Chapter 8: U.S. Treasury and Government Agency Debt
Collateralized Debt Obligations (CDOs)*
A collateralized debt obligation is a type of privately issued asset-backed security which is sold as a bond that's backed (collateralized) by a pool of bonds, loans, and various other assets. CDOs are similar in structure to collateralized mortgage obligations. Ownership of this type of security is also typically in the form of tranches (slices), with any given tranche carrying a different maturity and risk level. The return that an investor may expect to receive from this type of investment is based on the credit quality of the underlying assets that are contained in the pool. Due to their highly complex nature, CDOs are generally not suitable for retail investors. As corporate issues, CDOs are subject to the filing and registration requirements of the Securities Act of 1933, Securities Exchange Act of 1934, and Trust Indenture Act of 1939. Any interest received on these securities is fully taxable.
Collateralized Mortgage Obligations (CMOs)*
A collateralized mortgage obligation is essentially a mortgage-backed security that takes the principal and interest payments from underlying mortgages and separates them into various classes of bonds that are referred to as tranches (slices). Each tranche has a different rate of interest, repayment schedule, and priority level. CMOs have become very popular since investors are able to choose the yield, maturity structure, and risk exposure that best meets their needs. CMOs help minimize the prepayment risk that's associated with traditional mortgage-backed securities by repackaging their principal and interest payments. During a period of declining interest rates, homeowners usually prepay their mortgages either because they sell their home or they wish to refinance. Prepayments make the average life of a mortgage-backed security much shorter than the initial maturity. The result is that the investor ends up with an early return of principal and, in turn, must reinvest at lower interest rates. A unique feature of CMOs is that they spread the prepayment risk of the underlying securities among the various tranches. Generally, tranches with the highest risk offer investors the highest yield. CMOs are usually secured by FNMA, GNMA, and FHLMC pass-through securities, but may also be backed by pools of mortgage loans. Assets are placed in a protective trust for the exclusive benefit of the bondholders. Since the value of a CMO is based on the underlying mortgage-backed securities, it may be classified as a derivative. CMOs usually have high ratings due to the quality of the underlying collateral and the safety provided by the trust. Like many other types of bonds, CMOs are issued in denominations of $1,000. - repackages pass through certificates into a trust to avoid prepayment risk - investors can choose th
Agency Securities—Investor Profile*
Agency securities are suitable for conservative customers due to their relative safety. GNMA securities are direct obligations of the U.S. government and are viewed as default-free, while others (e.g., FNMA securities) are still considered to be of excellent credit quality. Agency securities are also quite liquid with little, if any, marketability risk. The primary reason that an investor may choose an agency security over a Treasury security is that many of these instruments provide monthly payments. Investors often use them to supplement their income from corporate pensions and/or Social Security. Traditionally, the yield on an agency security is somewhat higher than what's offered by a Treasury security. The downside is the maturity of a pass-through security is unknown due to potential prepayments from the underlying collateral. - these securities are typically default free (for conservative investors) - securities are quite liquid with low marketability risk - choosing an agency security over a treasury security because payments are made monthly, unlike semi-annual interest payments. yields are typically also higher - good opportunity for investors to supplement their - downside is that the maturity is unknown due to potential prepayments
Agency Securities
Agency securities include debt instruments that are issued and/or guaranteed by federal agencies and by government-sponsored enterprises (GSEs). Although agency securities are not direct obligations of the U.S. government, their credit risk is still considered low. The prevailing presumption is that since the federal government created these entities, it will not allow them to default on their obligations. Therefore, although actually unrated, agency debt may be considered to be AAA rated. Also, as with U.S. Treasury securities, agency debt is issued in book-entry form and is quoted in increments of 1/32nds of a point. Investors are attracted to agency securities due to their perceived safety and the fact that yields are slightly higher than the yields of corresponding U.S. Treasury securities. - agency securities have are attractive because of their perceived safety and slightly higher yields than treasury securities
Planned Amortization Class (PAC)*
Another popular structure is the Planned Amortization Class (PAC). This form is designed for more risk-averse investors and provides a predetermined schedule of principal repayments, but it's based on mortgage prepayment speeds remaining within a certain range. This greater predictability of maturity is accomplished by establishing a sinking-fund type of schedule. The PAC tranche has top priority and receives principal payments up to a specified amount. Thereafter, any excess principal payments are directed to a companion or support tranche, which has lower priority.
Taxation
As addressed earlier, the interest earned on all Treasury securities is subject to federal tax, but exempt from state and local taxes. This may be an important consideration for investors who live in states with high state income tax rates. The interest earned on T-bills must be reported in the year in which the T-bill matures, while interest on T-notes and T-bonds must be reported in the year in which it's received. As with other zero-coupon bonds, the interest on T-STRIPS must be accreted and reported on the investor's tax return each year. Obviously, there are many options available for investors interested in Treasury securities, government agency securities, and derivative securities (e.g., CMOs). The tax treatment of each type of instrument varies. Generally, Series 7 candidates can assume that the interest from all of these securities is, at a minimum, subject to federal taxes; however, state and local tax liability differs depending on which product is being discussed.
Prices
As is true for other types of bonds, prices for Treasury notes and bonds are quoted as a percentage of their par value. However, government securities are quoted in increments of 1 /32 nds of a point, while most other bonds are quoted in increments of 1 /8 ths of a point. For example, a U.S. government bond that's quoted at 97.08, actually means 97 8 /32. A price of 97 8 /32 equates to 97.25% of par, or $972.50.
Accrued Interest (with example)*
As mentioned previously, when an investor buys an existing bond in the secondary market, he's often required to pay the seller an amount of accrued interest. Interest on T-bonds and T-notes is paid semiannually and accrues (is earned) on the basis of actual days in each month and a 365-day year. The following example explains the method for calculating the number of days of accrued interest for a Treasury security. On Tuesday, March 8, an investor purchases a $10,000 face value 7.5% Treasury bond that matures on December 1, 2034. Assuming regular-way settlement, how many days of accrued interest does the buyer owe the seller? Interest is paid every six months on dates that are based on the bond's maturity date. In this example, interest is paid each June 1 and December 1. Accrued interest on the purchase is calculated by starting at December 1 (the last interest payment). Regular-way settlement on the transaction is Wednesday, March 9 (the next business day, or T+1). Remember, accrued interest on the purchase is calculated up to, but not including, the settlement date of March 9. The number of days of accrued interest owed includes all of December (31 days), January (31 days), February (28 days), and 8 days in March, which results in 98 days of accrued interest. Since both Treasury bills and Treasury STRIPS trade at a discount and are non-interest-bearing, they trade without accrued interest.
Companion or Support Bonds*
As mentioned with PACs, companion or support tranches absorb the prepayments from the PAC and TAC tranches. Once the scheduled payments have been made to the PAC or TAC tranches, any excess or shortfall is reflected in the companion tranche. Therefore, support tranches have greater volatility of cash flow and a high variability of average life. Generally, holders are compensated for this risk with higher yields.
Mortgage-Backed Securities
As the name implies, mortgage-backed securities are debt instruments that are secured by pools of home mortgages. The agencies that issue these securities include the Government National Mortgage Association (GNMA or Ginnie Mae), the Federal National Mortgage Association (FNMA or Fannie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).
Book-Entry Issuance
Both notes and bonds are currently issued in book-entry form which means that an investor never receives the actual paper security. Instead, the Federal Reserve Bank enters the names of the owners in its records. Don't confuse the term book-entry issuance with street-name holding. Any reference to street-name holding suggests that a security is being held in the name of a broker-dealer at a depositary, such as the Depository Trust & Clearing Corporation (DTCC). In many cases, a street-name security may be reregistered in a client's name and, if requested, delivered to the client.
Cash Management Bills (CMBs)
CMBs are unscheduled, short-term debt offerings that are used to smooth out Treasury cash flows. CMBs are issued at a discount, but will mature at their face amount. The duration of CMBs may be as short as one day. - used to smooth out treasury cash flows
Types of CMOs*
CMO issues may be structured in a number of different ways. In the simplest form, often referred to as plain vanilla or sequential pay, each tranche receives monthly interest payments, but only one tranche receives principal repayments at a time. In the example below, Tranche B doesn't receive any principal until all of the required principal has been repaid to Tranche A. Tranche C doesn't receive principal repayments until Tranche B is paid up, etc.
Regulation and Taxation (CMO)*
CMOs are privately issued corporate securities and, unlike Treasuries and agencies, their issuance is subject to registration under the Securities Act of 1933 and the Trust Indenture Act of 1939 (a corporate debt regulation). Additionally, ongoing filings may be required under the Securities Exchange Act of 1934. Interest payments are generally paid monthly and are subject to federal, state, and local taxes; however, the principal payments are considered a return of capital and are not taxable. - privately issues corporate securities (subject to SECA regulation) - interest payments are made monthly and are fully taxable - however, principal payments are considered a return of capital and are not taxable
Government-Sponsored Enterprises
Government-sponsored enterprises (GSEs) are publicly chartered, but privately owned organizations. Congress allowed for their creation to provide low-cost loans for certain segments of the population. The enterprise issues securities through a selling group of dealers with the offering's proceeds provided to a bank (or other lender). The bank then lends the money to an individual who is seeking financing (e.g., students, homeowners, or farmers). Although GSE securities are not backed by the U.S. government, they do have an implicit guarantee from the U.S. government. GSE securities are considered to have minimal default risk. GSE examples include: Federal Farm Credit Banks (FFCBs) Federal Home Loan Banks (FHLBs) Student Loan Marketing Association (SLMA or Sallie Mae)
Prepayment Risk
In addition to the risks inherent in all fixed-income investments (e.g., interest-rate, credit, and liquidity risk), mortgage-backed securities are subject to a special type of risk that's referred to as prepayment risk. This is the risk that's tied to homeowners paying off their mortgages early. When interest rates fall, homeowners have an incentive to refinance and pay off their existing mortgages. These prepayments are passed through to the pools that hold the old mortgages. At this point, the pass-through investors will need to reinvest this large amount of principal at a time when interest rates have declined. Since any mortgage in the pass-through pool may be paid off at any time, the cash flows from these investments can be highly unpredictable. As it relates to mortgage-backed securities, there are two terms with which a person should be familiar—prepayment rate and average life. The prepayment rate measures the speed at which mortgages in the pool are being paid off or how quickly prepayments of principal are being received. The prepayment rate usually rises when interest rates fall since this is the time that homeowners refinance their mortgages. Average life measures the average number of years that each dollar of principal is expected to remain outstanding. The pass-through securities of the preceding entities are all subject to prepayment risk. However, Fannie Mae and Freddie Mac also issue bonds and notes that pay interest semiannually and have a fixed maturity date. These notes and bonds have no prepayment risk. - investors in Fannie and Freddie can avoid prepayment risk because some bonds and notes pay interest annually and have a fixed maturity date
Treasury STRIPS
In order to facilitate the stripping of securities, the Treasury created its Separate Trading of Registered Interest and Principal Securities (STRIPS) program. Dealers are now able to purchase T-notes and T-bonds and separately resell the coupon and principal payments as zero-coupons (discounted securities) after requesting this treatment through a Federal Reserve bank. The difference between an investor's purchase price and the bond's face value is interest. STRIPS are backed by the full faith and credit of the U.S. Treasury and are quoted on a yield basis, not as a percentage of their par value. - quoted on a yield basis, not as a percentage of their par value
Stripped Securities*
In the 1980s, several broker-dealers began stripping the interest payments and final principal payments from Treasury notes and bonds and then repackaged and resold them as zero-coupon bonds. Although these stripped securities were not issued by the Treasury, their cash flows were very secure since the underlying securities are direct obligations of the U.S. government. Thereafter, a group of dealers began to issue generic stripped securities—referred to as Treasury Receipts (TRs). An important distinction is that Treasury Receipts are backed by Treasury securities that are owned by the issuing broker-dealer; they're not directly backed by the U.S. Treasury. - Treasury Receipts are backed by the treasury securities that are owned by the issuing broker-dealer, and they are not directly backed by the US Treasury
Interest Only (IO) Securities
Interest only (IO) bonds receive some or all of the interest portion of the underlying collateral and little or no principal. As the principal amount is paid on the underlying mortgages, the cash flow declines on the IO since the interest payment will be based on a lower principal amount. Once the principal amount declines to zero, no further payments are made on the IO. At high rates of prepayment, it's possible to get less money back than originally invested. On the other hand, IOs increase in value when prepayments are slow. - killed when prepayments are high, succeed when prepayments are low -
Treasury Inflation-Protected Securities
One of the primary concerns for bond investors is how inflation (a rise in prevailing prices) affects the purchasing power of the dollars received. This is somewhat amplified since bond investor often need to wait years for their return of principal. So how is a Treasury investor able to protect himself? One answer may be to acquire protection by investing in Treasury Inflation-Protected Securities (TIPS). TIPS are interest-bearing, marketable securities. The interest rate on TIPS is fixed; however, the principal amount on which that interest is paid may vary based on the change in the Consumer Price Index (CPI). During a period of inflation (a rise in CPI), the principal value will increase. However, if deflation occurs (a decline in CPI), the principal value will decrease. TIPS are issued in book-entry form in $100 increments and are available in 5-, 10-, and 30-year terms. For example, an investor buys a 10-year TIPS note at an initial face amount of $1,000, and a coupon of 4%. Six months later, the face amount has been adjusted to $1,010 to reflect a 1% increase in CPI. Given the 4% coupon, the investor's semiannual interest payment will be $20.20 (as shown below). Based on the 1% increase in the CPI, the principal value rises to $1,010. Therefore, $1,010 x 4% = $40.40. However, since the interest is paid semiannually, the amount paid will be $20.20 (40.40 ÷ 2). TIPS may be offered as notes or bonds and are auctioned periodically during the year. The total inflation adjusted principal will be paid at maturity. Although the face amount that's used to calculate interest payments may fall below $1,000, TIPS will pay at least $1,000 at maturity. In any year in which a principal adjustment is made, the annual adjustment will be taxed at the federal level as ordinary income. Additionally, any interest p
When evaluating two CMOs that are backed by GNMAs—one having a 6% yield and the other having a 10% yield, which statement is NOT TRUE?
Prepayment risk measures the possibility that homeowners will refinance (i.e., prepay) their mortgages. Historically, the speed of prepayment increases when interest rates fall. If this happens, payments will flow into the CMOs at an accelerated rate and investors will receive their invested funds earlier and thereby be forced to reinvest these funds at lower-than-anticipated rates. Therefore, the CMO with the higher interest rate will have higher prepayment risk. GNMA-backed CMOs are highly rated and have little credit risk. Since both CMOs are backed by GNMA securities, credit risk is minimal for both pools.
Principal Only (PO) Securities
Principal only (PO) mortgage bonds are created by stripping the interest payments from the underlying mortgages. The POs are then sold at a deep discount to their face value. Ultimately, the face value is paid to the investors through both scheduled and early payments of principal. Faster prepayments lead to a more rapid return of principal and, therefore, a higher yield.
Limited Tax Relief*
Remember, the interest earned on Treasury and agency securities is subject to federal tax. Therefore, for investors with higher-incomes, an investment in municipal securities may be appropriate since the interest earned on these issues is typically exempt from federal tax.
Which of the following securities does NOT trade with accrued interest?
Securities that pay interest periodically or have a stated rate of interest (such as Treasury bonds, municipal bonds, corporate bonds, and certificates of deposit) trade with accrued interest. However, many money-market securities such as Treasury bills and bankers' acceptances trade at a discount and are, therefore, purchased without paying accrued interest. Zero-coupon bonds (e.g., Treasury STRIPS) do not pay periodic interest and are traded without accrued interest.
Targeted Amortization Class (TAC)*
Similar to PACs, TACs were also developed to provide investors with greater protection from prepayment risk than a plain vanilla bond. However, TACs generally provide protection only from contraction risk (a shorter maturity schedule), not extension risk (a longer maturity schedule). The degree of protection that's offered by a specific TAC tranche will depend on the existence of PAC and TAC tranches that have higher priorities.
Federal Agencies
Since federal agencies are direct extensions of the U.S. government, the securities that they issue or guarantee are backed by the full faith and credit of the U.S. government. This category includes the Government National Mortgage Association (GNMA). GNMA securities will be examined when mortgage-backed securities are covered.
Private Label CMOs
Some private institutions, such as subsidiaries of investment banks, financial institutions, and home builders also issue mortgage-backed securities. When issuing these securities, the institutions often issue non-agency mortgage pass-through securities with the underlying collateral typically including different or specialized types of mortgage loans or mortgage loan pools that don't qualify as agency securities. These non-agency or so-called private-label mortgage securities are the sole obligation of the issuer and are not guaranteed by one of the GSEs or the U.S. government. As a result, private label CMOs have more credit risk than agency CMOs. Below are the some important points to remember regarding these private label CMOs: They have a higher degree of risk They typically don't carry a AAA rating An independent agency will base the rating on their structure, issuer, and collateral
Floating-Rate Tranches
Some tranches may offer interest rates that fluctuate with an interest-rate index, such as the London Interbank Offered Rate (LIBOR) or the Cost of Funds Index (COFI). The interest rate is reset periodically to a margin above the index, but is subject to a maximum rate (cap) and minimum rate (floor). If the interest rate is adjusted by more than the change in the index, it's referred to as a super-floater. If the interest rate moves in the opposite direction to the designated index, it's referred to as an inverse floater.
A 3-month Treasury bill is issued at a discount to yield 9.5%, and a corporate bond is issued to yield 9.5%. The bond is to mature in 10 years. If both are offered on the same day on a bond equivalent yield basis, which of the following statements is TRUE?
T-bills are issued and quoted on a discount yield basis, whereas corporate bonds are quoted on a yield-to-maturity basis. These yields are calculated in different manners. The bond equivalent yield of a T-bill is always higher than its discount yield.
Prices
T-bills are quoted on a discounted yield basis, not as a percentage of their par value. The yield represents the percentage discount from the face value of the security. The dynamic of the bid and asked quotation of T-bills is a distinguishing characteristic when comparing them to other government securities. Since the bid's higher yield represents a larger discount (a lower price), the bid will appear to be greater than the asked. For example, consider the sample quotations found in the newspaper and refer to the Tbills that mature on February 20, 20XX Although the bid (1.12 discount yield) is numerically higher than the asked (1.11 discount yield), remember, its higher yield actually represents a lower price. Along with the bid and asked quotation, the column titled ask yld signifies the bond or coupon equivalent yield. The bond equivalent yield allows investors to compare the yields available on T-bills with the yields available on notes, bonds, and other interest-bearing securities. The bond equivalent yield takes into account the fact that the interest being earned is on the amount invested, not on the face amount. For example, if a 26-week Treasury bill has a face value of $10,000 and is purchased at $9,800, the $200 of interest is earned on $9,800, not $10,000. As a result, a T-bill's bond equivalent yield is always greater than its discount yield.
Federal Home Loan Banks (FHLBs)
The 12 Federal Home Loan Banks help to provide liquidity for the savings and loan institutions that may need extra funds to meet seasonal demands for money. The two types of securities that they issue are discount notes and consolidated bonds. Discount notes have maturities of one year or less, while consolidated bonds have maturities that range from one to 30 years. The securities that are issued by FHLBs are not backed by the U.S. government; however, the Treasury is allowed to buy up to $4 billion of FHLB issues. As with FFCB debt, interest received on these securities is subject to federal tax, but is exempt from state and local taxes. - discount notes with maturities of one year or less - consolidated bonds with maturities from one to 30 years - not backed by government, but $4 billion is backed by the treasury - taxed at federal level
Federal Farm Credit Banks (FFCBs)
The Federal Farm Credit Banks provide funds for three separate entities—Banks for Cooperatives, Intermediate Credit Banks, and Federal Land Banks. These organizations make agricultural loans to farmers. The Federal Farm Credit Consolidated Systemwide Banks issue short-term discount notes and interest-bearing bonds with both short and long maturities. Interest received on these obligations is subject to federal tax, but is exempt from state and local taxes. - discount notes and interest-bearing bonds are offered at both short and long-term maturities - interest is subject to federal tax but not state and local tax
Federal National Mortgage Association (FNMA)
The Federal National Mortgage Association, or Fannie Mae, raises money to buy insured Federal Housing Administration (FHA), Veterans Administration (VA), and conventional residential mortgages from lenders such as banks and savings and loan associations. Rather than being backed by the U.S. government, FNMA issues are backed by its authority to borrow from the Treasury. Interest earned on FNMA securities is subject to federal, state, and local taxes (i.e., it's fully taxable). - raises money to buy FHA, VA, and conventional residential mortgages from lenders such as banks and saving institutions - not backed by US GOV, but Fannie has the authority to borrow from the treasury - fully taxable
PSA Model*
The Public Securities Association (PSA), an association of securities firms (now SIFMA), created the PSA Model to estimate the prepayment rate for mortgage-backed securities as measured against a benchmark. If a CMO is assigned a PSA number that is: Equal to 100—the assumption is that the prepayment speed will remain stable Greater than 100—the assumption is that the prepayment speed will be faster than normal Less than 100—the assumption is that the prepayment speed will be slower than normal If interest rates decline, homeowners often refinance which increases the prepayment of mortgages; however, if interest rates increase, there will be a decline in the prepayment of mortgages.
Student Loan Marketing Association (SLMA)
The Student Loan Marketing Association, or Sallie Mae, provides liquidity to student loan makers as well as financing for state student loan agencies. Sallie Mae is authorized to deal in student loans that are both insured in the federal Guaranteed Student Loan Program (GSLP) and those that are uninsured. Sallie Mae is also able to lend funds directly to educational institutions. Although originally created as a GSE, Sallie Mae is now a private company without government backing and its stock is listed on Nasdaq. Interest earned on Sallie Mae securities is subject to federal tax, but whether state and local taxation applies is determined by the state. -private company listed on Nasdaq - subject to federal tax and state and local tax may apply depending on each state
Federal Reserve Auctions*
The government sells Treasuries through auctions that are conducted by Treasury Direct. Weekly auctions are currently conducted for the three- and six-month T-bills every Monday and for the four-week T-bills every Tuesday The auctions for the 12-month T-bills are held on a monthly basis. All T-bills are issued on the Thursday following the auction. Many investment professionals pay close attention to these weekly auctions for changes in T-bill yields in order to anticipate trends in interest rates. Variable-rate mortgages and floating-rate bonds are often tied to T-bill rates. Two- and five-year T-notes are sold monthly, while 10-year T-notes are sold quarterly (usually February, May, August, and November). T-bonds are generally issued four times per year.
Average Life*
The maturities of CMOs are difficult to measure because of the likelihood that prepayment rates will fluctuate. One common way of estimating the maturity of CMOs is by determining their average life. The average life method compares CMOs to other types of fixed-income securities and essentially provides an average maturity for each tranche. Using a specific prepayment speed assumption, it represents the average amount of time that each dollar of principal that's invested in the bonds is expected to be outstanding. A change in prepayment speeds will ultimately have an impact on the average life.
Pass-Through Certificates
The most common security issued by government agencies is a mortgage-backed pass-through certificate. The simplest method of creating a pass-through certificate is for an agency to purchase a pool of mortgages that contains mortgages with similar interest rates and maturities. Interests in the pool are then sold to investors as pass-through certificates. Each certificate represents an undivided interest in the pool and the owners are entitled to share in the cash flow that's generated by the pool. On a monthly basis, the homeowners in the pool make their mortgage payments and, after certain administrative charges are deducted, the bulk of these payments are passed through to investors every month. Each payment includes a portion of both interest and principal. Pass-through certificates are fully negotiable, which means that investors may sell them to other investors in the secondary market
Federal Home Loan Mortgage Corporation (FHLMC) (Freddy)
The purpose of the Federal Home Loan Mortgage Corporation, or Freddie Mac, is to provide liquidity to federally insured savings institutions that are in need of extra funds to finance new housing. Essentially, Freddie Mac will purchase residential mortgages from the savings institutions. This typically occurs when credit is tight. Freddie Mac raises money for its operations by issuing mortgage-backed bonds, pass-through certificates, and guaranteed mortgage-backed certificates. These securities are not backed by the U.S. government; instead, they're backed by other agencies and the mortgages that are purchased by Freddie Mac. Interest earned on Freddie Mac securities is subject to federal, state, and local tax (i.e., it's fully taxable). - Freddy provides liquidity to federally insured saving institutions that are in need of extra funds to finance housing - purchases residential mortgages from the saving institutions when credit is tight - not backed by government - fully taxable
Summary
This chapter examines the debt instruments which are issued by the U.S. Treasury and the other federal government entities that have the ability to issue or guarantee securities. The primary attribute of these securities is safety since most possess little or no default risk. Investors who purchase these issues are willing to accept relatively modest yields in return for the peace of mind of knowing that the issuers are of such high quality
Non-Interest-Bearing Securities
This next section will describe various forms of Treasuries that are non-interest-bearing. These securities are issued at a discount and mature at face value.
Investor Profile*
Treasury and agency securities are typically appropriate investment choices for risk-averse investors. Although the returns on these issues are relatively modest, an investor can feel somewhat content knowing that all of her principal will be returned since default risk is virtually nonexistent. Keep in mind that Treasury and agency securities are still subject to interest-rate risk. To summarize, if investors have: A capital preservation goal—they may opt for the shorter maturity instruments since interest-rate risk is lessened on these issues Inflation concerns—they may want to consider TIPS A desire to obtain monthly income and are willing to accept slightly greater risk—they may consider either pass-through certificates or CMOs (provided they understand the complexities of these products)
An article in The Wall Street Journal states that yields on Treasury bills have declined in the past month to 4.58% from 4.61%. This indicates that:
Treasury bills are purchased at a discount from the dollar amount on its face. The larger the discount, the higher the discounted yield to maturity. In this example, the discounted yield to maturity has gone down to 4.58% from 4.61% from the previous month. This indicates that buyers of new bills paid more for the Treasury bills (meaning the discount was less) than buyers paid the previous month.
Treasury Bills (T-Bills)
Treasury bills are short-term securities that mature in one year or less. Currently, an investor may purchase T-bills with maturities of one month (4 weeks), three months (13 weeks), six months (26 weeks), and one year (52 weeks). T-bills are only issued in book-entry form and are sold in minimum denominations of $100, with subsequent multiples of $100. T-bills are always sold at a discount from their face value and, unlike Treasury bonds and notes, T-bills don't make semiannual interest payments. The difference between a T-bill's purchase price and its face value at maturity represents the investor's interest. Consequently, T-bills are referred to as discount securities or non-interest-bearing securities.
Treasury Notes (T-Notes) and Treasury Bonds (T-Bonds)
Treasury notes and Treasury bonds are interest-bearing securities and have all of the attributes of traditional fixed-income investments. Each pays a fixed rate of interest semiannually and investors receive the face value at maturity. Treasury notes have initial maturities that range from two to 10 years, while Treasury bonds are issued with maturities of more than 10 years. T-notes and T-bonds are both sold in minimum denominations of $100; however, most examples in this manual will use a par value of $1,000.
The Primary Market for U.S. Treasury Securities
U.S. government securities are exempt from registration under state and federal securities laws and government issuers are not subject to the SEC's filing requirements.
A customer purchased a government security, and later discovered that it was nonnegotiable. This security could have been:
U.S. savings bonds, which include EE, HH, and I bonds, are nonnegotiable. This means purchasers may not resell them to other investors in the secondary market. They can only be redeemed.
Types of Treasury Securities
United States government securities include both the direct debt obligations of the federal government (Treasuries) and securities issued by agencies of the U.S. government. Treasury securities are considered the safest type of fixed-income investment and are suitable for the most conservative investors. Since the securities are backed by the full faith and credit of the U.S. government, they have virtually no credit risk. Consequently, they're the benchmark against which the credit ratings of all other issuers are measured. The U.S. government issues securities in order to finance its operations. The securities may be divided into two major groups—non-marketable (non-negotiable), which includes savings bonds and marketable (negotiable), which includes Treasuries. Savings bonds are considered non-negotiable because they cannot be sold in the secondary market; instead, they may be redeemed only by the U.S. government. Marketable securities are negotiable because investors are able to sell their securities to other investors after they're issued. Of the two groups, Treasuries are much more important since they may be freely transferred after they're issued. Negotiable instruments include the following: Treasury bills Treasury notes Treasury bonds Treasury Separate Trading of Registered Interest and Principal Securities (T-STRIPS) Treasury Inflation-Protected Securities (TIPS) Treasury Cash Management Bills (CMBs) From this point on, when the word Treasuries is used, it will refer to marketable/negotiable securities only. The three most prevalent types of these marketable issues are T-bills, T-notes, and T-bonds. Let's begin our discussion with the interest-bearing Treasury securities and move on to other instruments that are non-interest-bearing.
Government National Mortgage Association (GNMA) (Modified Pass Through Certificate)*
Unlike FHLMC and FNMA, the Government National Mortgage Association, or Ginnie Mae, is a wholly-owned corporation that operates within the U.S. Department of Housing and Urban Development. Ginnie Mae's purpose is to provide financing for residential housing. Although Ginnie Mae securities are explicitly backed by the full faith and credit of the U.S. government, any interest earned on them is subject to federal, state, and local taxes. GNMA issues mortgage-backed securities and participation certificates, but its most popular securities are modified pass-through certificates. A modified pass-through certificate is backed by a pool of FHA and/or VA residential mortgages. As the homeowners in the pool make their mortgage payments (consisting of principal and interest), a portion of those payments is passed through to the investors who purchased the certificates from GNMA. GNMA guarantees monthly payments to the owners of the certificates, even if it's not been collected from the homeowners. The mortgages in the pool have maturities that range from 25 to 30 years. However, due to prepayments, foreclosures, and refinancings, the average life of the pool tends to be anywhere from 12 to 14 years, or even shorter during periods of declining interest rates. - although backed by the government, they are fully taxable - offer modified pass throughs which are made up of FHA and VAs - guarantees monthly payments to owners of certificates even if payment has not been collected from homeowners
Competitive versus Non-competitive Tenders
When Treasury auctions are held, securities firms compete with each other by submitting their bids to buy Treasuries through an automated system. These bids are called competitive tenders since they specify the price and/or yield at which the firm is willing to buy the Treasuries. If an individual wants to purchase Treasuries, she usually submits a noncompetitive tender. Non-competitive bids are filled first; however, the bidders must agree to accept the yield and price as determined by the auction. Non-competitive bidders agree to pay the lowest price of the accepted competitive tenders. Although all noncompetitive tenders are accepted (awarded) first, the yield that the investors will receive is determined after the competitive tenders are accepted. Therefore, all purchasers of Treasury securities through this auction process will pay the same price. This single price auction process is referred to as a Dutch auction.
Z-Tranches
Z-tranches, or Z-bonds, are deferred-interest bonds that have the longest average life of any tranche. During the initial phase of a Z-tranche's life, the bond provides no cash flow. Instead, similar to a zero-coupon bond, interest will compound. Only after all of the other tranches have been retired will interest and principal payments be made to the Z-tranche. Because they're last to be paid, Ztranches have more price volatility than the other tranches.
The bond with the most interest-rate risk or price volatility is the bond with
the longest maturity and the lowest coupon. This price sensitivity is based on the concept of duration. The first step is to identify the bond or bonds that have the longest maturity. In this question, there are two bonds with 30-year maturities, which eliminates the possibility of the three-month and five-year bonds as the answer. The second step is to find the long-term bond that offers the lowest coupon rate. Since a T-STRIP is a form of zero-coupon bond, it clearly has more interest-rate risk than another long-term bond that offers a 6% coupon. Remember, the greatest price sensitivity based on interest rate fluctuation is a long-term bond with a low coupon.