Debt: US Government Debt Section 3

Which statements are TRUE about TIPS? I The coupon rate is less than the rate on an equivalent maturity Treasury Bond II The coupon rate is more than the rate on an equivalent maturity Treasury Bond III The coupon rate is a market approximation of the real interest rate IV The coupon rate is a market approximation of the discount rate StatusA A. I and III StatusB B. I and IV StatusC C. II and III StatusD D. II and IV

The best answer is A. The interest rate placed on a TIPS (Treasury Inflation Protection Security) is less than the rate on an equivalent maturity Treasury Bond. For example, a 30 year Treasury Bond might have a coupon rate of 4%; but a 30 year TIPS has a coupon rate of 2.75%. The "difference" between the two is the current market expectation for the inflation rate (1.25% in this example). The coupon rate on the TIPS approximates the "real interest rate" - the rate earned after factoring out inflation. If 30 year T-Bonds have a nominal yield of 4%; and the inflation rate is expected to be 1.25%; then the "real" interest rate is 2.75%. The reason why the TIPS sells at a lower coupon rate is that, every year, the principal amount is adjusted upwards by that year's inflation rate. So there are really 2 components of return on a TIPS - the lower coupon rate plus the principal adjustment equal to that year's inflation rate

Which of the following is the most likely purchaser of STRIPS? StatusA A. Pension fund StatusB B. Money market fund StatusC C. Individual seeking current income StatusD D. Individual wishing to avoid purchasing power risk

The best answer is A. Pension funds and retirement accounts are the large purchasers of STRIPS. These zero-coupon bonds are purchased at a deep discount and are held to maturity to fund future retirement liabilities. There is little credit risk, because the U.S. Treasury is a top credit. There is no current income because they don't pay until maturity. They have a huge amount of purchasing power risk as a long-term zero coupon obligation, but this is not an issue if they are held to maturity. Retirement plan managers like STRIPS because they don't have to worry about reinvestment risk - there are no semi-annual interest payments to reinvest! It is an investment that can be "tucked away" for 20 or 30 years, with no further work or worry on the part of the retirement fund manager.

All of the following are true statements regarding Treasury Bills EXCEPT: A. T-Bills are issued in bearer form in the United States B. T-Bills are registered in the owner's name in book entry form C. T-Bills are issued at a discount D. T-Bills are non-callable

The best answer is A. T-Bills are registered in the owner's name in book entry form; no bearer securities can currently be issued in the U.S. to individual residents. T-Bills are original issue discount obligations and are not callable, since they are short term obligations.

Treasury Bills are issued by the U.S. Government in which form? A. Book Entry B. Bearer C. Registered to Principal Only D. Registered to Principal and Interest

The best answer is A. The U.S. Government issues Treasury Bills in book entry form only. No physical certificates are issued.

New issues of Treasury Notes are issued in: Correct A. book entry only form StatusB B. bearer form StatusC C. fully registered form StatusD D. registered to principal only form

The best answer is A. The U.S. Government issues Treasury Securities in book entry form only. No physical certificates are issued.

The smallest denomination available for Treasury Bills is: Correct Answer A. $100 Incorrect Answer B. $1,000 StatusC C. $10,000 StatusD D. $100,000

The best answer is A. The minimum denomination on a Treasury Bill is $100 maturity amount. The minimum denomination on Treasury Notes and Bonds is also $100 maturity amount. Note that this is different than the typical minimum $1,000 par amount for other debt issues.

The shortest initial maturity available for Treasury Bills is: StatusA A. 4 weeks StatusB B. 13 weeks StatusC C. 26 weeks StatusD D. 52 weeks

The best answer is A. Treasury Bills are issued in initial 4 week (1 month); 13 week (3 month); 26 week (6 month); and 52 week (12 month) maturities.

All of the following statements are true regarding Treasury STRIPS EXCEPT: StatusA A. interest earned is subject to reinvestment risk StatusB B. interest income is accreted and taxed annually StatusC C. the bonds are issued at a discount StatusD D. the bonds are zero coupon obligations

The best answer is A. Treasury STRIPS are bonds "stripped" of coupons, meaning all that is left is the principal repayment portion of the bond. This security is a zero coupon obligation which is an original issue discount. The accretion of the discount over the bond's life represents the interest earned. Even though no payments of interest are made annually, the discount must be accreted annually and is taxable as interest income earned. This investment is not subject to reinvestment risk since no interest payments are made. The rate of return on this bond is "locked in" at purchase. Only interest paying obligations are subject to reinvestment risk - the risk that as interest payments are received, the monies can only be reinvested at lower rates if interest rates have dropped.

Treasury bills: I are issued in minimum $100 denominations II are issued in minimum $10,000 denominations III mature at par IV mature at par plus accrued interest StatusA A. I and III StatusB B. I and IV StatusC C. II and III StatusD D. II and IV

The best answer is A. Treasury bills are original issue discount obligations that mature at par, in minimum denominations of $100 each.

Which investment does NOT have purchasing power risk? StatusA A. STRIPS StatusB B. TIPS StatusC C. Treasury Bonds StatusD D. Treasury Receipts

The best answer is B. Purchasing power risk is the risk that inflation will cause interest rates to increase; and therefore, bond prices will fall. "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher total payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities. STRIPS are zero-coupon Treasury obligations - these have the highest level of purchasing power risk. If there is inflation, market interest rates are forced upwards, and zero-coupon bonds such as STRIPS fall dramatically in price (Treasury Receipts are broker-created zero-coupon bonds). Long term T-Bonds are also susceptible to purchasing power risk, though not as badly as long-term zero-coupon bonds. The bonds that have the lowest purchasing power risk are short term money market instruments and TIPS.

Which of the following are TRUE statements regarding Treasury Bills? I T-Bills are registered in the owner's name in book entry form II T-Bills are issued in bearer form in the United States III T-Bills are callable at any time IV T-Bills are issued at a discount A. I and III B. I and IV C. II and III D. II and IV

The best answer is B. T-Bills are registered in the owner's name in book entry form only; no bearer securities can currently be issued in the U.S. to individual residents. T-Bills are original issue discount obligations and are not callable, since they are short term.

The nominal interest rate on a TIPS is: StatusA A. the same as the rate on an equivalent maturity Treasury Bond StatusB B. less than the rate on an equivalent maturity Treasury Bond StatusC C. more than the rate on an equivalent maturity Treasury Bond StatusD D. unrelated to the rate on an equivalent maturity Treasury Bond

The best answer is B. The interest rate placed on a TIPS (Treasury Inflation Protection Security) is less than the rate on an equivalent maturity Treasury Bond. For example, a 30 year Treasury Bond might have a coupon rate of 4%; but a 30 year TIPS has a coupon rate of 2.75%. The "difference" between the two is the current market expectation for the inflation rate (1.25% in this example). The reason why the TIPS sells at a lower coupon rate is that, every year, the principal amount is adjusted upwards by that year's inflation rate. So there are really 2 components of return on a TIPS - the lower coupon rate plus the principal adjustment equal to that year's inflation rate.

An investor wishes to "lock in" an assured stream of interest payments for the next several years. The best recommendation to the customer is: StatusA A. Treasury Receipts StatusB B. Non-Callable Treasury Bonds StatusC C. AAA Rated Corporate Bonds with high call premiums StatusD D. AAA Rated Corporate Bonds trading at large premiums

The best answer is B. The key term in the stem of this question is an "assured" stream of interest payments. To assure a stream of interest payments, the bond must be of the lowest risk. Treasury debt is of lower risk than any corporate obligation. Treasury bonds pay interest semi-annually, while Treasury Receipts are "zero-coupon" obligations, which only pay interest at maturity. Therefore, Treasury bonds meet the desired characteristic of a "stream" of interest payments.

The nominal interest rate on a TIPS approximates the: StatusA A. discount rate StatusB B. federal funds rate Correct Answer C. real interest rate Incorrect Answer D. expected interest rate

The best answer is C. The interest rate placed on a TIPS (Treasury Inflation Protection Security) is less than the rate on an equivalent maturity Treasury Bond. For example, a 30 year Treasury Bond might have a coupon rate of 4%; but a 30 year TIPS has a coupon rate of 2.75%. The "difference" between the two is the current market expectation for the inflation rate (1.25% in this example). The coupon rate on the TIPS approximates the "real interest rate" - the rate earned after factoring out inflation. If 30 year T-Bonds have a nominal yield of 4%; and the inflation rate is expected to be 1.25%; then the "real" interest rate is 2.75%. The reason why the TIPS sells at a lower coupon rate is that, every year, the principal amount is adjusted upwards by that year's inflation rate. So there are really 2 components of return on a TIPS - the lower coupon rate (the "real" interest rate) plus an adjustment equal to that year's inflation rate.

Treasury Bills are typically issued for which of the following maturities? I 4 weeks II 13 weeks III 26 weeks IV 78 weeks StatusA A. I and III only StatusB B. IV only Correct C. I, II, III StatusD D. I, II, III, IV

The best answer is C. The U.S. Treasury issues 4 week, 13 week, 26 week, and 52 week T-Bills.

A "riskless" security maturing in 52 weeks or less is a: StatusA A. Money market instrument StatusB B. Non-callable funded debt Correct C. Treasury bill StatusD D. Treasury note

The best answer is C. The key word is "riskless." Treasury bills mature in 52 weeks or less and are issued by the U.S. Government, the safest issuer available.

Which statement is FALSE regarding Treasury Inflation Protection securities? StatusA A. In periods of inflation, the coupon rate remains unchanged StatusB B. In periods of inflation, the amount of each interest payment will increase StatusC C. In periods of inflation, the principal amount received at maturity will be par StatusD D. In periods of inflation, the principal amount received at maturity is more than par

The best answer is C. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount.

Which statement is FALSE regarding Treasury Inflation Protection securities? StatusA A. In periods of deflation, the amount of each interest payment will decline StatusB B. In periods of deflation, the interest rate is unchanged StatusC C. In periods of deflation, the principal amount received at maturity will decline below par StatusD D. In periods of deflation, the principal amount received at maturity is unchanged at par

The best answer is C. Treasury "TIPS" are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. In periods of deflation, the principal amount is adjusted downwards. Even though the interest rate is fixed, the holder receives a lower interest payment, due to the decreased principal amount. In this case, when the bond matures, the holder receives par - not the decreased principal amount.

Which statements are always TRUE about Treasury Bonds? I Treasury Bonds are traded in 32nds II Treasury Bonds are quoted at a discount to par value III Treasury Bonds are issued in either bearer or registered form IV Treasury Bonds have minimum maturity of more than 10 years StatusA A. I and II only StatusB B. II and IV only StatusC C. I and IV only StatusD D. I, III and IV

The best answer is C. Treasury Notes have maturities of 10 years or less. Treasury Bonds have maturities that are greater than 10 years - currently they are issued with 30 year maturities. Both are quoted on a percentage of par basis in 32nds. All Treasury issues are available only in book entry form. There are no bearer or registered issues.

Which statements are TRUE about CMBs? I CMBs are sold at par II CMBs are sold at a discount to par III CMBs are sold at a regular weekly auction IV CMBs are sold on an "as needed" basis StatusA A. I and III StatusB B. I and IV StatusC C. II and III StatusD D. II and IV

The best answer is D. CMBs are Cash Management Bills. They are sold at auction by the Treasury on an "as needed" basis to meet unexpected cash shortfalls, so they are not part of the regular auction cycle. They are the shortest-term U.S. government security, often with maturities as short as 5 days. They are sold in $100 minimums at a discount to par value, just like Treasury Bills.

Which of the following statements are TRUE regarding Treasury Bills? I T-Bills are original issue discount obligations II T-Bills are auctioned off weekly by the Federal Reserve III When T-Bills mature, the difference between the purchase price and the redemption price is taxable as interest income IV Treasury Bills are a direct obligation of the U.S. Government StatusA A. I and III only StatusB B. II and IV only StatusC C. I, II, III Correct D. I, II, III, IV

The best answer is D. Treasury Bills are original issue discount obligations. They are auctioned off weekly by the Federal Reserve acting as agent for the U.S. Treasury. When the bills mature, the difference between the purchase price and the redemption value at par is taxable as interest income. T-Bills are a direct obligation of the U.S. Government.

Treasury notes and bonds are: StatusA A. bearer securities StatusB B. registered to interest only StatusC C. registered to principal only StatusD D. fully registered in book entry form

The best answer is D. Treasury Bills, Notes and Bonds are only available in book entry form.