US Government and Money-Market Securities

What is Planned Amortization Class, also called PAC?

A CMO structure designed for more risk-averse investors and provide a predetermined schedule of principal repayment, as long as payments speeds are within a range. This tranche has top priority on principal payments up to a specific amount and any excess principal goes to lower priority tranche.

What is Sequential Pay?

A CMO structure where each tranche receives interest payment, but only one tranche at a time receives principal payments.

What must BDs offer customers who are interested in CMOs?

A discussion of the characteristics and risk of CMOs, a discussion of the structure of CMOs, a discussion that explains the relationship between mortgage loans and mortgage securities, a glossary of terms applicable to MBSs.

What are Stripped Securities?

BDs began stripping interest payments from T-Notes and T-Bonds and repackaged them as zero-coupon bonds.

How are CMOs compared to other investments in regards to advertisements?

CMOs may not be compared to any other types of investments, including CDs due to their unique characteristics. Everything must contain a disclosure for any CMO in sales literature, advertisements, and correspondence.

What is contraction risk and extension risk?

Contraction risk is the risk of a shorter maturity schedule due to faster prepayments and extension risk is the risk of a longer maturity schedule due to slower prepayments.

What is Freddie Mac?

FHLMC provides liquidity to federally insured savings institutions needing extra funds to finance new home loans. It issues notes, bonds, and stock that trade on the NYSE.

What are some types of Agency Securities?

Government-Sponsored Enterprises and Mortgage-Backed Securities.

What are Interest Only Securities?

IO mortgage bonds receive the interest from the underlying mortgage with little to no principal. As prepayments are made, interest is less due to a smaller principal amount where interest is based. It is possible to receive less than invested if prepayments are made faster.

How is the interest from Savings Bonds treated?

Interest from Nonmarketable US Government Securities are not state or locally taxed, but they are subject to federal tax as income. The interest on Series EE or I can be deferred until the bond matures or is redeemed.

What are some risks for fixed-income investments?

Interest-rate risk, credit risk, and liquidity risk.

What are Companion or Support Bonds?

It absorbs the prepayment risk by having the excess or shortfall of payments in the PAC or TAC be reflected on the companion tranche. This causes greater volatility of cash flows and a higher variability of average life.

What does the Ask Yield allow investors to do?

It allows investors to compare the yield available on T-Bills with the yields on T-Notes, T-Bonds, and other interest bearing securities.

What is the average life method of CMOs?

It compares CMOs to other types of fixed-income securities and essentially provides an average maturity for each tranche.

What are Negotiable Certificate of Deposits?

It is a money-market security issued by a bank. There is a secondary market for these securities, but FDIC may not cover the amount of the CD since the limit is only $250,000.

What are Collateralized Mortgage Obligations, also called CMOs?

It is a mortgage-backed security that takes the principal and interest payments from underlying mortgages and creates various classes of bonds, called Tranches.

What is Commercial Paper?

It is a short-term money-market security that a corporation issues with terms of 270 days or less, which makes it exempt from prospectus requirements of the SA of 1933.

What is a Targeted Amortization Class, also called TAC?

It is similar to PACs and developed to provide investors with greater protection from prepayment risk than sequential pay. It only provides protection from contraction risk, not extension risk.

What are Treasury STRIPS?

It is the Separate Trading of Registered Interest and Principal of Securities program. BDs may purchase T-Notes and T-Bills and separately resell the coupon and principal payments as zero-coupons. They are sold at a discount and quoted on a yield basis.

What is the Student Loan Marketing Association, also called Sallie Mae?

It provides liquidity to student loan makers and financing for state student loan agencies.

What is Fannie Mae?

It raises money to buy insured FHA, VA, and conventional residential mortgages from lenders. It issues notes, bonds, and stock that trade on the NYSE.

What are the two types of Treasuries?

Marketable, which are true Treasuries, and Nonmarketable, or savings bonds. Savings bonds are said to be non-negotiable because they cannot be sold in the secondary market and can only be redeemed through the US Government.

What are Principal Only Securities?

PO mortgage bonds are created by stripping the interest from the underlying mortgage. They are sold at a discount from face value. Faster repayment returns a higher yield.

What are some types of Tranches?

Plain Vanilla or Sequential Pay, Planned Amortization Class, Targeted Amortization Class, Companion or Support Bonds, Z-Tranches, Principal-Only Securities, Interest-Only Securities, and Floating-Rate Tranches.

What are additional risks for MBSs?

Prepayment risk is another risk for this fixed-income investment. Typically, the prepayment rate increases as interest rates fall due to homeowners refinancing a lower rate. Extension Risk is another risk, which is the opposite of Prepayment Risk.

How are prices quoted for T-Notes and T-Bonds?

Prices are quoted as a percentage of par value. The difference between government securities and other bonds is that government securities are quoted in increments of 32nds of par while other bonds are quoted in 8ths. 118.08 means 118 and 8/32 of par value.

What are Repurchase Agreements?

Repos are secured loans between BDs that lend securities, typically T-Bills. One BD agrees to pay another BD the securities lent at a specific price and on a certain date.

What are the three types of Nonmarketable US Government securities, also called savings bonds?

Series EE Bonds, Series HH Bonds, and Series I Bonds.

How are prices quoted for T-Bills?

T-Bills are quoted on a discounted yield basis, not a percentage of par value. The prices of T-Bills always distinguish themselves from other government securities because the Bid Price is higher than the Ask Price, since no interest is paid. The Ask Yield is the bond equivalent yield.

What are the maturity ranges for T-Notes and T-Bonds?

T-Notes have initial maturities from 2 to 10 years while T-Bonds have maturities of more than 10 years.

What are Treasury Inflation-Protected Securities?

TIPS are offered as notes or bonds and are auctioned periodically during the year. The principal value of these securities are inflation adjusted based on the CPI; however, the interest rate is fixed.

What is the Prepayment Speed Assumption Model?

The PSA Model estimates the speed of payment as measured against a benchmark. PSA of 100 assumes prepayment will remain stable. Above 100 assumes faster prepayment while less than 100 assumes slower. It was created by the Public Securities Association.

What are Treasuries used for?

The US Government issues Treasury securities in order to finance its operations.

What are Floating-Rate Tranches?

These tranches fluctuate with an interest-rate index, typically the London Interbank Offered Rate or Cost of Funds Index. If it is adjusted more than the change in the index, it is called a super floater. If it is adjusted in the opposite direction of the index, it is called an inverse floater.

What are Series HH Bonds?

They are 20 year investments with face values ranging from $500 to $10,000. These bonds pay interest semiannually and are not offered to the public. They are exchanged for EE bonds that are least 6 months old and did not mature more than one year ago. They are no longer offered as of August 2004.

What are Series EE Bonds?

They are 30 year investments ranging from $50 to $10,000. Investors purchase them at 50% discount from face value. The interest is reset twice a year and investors can cash in these bonds after 1 year of purchase, but will pay 3 month interest penalty if it is under 5 years.

What are Series I Bonds?

They are bonds that are indexed for inflation. They are sold at face value and the government resets the interest twice a year.

What are Z-Tranches, also called Z-Bonds?

They are deferred-interest bonds and have the longest life of any tranche. The bond has no cash flow. Interest will compound like a zero-coupon bond.

What are Treasury Receipts?

They are generic stripped securities issued by BDs. TRs are not direct obligations of the the US Government because BDs issue them; however, the underlying security of TRs are backed by the US Treasury.

What are Federal Funds?

They are money-market securities that are borrowed overnight on a bank-to-bank basis. Banks with excess funds are able to lend the funds to other banks who need to meet the minimum reserve requirement. This allows the lending bank to make some interest on dormant funds.

What are Bankers' Acceptances?

They are money-market securities used to facilitate foreign trade. It is used as a form of payment for a future date but may be cashed early for a discount. BAs may be traded and are guaranteed by the products purchased by the importer.

What are Long-Term CDs?

They are not considered money-market securities due to length of investment. These can be brokered through BDs and include certain risks due to length. FDIC coverage may not apply depending on amount. The CD may also be callable.

What are Government-Sponsored Enterprises?

They are publicly chartered but privately owned. GSEs are not backed by the US Government; however, their default risk is considered to be minimal. Some examples are: Federal Farm Credit Banks (FFCB), Federal Home Loan Banks (FHLB), and Student Loan Marketing Association (SLMA).

What are Mortgage-Backed Securities?

They are securities tied to pools of home mortgages. The agencies that issue them are Federal Home Loan Mortgage Corporation, also called Freddie Mac, Federal National Mortgage Association, also called Fannie Mae, and Government National Mortgage Association, also called Ginnie Mae.

What are Money-Market Securities?

They are short-term debt securities of one year or less and are considered cash equivalents due to safety. Examples include Commercial Paper, Bankers' Acceptances, Negotiable Certificate of Deposits, Federal Funds, Money-Market Funds, and Repurchase Agreements (Repos).

What are Treasury Bills, also called T-Bills?

They are short-term securities that mature within a year. They do not pay interest and referred to as non-interest bearing securities or discount securities. They sell at a discount and mature at par value.

What are Tranches?

They are the underlying securities of CMOs that has different rates of interest, repayment schedule, and priority level that allows investors to choose yield, maturity structure, and risk exposure.

What are Cash Management Bills, also called CMBs?

They are unscheduled short-term debt offerings used to even out Treasury Cash Flows.

What are Treasury Notes and Treasury Bonds, also called T-Notes and T-Bonds?

They pay a fixed rate of interest semiannually and the investor receives the face value upon maturity. They are referred to as Interest-bearing securities and are only in Book Entry form.

What are Federal Farm Credit Banks, also called FFCBs?

They provide funds for three separate entities: Banks for Cooperatives, Intermediate Credit Banks, and Federal Land Banks. They issue short-term discount notes and interest-bearing bonds with both short & long term maturities.

What are Federal Home Loan Banks, also called FHLBs?

They provide liquidity for savings and loans institutions which may need extra funds to meet seasonal demands for money. They issue discount notes and consolidated bonds.

What are Pass-Through Certificates?

This is the most common security issued by government agencies. The agency purchases a pool of mortgages and issues Pass-Through Certificates to certificate holders. As homeowners pay their mortgage, the money passes through to the certificate holders.

What are the debt instruments used by the US?

Treasuries, which are issued by the federal government, and Agencies, which are issued by governmental agencies.

What is Ginnie Mae?

Unlike Fannie Mae and Freddie Mac, Ginnie Mae is part of the Department of Housing and Department of Urban Development, which makes it a true government agency. It provides financing for residential housing and the securities are direct obligations of the US.