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 large amounts 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 time there was a federal surplus. Even though the federal government has been deficit spending for nearly 20 years, it still brings in substantial revenue through taxes and other sources. Income taxes and payroll taxes brought in roughly 83% 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 managing 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).
The US Treasury issues several products to finance the federal government. These securities range from short-term to long-term maturities, and they come with different features and risks. One common feature across Treasury products is their minimum denomination. While most bonds have a minimum investment amount of $1,000, Treasuries have a minimum denomination of $100.
Treasury bills are short-term, zero coupon debt issued by the Treasury. They are the most commonly sold Treasury security, in part because 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. Because of their short-term nature, Treasury bills do not pay semi-annual interest like most other bonds. Instead, the investor earns interest through the discount and receives it at maturity.
For example, an investor purchases a one-year Treasury bill for $970. One year later, the US Government pays $1,000 (par), so the investor earns $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 stand for Separate Trading of Registered Interest and Principal of Securities. In plain terms, STRIPS are long-term, zero coupon bonds created from US Treasury securities. They are issued at deep discounts and then mature at par several years later.
STRIPS, like any zero coupon bond, are not suitable for investors seeking current income. With a traditional bond, you can receive semi-annual interest payments. With STRIPS, you don’t receive interest until 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 it’s not a security of the US government. Treasury Receipts are created by financial institutions like banks and investment firms. 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. The key point is that Treasury Receipts are very similar to STRIPS, but they have 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 from those securities is not backed.
STRIPS are not technically issued directly by the US Government (securities dealers issue them), but the Federal Reserve oversees their creation. That oversight gives STRIPS the same backing as other Treasury securities like Treasury bills, notes, and bonds.
If that distinction feels confusing, it’s because the structure is confusing. The main point to remember is that STRIPS are fully backed by the US Government, while Treasury Receipts are not. This can affect safety and yield: STRIPS are slightly safer and tend to trade with lower yields, while Treasury Receipts are slightly riskier and tend to trade with higher yields.
Both STRIPS and Treasury Receipts are subject to annual taxation, even though investors don’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 collect taxes sooner rather than later.
We first discussed price volatility in the fixed income basics chapter. Recall that bonds with long maturities and low coupons tend to move the most when interest rates change. STRIPS and Treasury Receipts can have very volatile market prices because they have both characteristics: long term (up to 30 years) and low coupon (0%). Investors should understand this potential price volatility before investing in these securities.
To be clear, even though STRIPS and Treasury Receipts have a 0% interest rate, they are still highly exposed to interest rate risk. A bond doesn’t 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.
Here’s the basic issue: if you own a $1,000 par, 5% bond, it pays $50 a year in interest. That $50 might buy a fair amount today, but after 20 years of high inflation, $50 could buy much less.
Now scale that up. 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 2026 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 20-year fixed-interest-rate bonds, those bonds still 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, they 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 see how this works, let’s walk through an 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 adjusts based on Consumer Price Index (CPI) levels. 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 because the interest payment is calculated using the adjusted principal.
For example, here’s what happens when inflation rises by 2% in six months.
30-year TIPS adjustment (+2% CPI)
Because inflation increased, the bond makes a higher semi-annual interest payment. The coupon (3%) stays fixed, but the adjusted principal value increases the dollar amount of interest.
With inflation rising by 2%, the par value rises by 2% as well (2% of $1,000 = $20). Now the bond pays 3% of $1,020, which is $30.60 annually. The semi-annual interest payment 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 valuable feature because it increases the maturity payout if inflation has risen.
While inflation is 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 can be a problem for the economy. Your grocery store bill may fall during deflationary periods, but so can your paycheck and other forms of revenue. Deflation also tends to delay spending, which can reduce economic output.
For example, if you needed to buy a car, why buy it right now if prices are falling? Waiting could mean a lower price later. That may be good for you personally, but it can leave businesses with inventory they can’t sell.
When deflation occurs, TIPS adjust as well. Let’s return to our earlier example:
30-year TIPS issued
What would happen 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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