Understanding Treasury Bond Pricing on the Secondary Market: Pricing Before Maturity
When an investor sells a 10-year Treasury bond on the secondary market 3 months before its maturity, the bond is not sold at the current market price of 3-month Treasury bills. Instead, it is sold at a price such that the yield matches the yield on a 3-month Treasury bill. However, it is important to understand that the yield and price calculations differ between the two securities, which can lead to some confusion. Let's delve into the details to clarify this concept.
Yield Considerations and Price Precision
The yield of a 10-year Treasury bond three months before maturity is closer to the yield on 3-month Treasury bills than to the yield on new 10-year Treasury notes. This is because the yield takes into account the deferred coupon payments and the time remaining until the bond's maturity. To illustrate, let's examine a specific example using a 2.375 Treasury note due in August 2024.
Example: Selling a 2.375 Treasury Note Close to Maturity
Consider a 2.375 Treasury note with a CUSIP of 912828D564, issued on August 14, 2014, set for settlement on May 23, 2024. The bond is currently priced at 99.2930 of par value, and it gives the seller 97 days of accrued interest from the last coupon period, totaling 0.6329. Therefore, the total payment is 99.9259 of par on May 23, 2024. The bond pays a full coupon of 100 of par plus half of the 2.375 coupon, equaling 101.1875 of par on August 15, 2024. The yield over this 85-day period, annualized, is 5.5353.
Comparing with New 10-Year Treasury Yield
A newly issued 10-year Treasury bond is currently trading at a yield around 4.41. On the other hand, the quoted yield on a Treasury bill maturing on August 15, 2024, is 5.2250. However, this yield is calculated as a discount yield, meaning you subtract it from 1 and get 1 back at maturity, with a 360-day year convention.
To get the actual price, you pay 98.7663 of par on May 23, 2024, to receive 100 back on August 15, 2024. This results in a yield of 1.2491 over the 85-day period, annualized to 5.4751. This figure is closer to the yield of the 10-year Treasury note with three months to maturity (5.5353) compared to the yield of a newly issued 10-year Treasury note (4.41).
Market Efficiency and Pricing
On the secondary market, the price of a bond three months before maturity is determined by ensuring its yield matches the 3-month Treasury bill's yield. This price is typically very close to the fair market value due to market efficiency. In practice, if the market is efficient, the price will be close to what it should be, meaning the yield will align as described.
Moreover, the key point to remember is that the yield and price of a bond are interconnected, and the price is not static. The bond pays coupons over its life, which affects the price as the maturity approaches. Therefore, the bond's price on the secondary market is influenced by the anticipated yield and the remaining time to maturity.
Conclusion
Understanding how Treasury bonds behave on the secondary market is crucial for investors. The price of a 10-year Treasury bond three months before maturity is determined by aligning its yield with the 3-month Treasury bill's yield. This process ensures that the bond's price reflects the current market conditions accurately. While the yield calculations differ between bills and long-term bonds, the pricing mechanism is designed to ensure that investors receive fair compensation for the time remaining until maturity.
Keywords
Treasury bonds, secondary market, yield computation, Treasury bills, price discount/premium