your costs can be much larger.  As a general rule, when buying 20 or more Treasuries, you will likely realize lower trade costs by buying through the auction rather than in the open market.

Brokers charge more on longer-dated bond trades vs. shorter-dated bond trades.  Regardless of the trade size and maturity, you still pay only $50 in an auction.  You control the trade, get the bonds into your brokerage account, and you buy Treasuries real cheap. 

  • U.S. agency bonds are trickier to buy than Treasuries.  You may like the extra yield that you realize in an agency bond over a similar Treasury.  Depending on maturity and features, you can see 20 to 50 basis points in additional yield.

Many brokers will treat a U.S. agency bond trade like a high-quality corporate bond trade (i.e., rather than as a Treasury bond trade).  Point is, as a corporate bond trade, you will pay too much in broker costs for your U.S. agency bond. 

You should look to buy your agencies through a new issue selling group at an online bond broker.  The selling groups are to U.S. agency bonds what auctions are to Treasuries.  Both are ways for the Treasury and the U.S. agencies to place new bonds into the market.  They are low-cost delivery channels for you.  Take advantage of them to save money.

In later chapters, we will compare online brokers that offer access to both auctions and selling groups.  Before we leave the Treasury market, we will next discuss the popular Treasury inflation-protected bonds --- called TIPs.

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June 3, 2005 | Permalink

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