A treasury department planning a bond issue considers how to prepare for movements in Treasury yields before the issue date. A T-lock is one of the transactions considered for that purpose.

What a T-lock pays

A T-lock pays the difference between the US Treasury yield on a set future date and a yield fixed today (the locked-in yield). It is settled in cash, and no Treasury security changes hands1. The buyer receives money when the yield rises (the Treasury price falls), so the profit and loss runs in the same direction as a forward sale of a US Treasury. For this reason a T-lock is described as a "synthetic forward sale"1. At the start, the buyer and the seller agree on the notional amount, the locked-in yield, the calculation date on which the yield is checked, and the reference Treasury2.

If the yield on the calculation date is above the locked-in yield, the seller pays the buyer the difference. If it is below, the buyer pays the seller. If the two are equal, nothing is paid2. The yield compared on the calculation date is the final yield derived from the ask price of the reference Treasury2.

The reference Treasury is either the most recently issued Treasury of a specified maturity on the calculation date, or a specific issue named in advance3.

The example confirmation form published by a bank has one trade date, one calculation date, and one payment date, and no periodic payments. The difference is paid once after the calculation date, on the third business day after it4. The form uses the 2006 ISDA Definitions and is written as a confirmation under an ISDA Master Agreement5.

Consider a hypothetical example in which Company R buys from Bank S a T-lock with a notional amount of USD 100 million and a locked-in yield of 4.00% per year. The calculation date is three months away, and the reference is the 10-year US Treasury. Company R plans to issue USD 100 million of 10-year bonds around the calculation date. Company R is the buyer and Bank S is the seller.

The difference and DV01

The difference is the gap between the calculation-date yield and the locked-in yield, expressed in basis points (bp, 0.01%), multiplied by the DV01 of the reference Treasury, which is the amount per basis point. DV01 is the change in the Treasury's price when the yield moves by 1bp. The form defines it per USD 1 million of the reference Treasury6. This page expresses it as an amount converted to the notional amount.

Settlement amount=yield difference (bp)×DV01 (converted to the notional amount)\text{Settlement amount} = \text{yield difference (bp)} \times \text{DV01 (converted to the notional amount)}

Assume that the DV01 of the reference Treasury is USD 800 per USD 1 million, whatever the calculation-date yield. For a notional amount of USD 100 million, that is USD 80,000 per basis point. If the calculation-date yield is 4.50% per year, the yield difference is 50bp and the settlement amount is 50 × USD 80,000 = USD 4 million. Bank S, the seller, pays Company R USD 4 million. If the yield is 3.50% per year, the difference is −50bp, and Company R pays Bank S USD 4 million.

−10−50+5+104T-lock profit or loss (USD million)Calculation-date 10-year Treasury yield (%) (USD million)ProfitLossBreakeven 4
Figure 1Settlement of the T-lock bought by Company R on the calculation date
Figure description

This chart shows the profit and loss, in USD million, of the T-lock bought by Company R on the calculation date. The horizontal axis is the 10-year Treasury yield on the calculation date, and the vertical axis is Company R's profit or loss. The breakeven point is the locked-in yield of 4.00%. The line is straight, with a slope of USD 8 million per percentage point of yield. It is 0 at the locked-in yield of 4.00%. At 3.00% Company R pays USD 8 million, and at 5.00% it receives USD 8 million.

Hedging before a bond issue

If a company buys a T-lock before issuing bonds, the difference paid or received softens the effect of Treasury yield movements on its interest payments between now and the issue. A T-lock is used to fix the Treasury component of a planned bond issue7. Accounting is covered in the Hedge Accounting Basics page.

Suppose the coupon on Company R's bonds is set at the 10-year Treasury yield on the calculation date plus 1.00% per year. The table shows Company R's costs for each calculation-date yield.

10-year Treasury yield on the calculation date Coupon on the bonds Annual interest payment (USD million) T-lock settlement (USD million)
4.50% per year 5.50% per year 5.50 Receive 4.00
4.00% per year 5.00% per year 5.00 0
3.50% per year 4.50% per year 4.50 Pay 4.00

If the yield rises to 4.50%, annual interest payments increase by USD 0.5 million. Over ten years that is a total increase of USD 5 million, paid in the future. Assume one payment per year and discount rates of 4.5% to 5.5%. The present value is then about USD 3.77 million to USD 3.96 million. That is close to USD 4 million, but the two are not necessarily equal. Company R receives USD 4 million on the T-lock, so the increase in its burden in present-value terms is roughly offset.

If the yield falls to 3.50%, annual interest payments decrease by USD 0.5 million, but Company R pays USD 4 million on the T-lock. Through the settlement, it gives up the saving on interest that it would have had without the T-lock. A T-lock offsets both the loss when yields rise and the gain when yields fall.

What a T-lock does not fix, and its risks

A T-lock fixes only the Treasury yield part7. It does not fix the part by which the yield on the bonds exceeds the Treasury yield (the credit spread). If the 1.00% spread in the example widens to 1.20% on the issue date, annual interest payments rise by USD 0.2 million, and the T-lock settlement does not change.

If yields fall, the buyer pays the difference. A lock usually has no upfront cost, but settlement can require a large payment9. How to think about the risk that a counterparty cannot pay is covered in counterparty credit risk.

The example confirmation form does not make the bond issue a condition of settlement. Even if the issue is cancelled, the difference between the calculation-date yield and the locked-in yield is paid10.

How a T-lock differs from futures, FRAs, and swap locks

Futures, FRAs, and swap locks also fix a future price or rate today, as a T-lock does. They differ in the rate they fix and in how they end.

Transaction Rate fixed How it ends
T-lock Yield of a specified US Treasury The difference from the calculation-date yield is paid once in cash (the form's example)
Japanese long-term government bond futures Price of a notional bond set by the exchange (the standard bond) Delivery of government bonds if held to final settlement
FRA Benchmark rate for a future period The difference is paid once at the start of the period in which the rate is set
Swap lock Swap rate Generally ended around the bond issue, with the swap's gain or loss paid at termination

JGB futures in Japan trade a notional government bond (the standard bond), and the contract is converted to actual bonds at delivery. The terms are standardized for exchange listing, and gains and losses are settled through daily mark-to-market11. Japanese long-term government bond futures held to final settlement are settled by delivery of actual government bonds12. A T-lock names the reference Treasury and pays only the difference, with no delivery of Treasuries. The mechanics of government bond futures are covered in the JGB Futures page.

An FRA is an over-the-counter transaction that exchanges interest on a floating rate and a fixed rate for a future period on a single date13. Unlike a T-lock, its reference is a floating rate, not a Treasury yield.

A lock on a swap rate is called a forward-starting swap14. How interest rate swaps work is covered in the Interest Rate Swaps page. One US company compared a T-lock with a forward-starting swap and chose the latter (paying the fixed rate). The swap fixes the rate from the day it is entered into until it is terminated, and it is generally terminated around the time of the bond issue15.

The gap between the yield of a Treasury and the swap rate of the same maturity is called the swap spread16. The rates fixed by a T-lock and by a swap lock differ by the spread, and that difference is not constant. A 2018 paper by the Federal Reserve Bank of New York shows that the average 10-year US swap spread was 38bp before it turned negative in October 2015 and −11bp afterward16.

Notes

  1. Healthcare Trust of America, Inc., Form 10-K (external site) (fiscal 2019), the note "Derivative Financial Instruments and Hedging Activities", "Cash Flow Hedges of Interest Rate Risk". ↩ ↩2

  2. Standard Chartered Bank, "US Treasury Lock" (external site) (draft confirmation), pp. 2–3, "General Terms", "Specified Rate", "Payment Date", and "Settlement Amount Payment". ↩ ↩2 ↩3

  3. Standard Chartered Bank, "US Treasury Lock" (external site), p. 2, "Relevant United States Treasury". The choice is either an "on the run" Treasury of a specified maturity or a specific Treasury identified by issuer, coupon, maturity, and CUSIP/ISIN. ↩

  4. Same form (external site), p. 3, "Payment Date" ("[3] Business Days after the Calculation Date"; the brackets mark the form's default for a blank). ↩

  5. Same form (external site), p. 1, opening paragraph (references to the 2006 ISDA Definitions and the ISDA Master Agreement). ↩

  6. Same form (external site), p. 3, "Dollar Value of an 0.01% Change ("DVBP")", and p. 4, "Settlement Amount". ↩

  7. Healthcare Trust of America, Inc., Form 10-K (external site) (fiscal 2019), the same note, at the passage "fix the treasury component of an upcoming debt issuance". ↩ ↩2

  8. Chatham Financial, "Forward Hedging FAQ" (external site), "Should I hedge Treasury yields or swap rates?" (the source gives no date), at the passage "It’s unusual to hedge Treasury yields for more than six months". ↩

  9. Chatham Financial, "Forward Hedging FAQ" (external site), "What are the common products for managing these risks?" (the source gives no date). ↩

  10. Standard Chartered Bank, "US Treasury Lock" (external site), pp. 2–4. The "Settlement Amount" terms contain no condition tied to the bond issue. ↩

  11. Japan Exchange Group, "国債先物入門" (external site) (Introduction to JGB Futures, our translation; in Japanese; Takahiro Hattori, 2021), section 2.3, pp. 4–5. ↩

  12. Japan Exchange Group, "国債先物入門" (external site) (Introduction to JGB Futures, our translation; in Japanese; Takahiro Hattori, 2021), section 4.1, pp. 10–11. ↩

  13. Jennifer Carpenter, "Forward Rate Agreements" (external site) (lecture notes, New York University Stern School of Business), p. 2. ↩

  14. Chatham Financial, "Forward Hedging FAQ" (external site), "What are the common products for managing these risks?", at the passage "a lock product on a swap rate is known as “forward starting swap.”" ↩

  15. Sysco Corporation, letter to the SEC (external site) (March 31, 2016), p. 3. It explains why the company chose a forward-starting swap over a T-lock, and states that a forward-starting swap is generally terminated around the time of issue. ↩

  16. Federal Reserve Bank of New York, "Negative Swap Spreads" (external site), Economic Policy Review (October 2018), the definition on p. 1 and p. 4. ↩ ↩2