The US Government is the largest and most active issuer of securities in the world. With debt levels currently more than $33 trillion, the US Government securities market is massive. Investors around the world fund the activities of our federal government.
Our federal government raises significant sums of capital to fund its various activities. The top recipients of federal spending are Social Security, Medicare/Medicaid (health-related spending) and Defense (military, National Guard, etc.). The federal government also spends massive amounts of money on veterans’ benefits, education, housing assistance, and transportation-related costs.
Deficit spending (borrowing more money than it brings in) has been the government’s funding method since 2001, which was the last point in time there was a federal surplus. Although the federal government has been deficit spending for nearly 20 years, it does bring in a large amount of money through taxes and other revenues. Income taxes and payroll taxes brought in roughly 83% percent of federal revenues in 2019. Other forms of revenue include excise taxes, estate taxes, gift taxes, and taxes on imports and exports (tariffs).
In this chapter, we’ll learn about the specific securities the US Government issues, how they influence the economy, and suitability for their products.
The US Department of Treasury is responsible for running the finances of the US Government. The Treasury prints money, collects taxes through the IRS, and issues securities to pay for federal projects and expenditures.
Technically, the US Mint creates coins, while the Treasury’s Bureau of Engraving and Printing creates paper bills. The Federal Reserve creates digital currency and distributes all forms of currency (coins, bills, and digital).
There are several products the US Treasury issues to finance the federal government. They range from short to long-term in maturity and have different risks and features. One common theme Treasury products share is their minimum denominations. While most bonds have a minimum investment amount of $1,000, Treasuries have a minimum denomination of $100.
Treasury bills are a form of short-term, zero coupon debt issued by the Treasury. They are the most commonly sold Treasury security, as they can be auctioned as often as weekly (many other Treasury products are auctioned on monthly or quarterly cycles).
The US Government offers Treasury bills in these maturities:
When Treasury bills are sold, they are sold at slight discounts. Due to their short-term nature, Treasury bills do not pay semi-annual interest like most other bonds. Instead, interest is received at maturity. For example, an investor purchases a one-year Treasury bill for $970. One year later, the US Government pays them $1,000 (par), netting $30 in interest.
Treasury notes are interest-paying, intermediate-term US Government bonds typically issued monthly. Treasury notes are typically sold at par, pay semi-annual interest, and mature within 2-10 years of issuance. Although lightly tested, Treasury notes are generally offered in 2-year, 3-year, 5-year, 7-year, and 10-year intervals.
Treasury bonds are interest-paying, long-term US Government bonds typically issued on a quarterly basis. Treasury bonds are sold at par, pay semi-annual interest, and mature within 30 years of issuance. Although lightly tested, Treasury bonds are generally offered in 20-year and 30-year intervals.
You don’t need to know this for the exam, but STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. That’s a fancy way of saying STRIPS are long-term, zero coupon bonds issued by the US Government. They are issued at deep discounts, then mature at par several years later.
STRIPS, as well as any zero coupon bond, are not suitable for investors seeking income. Normally, an investor could purchase a set of bonds and live off the semi-annual income. This won’t occur with STRIPS, which only pay interest at maturity (which could be up to 30 years later).
Assume you find 20-year STRIPS selling for $600. You purchase the STRIPS today for $600, hold the investment for 20 years, then receive $1,000 at maturity. Your return over 20 years would be $400, or the equivalent of $20 a year in interest.
There’s another security that’s very similar to STRIPS, but they’re not securities of the US government. Treasury Receipts are created by financial institutions like banks and investment firms. Just like STRIPS, Treasury Receipts are long-term, zero-coupon bonds. To create Treasury Receipts, financial institutions purchase sets of Treasury Notes and Treasury Bonds, place them into a portfolio, strip them of their coupons, and re-sell them as zero-coupon bonds.
You won’t need to know the logistics of creating a Treasury Receipt. It’s most important to know they’re very similar to STRIPS, but have slightly different backing. Treasury Receipts are created without government oversight (in particular, Federal Reserve oversight), which means they do not have the direct backing of the US Government. While the securities used to create Treasury Receipts (T-notes and T-bonds) are fully backed, the new product created with the manipulated Treasury securities is not backed. STRIPS are not technically issued by the US Government (securities dealers issue them), but the Federal Reserve oversees their creation, which gives them the same backing as other Treasury securities like Treasury bills, notes, and bonds.
If the previous paragraph was confusing, it’s because the system in place is confusing. The big point to remember is STRIPS are fully backed by the US Government, while Treasury Receipts are not. Of course, this could factor into safety and yield. STRIPS are slightly safer and trade with lower yields, while Treasury Receipts are slightly riskier and trade with higher yields.
Both STRIPS and Treasury Receipts are subject to annual taxation, even though investors won’t receive interest until maturity. This is sometimes referred to as “phantom tax.” If you purchase 20-year STRIPS at $600, you’ll receive a tax bill for $20 of interest annually ($400 discount / 20 years = $20 annualized interest). The IRS prefers to get their tax money sooner rather than later!
We first discussed price volatility in earlier in this material. If you recall, the market price of bonds with long maturities and low coupons move the fastest when interest rates change. STRIPS and Treasury Receipts have very volatile market price movements because they meet both characteristics: long-term (up to 30 years) and low coupon (0%). Investors should be aware of the potential price volatility prior to investing in these types of securities.
To be clear, even though STRIPS and Treasury Receipts have a 0% interest rate, they are very subject to interest rate risk. A bond does not need to pay ongoing interest to be subject to interest rate risk.
In the common stock suitability chapter, we learned how these securities hedge against the risks of inflation. While common stock tends to protect investors from purchasing power risk, fixed income securities (preferred stock and bonds) are particularly susceptible to inflation. Think about it - if you owned a $1,000 par, 5% bond, it would pay you $50 a year in interest. While $50 can buy a fair amount of small items today, it’s possible $50 wouldn’t buy an average sandwich from a deli in 20 years if high levels of inflation occurred.
Now, let’s think in bigger numbers. Assume a retired investor buys a large amount of bonds and currently receives $50,000 in annual interest. They need this amount of money in 2020 to pay for living expenses. At an annual inflation rate of 3%, 20 years later they’ll require roughly $90,000 of annual income to keep pace with inflation. If the investor bought a bunch of 20-year fixed-interest rate bonds, their bonds pay the same $50,000 of fixed interest annually. This is a problem for bond investors!
To keep pace with inflation, investors can keep a portion of their portfolio invested in the stock market, which tends to outpace inflation over long periods of time. If the stock market is too risky for the investor, investors can consider investing in TIPS.
Treasury Inflation Protected Securities (TIPS) are long-term debt securities issued by the US Government that pay semi-annual interest to investors. Unlike securities like Treasury bonds, TIPS make higher payments when inflation rates rise. To better understand TIPS, let’s discuss a specific example:
30-year TIPS issued
TIPS are typically issued at par with a fixed coupon. In our example, the 20-year TIPS have a 3% coupon, which is always fixed (doesn’t change). At issuance, these securities are set to pay $15 twice a year ($30 in annual interest). To compensate for inflation, the principal (par) value changes over time. Every six months, the TIPS make an adjustment based on Consumer Price Index (CPI) levels. As a reminder, CPI is the government’s measure of inflation as measured by the U.S. Bureau of Labor Statistics. Every month, they capture price changes of goods and services across the United States.
When CPI is rising, inflation is rising. When inflation rises, TIPS make higher interest payments. For example, let’s take a look at what happens when inflation rises by 2% in six months.
30-year TIPS adjustment (+2% CPI)
Because inflation rates increased, the bond makes a higher semi-annual interest payment. While the coupon (3%) stays fixed, the adjusted principal value results in a higher semi-annual interest payment. With the inflation rate rising by 2%, so does the par value (2% of $1,000 = $20). Now, the bond pays 3% of $1,020, which is $30.60 annually. We’re focusing on the semi-annual interest payment, which is half of that - $15.30.
Let’s see if you can tackle a slightly more difficult question related to this topic:
An investor purchases 10-year, $1,000 par TIPS with a 5% coupon. After one year of owning the security, CPI is reported at 4%. What is the investor’s interest payment at the one-year mark?
A) $24.00
B) $25.51
C) $26.01
D) $51.02
Can you figure it out?
Answer = C) $26.01
TIPS are adjusted every six months to reflect changes in CPI (inflation) rates. With an annual CPI increase of 4%, inflation is increasing by 2% every six months. Therefore, these calculations must be done:
*An easy way to calculate a percentage change to a number is by adding the percent in decimal form (2% = 0.02) to the number 1 (1 + 0.02 = 1.02). Then, multiply this by the original value to get the adjustment.
After one year, the par value is adjusted to $1,040.40. Now, we must find 5% of this adjusted par value:
Last, we must divide this annual dividend amount by two given these payments are made semi-annually:
Therefore, this bond will pay $26.01 in interest at the one-year mark.
These semi-annual adjustments to par occur over the TIPS lifetime. TIPS are issued in 5, 10, and 30-year maturities, so the adjustment process can result in large par values over long periods of time. At maturity, the investor will always receive the greater of the original par value (typically $1,000) or the adjusted par value. This is a great benefit to the investor as they’ll receive a higher payout at maturity if inflation has risen.
While inflation is much more common, deflation can and does occur. Instead of prices rising, deflation results in lower prices. This may sound good on the surface, but it’s a problem for the economy. Your grocery store bill may be falling during deflationary periods, but so does your paycheck and other forms of revenue. Plus, deflation tends to delay businesses and people from spending money, driving down economic output. If you needed to buy a car, why would you do it right now if prices are falling? Waiting may result in a much lower price tag. This may be great for you personally, but it leads to businesses having large inventories they can’t sell. See how it can be a problem?
When deflation occurs, TIPS adjust as well. Let’s assume our previous example from the start:
30-year TIPS issued
What would be the result if CPI reported a 4% annual fall in prices? Specifically, what is the adjustment to the par value and the next interest payment?
With an annual falling CPI rate of 4%, the par value adjusts after 6 months at a rate of -2% (half of the annual 4% decline) . 2% of $1,000 is $20, so the par value will fall to $980.
Now, calculate the fixed coupon (3%) based on the adjusted par value ($980). This results in a new annual rate of $29.40, leading to semi-annual interest payments of $14.70 ($29.40 / 2).
The rule regarding adjusted principal at maturity is especially useful in deflationary environments. Even if the adjusted principal is far below the original par ($1,000 in our example), the investor always receives the greater of the original par value or the adjusted principal.
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