Suitability

Benefits

The primary benefit from Treasury securities is interest income, like all other debt securities. Some Treasury securities pay consistent semi-annual interest (Notes, Bonds, and TIPS), while some only pay interest at maturity (Bills, STRIPS, and T-Receipts).

Agency securities also provide income to their investors, sometimes on a more consistent basis. As we discussed, mortgage-backed securities typically pay monthly income to investors. For investors in need of more frequent interest payments, pass through certificates, collateralized mortgage obligations (CMOs), or mutual funds investing in these agency products can be good solutions.

US Government and agency securities are generally safe from default risk as they’re all directly or indirectly backed. In most cases, these securities are AAA or AA-rated. Also, liquidity risk is virtually non-existent with US Government securities. The market for US Government securities is the largest in the world and is subject to global demand. If an investor needs to sell something like a Treasury bond, they can easily find a buyer.

Risks

Other than default and liquidity risk, most of the other “normal” bond risks apply, including interest rate risk, inflation (purchasing power) risk, and reinvestment risk.

The longer the maturity, the more subject to interest rate risk and inflation risk. Of course, TIPS are not subject to inflation risk. Other long-term securities are very subject to these risks. As we learned in the bond volatility section, long-term, low coupon bonds are very susceptible to interest rate risk. Therefore, STRIPS and Treasury Receipts fall significantly in price when interest rates rise. Inflation and interest rates are very closely tied together. As you learned on the SIE exam, the Federal Reserve works to raise interest rates when inflation rates rise more than expected.

The higher the coupon and more frequent interest payments, the more reinvestment risk applies. When interest rates fall, interest payments begin to be reinvested at lower rates of return. Zero coupon securities like Treasury bills, STRIPS, and [Treasury Receipts avoid reinvestment risk (there’s no interest to reinvest), but the other debt securities discussed in this chapter do not. Mortgage-backed securities are particularly subject to reinvestment risk due to their monthly payments. The more payments to reinvest, the more reinvestment risk.

Typical investor

The typical investor in US Government securities are safer, older, income-seeking investors. There is no security with lower levels of default (credit) risk, as the chance of default is virtually non-existent. Federal debt levels are high, but the government prints its own money. The chances of the Treasury being unable to make required interest and/or principal payments is very low. US Government securities have lower yields due to their lower levels of risk. This is a tradeoff, but it’s the right investment for conservative (low-risk) investors.

Treasury bills and CMBs are most suitable for investors looking to park cash in a safe, short-term investment. They don’t pay ongoing income, but with maturities as short as a month for T-bills and as short as a day for CMBs, investors receive their money back quickly.

Treasury notes and bonds are suitable for investors seeking ongoing income for longer periods of time. Investors in longer-term Treasury products must be comfortable with additional risks (like interest rate and inflation risk).

STRIPS and Treasury Receipts are long-term zero coupon securities that are not suitable for investors seeking income. These are great investments for those seeking a payout in the future, but don’t need income along the way. Many investors seek these out for retirement plans when income isn’t needed for a long period of time. Additionally, the retirement plan shields them from phantom tax. Additionally, young parents utilize these securities to save for their young or unborn child’s education (usually college).

Mortgage-backed securities are suitable for safer investors seeking consistent income. These securities pay monthly income and are typically AAA (or highly) rated.