Government Bond Markets: Treasuries, STRIPS, Auctions, and the On-the-Run Premium

The US Treasury market is the largest, most liquid, and most credit-risk-free bond market in the world. Its yields are the global risk-free rate — the base from which every other fixed-income spread is measured. When the Federal Reserve sets monetary policy, it does so by managing the short end of the Treasury curve; when pension funds and central banks around the world seek safe stores of value, they hold Treasuries. Understanding the structure of this market — its instruments, its auction mechanism, and its peculiar pricing anomalies — is prerequisite to every subsequent interest-rate discussion in this unit.

Two features of the Treasury market are particularly important for quantitative finance. First, the STRIPS program creates a direct market for zero-coupon Treasury securities at every coupon payment date, providing the raw material for bootstrapping the spot rate curve. Second, on-the-run bonds (the most recently issued bonds at each maturity) trade at a premium to off-the-run bonds with the same cash flows, driven by liquidity and the repo market — a persistent, measurable deviation from the law of one price that opens up relative-value opportunities.

• distinguish Treasury bills, notes, bonds, FRNs, and TIPS by maturity, structure, and coupon convention;
• describe the single-price auction mechanism: competitive vs. noncompetitive bids, the stop-out yield, and the bid-to-cover ratio;
• convert a T-bill bank discount yield to a bond-equivalent yield;
• explain coupon stripping and reconstitution, and state why the law of one price keeps STRIPS yields close to the theoretical spot rate curve;
• distinguish on-the-run from off-the-run Treasuries and explain what drives the on-the-run liquidity premium;
• state the actual/actual day-count convention and compute accrued interest for a Treasury bond.

1. The US Treasury market
2. Treasury instruments
3. The Treasury auction process
4. T-bill yield conventions
5. STRIPS and the law of one price
6. The secondary market: primary dealers and interdealer brokers
7. On-the-run vs. off-the-run: the liquidity premium
8. Day-count and accrued interest for Treasuries