An Investor s Guide to the US Treasury Market

Transcription

1 an INVESTOR S GUIDE TO THE US TreASURY MARKET february 2014 An Investor s Guide to the US Treasury Market summary in brief Many investors concerned with principal preservation turn to US Treasury securities when building the foundation of their investment portfolios. Commonly used as a core investment, they provide periodic interest income and are considered to be among the highest credit quality fixed income securities. This guide covers certain key topics related to Treasury securities, including an overview of the market, their features, benefits and risks and the different structures available. If you are planning for retirement or other future financial obligations, a laddered portfolio strategy using Treasury securities may be worth considering. Consult your Morgan Stanley Financial Advisor to find out how they may be able to help you meet your specific investment goals. 2 What are US Treasury Securities? 3 Types of US Treasury Securities 5 An Overview of the US Treasury Market 6 Utilizing Treasury Securities in Your Portfolio 6 Treasury Investment Basics 7 Treasury Security Investment Considerations This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This is not a research report and was not prepared by the research departments of Morgan Stanley & Co. LLC or Morgan Stanley Smith Barney LLC. It was prepared by Morgan Stanley Wealth Management sales, trading or other non-research personnel. Past performance is not necessarily a guide to future performance. Please see additional important information

2 What Are US Treasury Securities? Treasury securities are debt obligations issued by the US government to raise cash needed to fund its operations and to help finance the federal deficit. When you buy them, you are lending money directly to the US government. In return, the government is obligated to pay periodic interest, plus full principal at maturity. Of all fixed income investments, Treasury securities are thought to provide the most secure haven for principal preservation. what are the benefits of investing in us treasury securities? principal preservation. Backed by the full faith and credit of the US government, Treasury securities are considered to be among the most secure fixed income investments available. They provide a guaranteed return of principal and interest when held to maturity. However, this guarantee does not eliminate market risk. See page 7 for an explanation about Treasury security investment considerations. a reliable income stream. In addition to principal preservation, the US government guarantees timely interest payments to investors holding coupon-bearing Treasury securities. state & local tax-exempt income. The interest generated by Treasury securities is exempt from state and local taxes. This tax-exemption feature provides a yield advantage over fully taxable securities, especially for residents of high-tax states. Keep in mind that Treasury securities are subject to federal income tax on interest income. a wide range of maturities. Treasury securities are available in a wide range of maturities, from a few days to 30 years. liquidity at market prices. If necessary, you can sell your Treasury investment in the secondary market, prior to maturity. Morgan Stanley Wealth Management maintains a secondary market in Treasury securities enabling you to sell your holdings at market prices. Of course, the price you receive may be more or less than your original investment, or par value, depending on market conditions at the time of sale. See page 5 for more information on the secondary market. 2 MorGAn STAnley 2014

3 Types of US Treasury Securities Treasury securities are issued in six classes: bills, notes, bonds, Treasury Inflation Protection Securities (TIPS), floating rate notes and zerocoupon Treasury (STRIPS). Most Treasury issues are non-callable, eliminating early redemption risk. treasury bills. Treasury bills (Tbills) are short-term securities with maturities of four, 13, 26 and 52 weeks. Bills are typically traded in $1,000 denominations and increments; however, they are available from as little as $100 denominations and increments. They are traditionally issued at a discount and pay accreted interest at maturity. 1 However, under certain market conditions, T-bills may be issued at or above par, which will result in a zero or negative return. Any interest received is the difference between the discounted purchase price, if any, and the par (or face) value of the security at maturity. T-bills are primarily quoted on a discount yield basis and rarely at a dollar price. The yield, if quoted, represents the percentage discount from the face value of the security. For example, an investor might pay $9,900 for a $10,000, 26-week T-bill and receive accreted interest of $100 at maturity. This translates into a 2% discount yield. When comparing the yields of T-bills to Treasury notes or bond yields, the T-bill discount rate is converted to a bond equivalent yield (BEY), which allows a direct comparison to be made between T-bills and other Treasury securities. New issue T-bills are sold at auction by the US Treasury on a regular basis. Auctions for four-week bills occur on Tuesday, 13- and 26-week bills are auctioned on Monday, while 52-week bills are auctioned monthly. Please note federal holidays may cause these schedules to change. (See page 5 for details on purchasing Treasury securities at auction through Morgan Stanley Wealth Management.) treasury notes. T r e a s u r y securities with intermediate term maturities ranging from two to 10 years are called Treasury notes (T-notes). T-notes offer a fixed rate of interest (known as the coupon rate) which is paid semiannually. Notes are typically traded in $1,000 face value denominations and increments (although $100 is the minimum available) and are auctioned in regular cycles, like T-bills, but less frequently. treasury bonds. Treasury securities with maturities greater than 10 years are called Treasury bonds (T-bonds). Like T-notes, T-bonds are typically traded in $1,000 face value denominations and increments (but are also available from $100 face value minimums), have a fixed coupon rate and pay interest semiannually. Currently, Treasury bonds are issued in 30-year maturities only. Both T-notes and T-bonds are generally quoted on a price basis and in 32nds, for example; 100:10 equals /32 which equals per $1,000 par amount, or $1, treasury inflation protection securities tips. Treasury Inflation Protection Securities (TIPS) are designed to protect the investor s capital from the effects of inflation (in periods of rising inflation a dollar today will be worth less when it is redeemed in the future). The principal value of TIPS is adjusted in line with changes in the Consumer Price Index (CPI), therefore the principal amount increases with inflation and decreases with deflation. When TIPS mature, investors are paid the adjusted principal or original principal amount, whichever is greater; the government guarantees the investor will receive at least par value at maturity. MorGAn STAnley

4 TIPS are issued in five-, 10- and 20-year maturities and are typically traded in $1,000 face value denominations and increments, although the minimum face value and increment is $100. They pay interest semiannually at a fixed rate and this rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation. The initial coupon rate on TIPS is often lower than that of a T-note of the same maturity because the issuer may be required to pay a higher rate of interest over time, due to future increases in the CPI. However, there is no assurance that these increases in the CPI will occur and, because the return on TIPS is linked to inflation, they may underperform fixed rate Treasury securities in times of low inflation. As with other Treasury securities, TIPS interest payments are exempt from state and local taxes but are federally taxable each year. In addition, although the inflation-adjusted principal amount is not received until maturity, the adjustment to the principal amount is federally taxable each year. TIPS may be an appropriate choice for qualified retirement accounts, including IRAs and 401(k) plans; the tax-deferred nature of these accounts enables investors to compound interest tax-free until withdrawn, and to defer the tax liability of any potential increase in the inflation-adjusted principal. floating rate notes. Floating rate notes or floaters are bonds that pay interest income based on the performance of an underlying reference rate that resets periodically: daily, quarterly or semiannually, for example. The bond issuer agrees to pay interest in an amount equal to the reference rate, which is a specified index or interest rate, plus a fixed spread. As a result, floaters may help protect against interest rate risk the decline in a bond s price when interest rates rise because the coupon (the reference rate plus the spread) resets to the higher interest level. See page 7 for a more a detailed explanation about interest rate risk. A floater s initial coupon is the sum of the reference rate at issuance and the spread. Thus, if the reference rate is 0.04% and the spread is 12 basis points, 2 the initial coupon will be 0.16%, (Coupon = Reference Rate ± Spread). 3 The note s payments then increase or decrease periodically, based on the movement of the reference rate. For Treasury floaters, which debuted in January 2014, the reference rate is the 13-week Treasury bill auction High Rate. They may be sold at discount, par or premium; are issued with maturities of at least one year, but not more than 10; and may provide a yield pickup over traditional T-bills. Interest on Treasury floaters accrues daily throughout the payment period and is paid quarterly on the last calendar day of the month. zero coupon TREASURY STRIPS. To facilitate the issuance of zero coupon Treasury bonds, the Treasury developed the STRIPS (Separate Trading of Registered Interest and Principal of Securities) program, whereby the coupon and principal payments are stripped from T-notes and T-bonds and then traded separately as zero coupon bonds. After it is stripped, each piece of the original security can effectively trade by itself. For example, a newly issued five-year note would be stripped into eleven separate securities ten representing the note s semiannual coupon payments (called coupon STRIPS) and one representing its final principal payment (principal STRIP). The principal STRIP would have a maturity of five years, while the coupon STRIPS would be traded individually, or repackaged into a range of different maturities (e.g., six months, 18 months). STRIPS are bought directly from qualified financial institutions and brokers, such as Morgan Stanley Wealth Management, but they still carry the full faith and credit of the US government and are state and local income tax-exempt. As with T-bills, STRIPS are generally sold at a deep discount to their face value, and do not make periodic interest payments. Instead, accreted interest compounds semiannually at a stated fixed rate, and the zero grows to its full face value at maturity. The difference between the bond s face value and its discounted purchase price represents the investor s return. Due to the internal interest compounding feature, zero coupon bonds mitigate reinvestment risk; however, in the secondary market these securities have the most price volatility versus coupon bearing bonds of the same maturity. STRIPS are typically offered in $1,000 face values and with maturities from one to 30 years; the longer the term to maturity, the greater the purchase discount. Although interest is not received until maturity, the accreted interest is subject to annual federal taxation, when held in a taxable account. Therefore, STRIPS, like TIPS may be suitable investments for tax-deferred accounts such as IRAs or 401(k) plans, as accreted interest is not taxed until it is withdrawn. 1 Accreted interest is treated as ordinary income for federal tax purposes and must be declared in the period in which it is received (at maturity). 2 A basis point is one one-hundredth of one percent or.01%. 3 The quoted yield is hypothetical, is for illustrative purposes and does not reflect current rates. 4 MorGAn STAnley 2014

5 An Overview of the US Treasury Market The Treasury market is the most active capital market in the world. Thousands of investors are daily participants, exchanging billions of dollars worth of securities. The movements of Treasury securities are more closely watched than those of any other fixed income security and help determine the direction of the bond market. the primary market. Treasury securities are initially issued and sold in the primary (new issue) auction market. The Treasury sells T-bills, notes and bonds, as well as Treasury Inflation Protection Securities (TIPS) and Treasury floaters through a competitive bidding process at regularly scheduled auctions held by the Federal Reserve. morgan stanley primary dealer. The Federal Reserve works directly with designated primary dealers when issuing and selling US Treasury securities. It is the responsibility of a primary dealer to make a market in all government securities. Morgan Stanley & Co. LLC is one of 22 primary dealers and an affiliate of Morgan Stanley Wealth Management. the auction process. Primary dealers participate in a competitive auction to determine the interest rate on each new issue of Treasury securities. Each bid and order size is ranked from the lowest to the highest bid rate. The lowest bid rate at which all the securities can be sold establishes the discount rate or yield. This rate is paid on the entire issue. Investors whose bid rates were at or below the established discount rate or yield will receive an allotment of Treasury securities; however, an allotment may be prorated if the bid rate equals the clearing rate / yield. Investors may purchase new issue Treasury securities through Morgan Stanley Wealth Management or through the Federal Reserve TreasuryDirect program. If placed directly with the Treasury, your bid is classified as non-competitive and you will receive securities at the rate cleared in the auction. However, noncompetitive bids can also be placed with Morgan Stanley Wealth Management. Purchasing Treasury Securities at Auction Through Morgan Stanley Wealth Management We are committed to offering our clients efficient access to Treasury auction transactions. You can purchase Treasury securities at auction through Morgan Stanley Wealth Management, gaining a number of benefits not offered through the TreasuryDirect program. These advantages include: easy to purchase. One phone call to your Morgan Stanley Financial Advisor is all it takes for you to buy Treasury securities at auction through Morgan Stanley Wealth Management. You can enter either a competitive or a non-competitive bid. A non-competitive bid automatically secures Treasury securities at the rate cleared in the auction. A competitive bid allows you to specify a minimum discount rate or yield; hence, securities will only be purchased if the auction clears this rate. liquidity. If you want to sell all, or a portion, of your Treasury securities prior to maturity, a simple phone call to your Morgan Stanley Financial Advisor can effect the transaction through our actively traded secondary market. Convenient collection and reinvestment of interest. By maintaining your Treasury investments in a Morgan Stanley Wealth Management brokerage account, you can conveniently instruct your Financial Advisor to reinvest interest and principal payments as they are received. You will be charged a per transaction service fee when purchasing Treasury securities at auction through Morgan Stanley Wealth Management. When interest rates are low, the impact of the fee may result in a negative yield. The Secondary Market After Treasury securities are auctioned in the primary market, they are immediately bought and sold in the secondary market. Individual investors may purchase previously issued bonds, notes and bills through Morgan Stanley Wealth Management s active secondary market, overseen by our experienced trading staff. Treasury securities can also be sold before maturity in the secondary market. However, you should be aware that the price you receive in the secondary market may be more or less than the original purchase price or maturity value, depending on market conditions at the time of sale. MorGAn STAnley

6 Utilizing Treasury Securities in Your Portfolio The Laddered Portfolio Investment Strategy Planning for retirement, generating predictable income to meet expenses or funding other future financial obligations, requires a portfolio management strategy that takes into account changing interest rates as well as your changing investment needs. With a laddered portfolio strategy, you can invest in Treasury securities with different maturities short, intermediate, and /or long-term to generate an attractive average portfolio yield, maintain periodic liquidity and protect against reinvestment risk due to changing interest rates. For instance, the example below assumes an investment of $100,000. Rather than investing the entire $100,000 in a three-year Treasury note with a yield of 1.50%, the investment can be structured using a laddered portfolio investing the $100,000 in two-, three-, five- and 10-year Treasury notes, for an estimated average portfolio yield of 2.05% (typically yields increase as the maturity term increases). By using the laddered portfolio strategy as this example illustrates, investments can be structured to maintain periodic liquidity through the shorter-term notes while increasing the portfolio s average yield through the longer-term notes. Keep in mind, as with any fixed income security, the price of the bonds in a laddered portfolio will fluctuate due to changing market conditions and interest rates. Although a laddered portfolio may not outperform all comparable investments under any conditions, it can help to stabilize a portfolio s performance by potentially reducing exposure to interest rate risk. Treasury Investment Basics Below, we discuss some basic bond concepts that you should be familiar with when investing in Treasuries: Prior to maturity, bond prices and interest rates have an inverse relationship. That is, when interest rates fall, bond prices rise, and, when interest rates rise, bond prices fall. This price fluctuation is also influenced by changing economic, political and market factors. However, when held to maturity, investors receive the full par value of the security. The par (or face) value of a coupon-bearing Treasury security typically equals $1,000 (although they are also available in $100 par value). Due to the inverse relationship between bond prices and interest rates, a bond with a coupon rate that is higher than the prevailing market interest rate will trade at a price above par value and is called a premium bond. A bond with a coupon rate that is lower than the prevailing interest rate will trade below its par value and is called a discount bond. The prices of Treasury securities quoted in financial newspapers are indications of prices as of time of press, for trades of $1 million or more. The bond table will show a closing bid and ask from the previous trading day. The bid price is the highest price that a buyer is willing to pay. The ask price is the lowest price that a seller is willing to accept. Hypothetical Example of a Short to Intermediate Treasury Laddered Portfolio Quantity Description Coupon Maturity ytm Price 25M 2-yr Treasury Note 1.25% % M 3-yr Treasury Note 1.50% % M 5-yr Treasury Note 2.50% % M 10-yr Treasury Note 3.00% % 100 Average Portfolio Coupon / Yield to Maturity: 2.05% Hypothetical example. Yields will vary. The yields quoted in this hypothetical laddered portfolio are for illustrative purposes only and do not reflect current rates. Your Morgan Stanley Financial Advisor can inform you of the current yields available in the Treasury market. M = $1,000, i.e., 25M = $25, MorGAn STAnley 2014

7 Treasury Security Investment Considerations As with all investments, Treasury securities have inherent risks, and while holding a diversified 4 portfolio may help mitigate some risks, the following should be considered: interest rate and Duration risk. Interest rate risk is the risk that the market value of securities might rise or fall, primarily due to changes in prevailing interest rates. Generally, fixed income securities are sensitive to fluctuations in interest rates; if interest rates rise, bond prices will fall and vice versa. The rationale is that as interest rates rise, investors are able to realize greater yields from other bond investments that reflect the new higher market interest rate; hence the value of those securities with coupons lower than the current market rate will be reduced. Usually, the longer the term to maturity, the greater the degree of price volatility. However, if held to maturity, the investor will receive the original principal amount. Duration measures a bond s price sensitivity to changes in interest rates. The longer the bond s duration, the more sensitive its market value is to changes in interest rates. Your Financial Advisor can provide you with the duration risk of your fixed income investments. credit risk. Credit risk is the risk that the issuer might be unable to pay interest and / or principal in a timely manner. Among domestic fixed income investments, US Treasury securities are considered to be among the safest investments as they are backed by the full faith and credit of the US government. reinvestment risk. Reinvestment risk is the risk that the income stream from a given investment must be reinvested at a lower interest rate. This risk is especially evident during periods of falling interest rates where coupon payments are often reinvested at a lower rate than the original instrument. Inflation is another factor that should be considered. During inflationary periods, the purchasing power of returned principal and coupon payments may be eroded. To compensate investors for this uncertainty, the coupon rate of non-inflation adjusted securities usually includes a risk premium. 4 Diversification does not guarantee a profit or protect against a loss in a declining financial market. for more information Your Morgan Stanley Financial Advisor can provide you with additional information on US Treasury securities, including a selection of current offerings, and will assist you in structuring a portfolio that is suited to your financial goals. MorGAn STAnley

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