Treasury Lock

What Is a Treasury Lock?

A Treasury lock is a hedging tool used to manage interest-rate risk by effectively securing the current day's interest rates on federal government securities, to cover future expenses that will be financed by borrowing.

A Treasury lock can also be referred to as a bond lock.

How a Treasury Lock Works

Between the time a company makes a financial decision and the time it takes to complete the intended transaction, there is a risk that the yield of the Treasury bond will move adversely to the economics of the company’s transaction plan. When a certain yield is important to an investor’s or company’s investment strategy, but there is uncertainty in the economy about the future direction of Treasury yields, a company or investor may choose to buy a Treasury lock. A Treasury lock is a customized agreement between the issuer of a security and the investor in which the price or yield of the security is agreed to be locked. This strategy guarantees a fixed return for an investor or, in the case that the yield is locked, creates an interest rate risk hedge that can be used to the investor’s advantage. The lock acts like a separate security in addition to the Treasury because it guarantees a fixed return.

Understanding a Treasury Lock

Treasury locks are a type of customized derivative that usually has a duration of one week to 12 months. They cost nothing upfront to enter into as the carrying cost is embedded in the price or yield of the security, but they are cash-settled when the contract expires, usually on a net basis, although there is no actual purchase of Treasuries. The parties involved in a Treasury lock, depending on the respective sides of the transaction, pay or receive the difference between the lock price and market interest rates. The direction of interest rate movements will result in a gain or loss that will offset any advantageous or adverse rate movements.

Treasury locks provide the user the benefit of locking in benchmark rates associated with future debt financing and are commonly used by companies that plan to issue debt in the future, but want the security of knowing what interest rate they will pay on that debt.

Treasury Lock Example

For example, consider a company that is in the process of issuing bonds at the time the prevailing interest rate in the economy is 4%. The nuances involved in the pre-issuance stage such as hiring a trustee, analyzing supply and demand conditions in the market, pricing the security, regulatory compliance, etc. can cause a delay before the bond issuance is placed in the market. During this time, the issuer is exposed to the risk that interest rates will increase before pricing the securities, which will increase the cost of borrowing in the long term for the issuer. To hedge itself against this risk, the company purchases a Treasury lock and agrees to settle in cash, the difference between 4% and the prevailing Treasury rate at settlement.

The 4% interest rate establishes the benchmark that both parties involved in a Treasury lock agree to use as part of the investment agreement. If the interest rate at the time of settlement is higher than 4%, the seller will pay the company the difference between the higher rate and 4%. The payment is roughly equivalent to the present value of the future cash flows on the difference between the actual rate and locked rate on the executed notional amount. This gain, however, will be offset by a corresponding rise in the coupon rate of the bond issue when it is priced. However, if upon settlement, interest rates fall below 4%, the company will pay the seller the interest rate differential. This additional expense incurred by the company will be offset by a corresponding decrease in the company’s bond yield when issued.