The primary benefit of Treasury securities is interest income, like other debt securities. Some Treasury securities pay consistent semiannual interest (Notes, Bonds, and TIPS), while others pay interest only at maturity (Bills, STRIPS, and T-Receipts).
Agency securities also provide income to investors, sometimes more frequently. Mortgage-backed securities typically pay monthly income to investors. If an investor needs more frequent payments, pass through certificates, collateralized mortgage obligations (CMOs), or mutual funds investing in these agency products can be good solutions.
U.S. Government and agency securities are generally considered safe from default risk because they’re directly or indirectly backed. In most cases, these securities are AAA- or AA-rated. Liquidity risk is also virtually non-existent with U.S. Government securities. The market for U.S. Government securities is the largest in the world and is supported by global demand. If an investor needs to sell something like a Treasury bond, it’s typically easy to find a buyer.
Even though default and liquidity risk are minimal, most of the other “normal” bond risks still apply, including interest rate risk, inflation (purchasing power) risk, and reinvestment risk.
In general, the longer the maturity, the greater the exposure to interest rate risk and inflation risk. (Of course, TIPS are not subject to inflation risk.) As you saw in the bond volatility section, long-term, low-coupon bonds are very susceptible to interest rate risk. That’s why STRIPS and Treasury Receipts can fall significantly in price when interest rates rise.
Inflation and interest rates are closely related. When inflation rises more than expected, the Federal Reserve typically works to raise interest rates (a concept you may have seen on the SIE exam).
Reinvestment risk is higher when a security has a higher coupon and pays interest more frequently. If interest rates fall, the interest payments you receive may have 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.
The typical investor in U.S. Government securities is a safer, older, income-seeking investor. There is no security with lower levels of default (credit) risk, since the chance of default is virtually non-existent. Federal debt levels are high, but the government prints its own money. The chance of the Treasury being unable to make required interest and/or principal payments is very low.
Because these securities have lower risk, they generally offer lower yields. This tradeoff is often acceptable 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, so they’re not suitable for investors seeking current income. They can be a good fit for investors who want a known payout in the future but don’t need income along the way. Many investors use them in retirement plans when income isn’t needed for a long period of time. In addition, the retirement plan can shield them from phantom tax. Young parents may also use these securities to save for a 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.
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