US government securities

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% 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.

Bills, Notes, and Bonds

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:

• One month (4 weeks)
• Two months (8 weeks)
• Three months (13 weeks)
• Four months (17 weeks)
• Six months (26 weeks)
• One year (52 weeks)

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.

Sidenote

CMBs

Cash management bills (CMBs) are very similar to Treasury bills. They are issued at a discount, are zero coupon, and mature at par. The Treasury issues CMBs to close short term funding gaps if spending rises unexpectedly, leading them to be issued on an “as needed” basis (issuance is not formally scheduled). The maturities of CMBs can vary depending on need, and can be as short as one day.

Because CMBs are only issued in times of need, they often are not a large topic of discussion in the world of US government securities. Regardless, you could see them mentioned on the exam.

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.

STRIPS and Receipts

You don’t need to know this for the exam, but STRIPS stand 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 a 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 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 get their tax money sooner rather than later!

We first discussed price volatility in the fixed income basics chapter. 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.

TIPS

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 very 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, 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 better understand TIPS, let’s discuss a specific example:

30-year TIPS issued

• $1,000 par
• 3% fixed coupon
• Semi-annual interest payments = $15

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)

• $1,020 adjusted par value
• 3% fixed coupon
• Semi-annual interest payment = $15.30

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?

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

• $1,000 par
• 3% fixed coupon
• Semi-annual interest payments = $15

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?

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.

Sidenote

Callable Treasuries

Starting in 1985, the US Treasury no longer issued callable securities. Before then, some 30 year Treasury bonds used to be callable. All of those bonds have since been redeemed, so it’s safe to assume all US Treasury securities today are non-callable.

Mortgage agency securities

Three federal agencies exist to incentivize homeownership for Americans. We’ll discuss each of them in this section.

Ginnie Mae, officially known as the Government National Mortgage Association (GNMA) only purchases VA (Veterans Affairs), FHA (Federal Housing Administration), and USDA Rural Development insured loans. These are loans that are insured by another part of the federal government and are only available to specific types of homeowners (e.g. veterans and low-income householders).

Due to the minimal risk involved, the US Government directly backs Ginnie Mae securities, making them virtually default-risk-free like Treasury securities. As we’ll discuss below, this is unlike all other agencies that only have indirect backing.

Fannie Mae, officially known as the Federal National Mortgage Association (FNMA), purchases insured (VA and FHA) and conventional (non-insured) mortgages. Freddie Mac, officially known as the Federal Home Loan Mortgage Corporation (FHLMC), only purchases conventional mortgages.

With a significant amount of non-insured mortgages handled by these two agencies, Fannie Mae and Freddie Mac both are considered riskier than Ginnie Mae and only have indirect backing from the US Government. Additionally, both are publicly traded companies. Although they were started by the US Government, they are technically owned by their stockholders.

These agencies typically purchase mortgages from lenders with capital raised by investors. By doing so, lenders are flooded with cash they can then lend out to new home purchasers. The agencies then begin to collect mortgage payments from the purchased mortgages and subsequently pass through the income to investors. Similar to how mortgages are paid off, mortgage agency securities typically make monthly payments to investors representing principal and interest.

The securities purchased by investors are known as mortgage-backed securities (MBS). Retail investors tend to gain access to these securities through mutual funds, which we’ll learn about in a future section.

MBSs are subject to two unique risks, which are prepayment and extension risk. When an investor purchases a normal, non-mortgage related bond, they know how long their bond will last. If the bond has a 20-year maturity, they know the bond cannot last more than 20 years.

When an investor purchases an MBS, they will not know the exact maturity. While the majority of mortgages are 30-year mortgages, most mortgages do not last 30 years. Many homeowners pay off their mortgages early, refinance their mortgages, or sell their homes and pay off their mortgages. In each of these circumstances, the mortgage comes to an end when the homeowner pays back the principal of the loan.

If you were to invest in an MBS, you won’t know how long your investment will last. If interest rates fall, you can expect many homeowners to refinance and get rid of their old mortgages. In this type of environment, your investment will likely end sooner than expected. You wouldn’t be too happy about it, either. Your MBS had a higher yield than what the current market offers (lower interest rates), but your investment is ending earlier than expected. This is prepayment risk.

It can also go the other way if interest rates rise. When this occurs, homeowners generally keep their mortgages longer and avoid refinancing. Therefore, your mortgage-backed security has a lower yield than what the current market offers (higher interest rates), and your investment will last longer with fewer people paying off their mortgages. This is extension risk.

US Government auction & quotes

After US Government debt is sold at Treasury auctions, those securities trade exclusively in the over-the-counter (OTC) markets. An OTC trade is one that does not take place on a physical exchange like the New York Stock Exchange.

Similar to how corporate bonds are quoted, US Government debt is quoted in percentage of par format. However, instead of eighths, US Government securities are quoted in 32nds. Government bonds are quoted in 32nds because the market is larger and has more price changes. When a bond can be quoted in 32nds, there are more possible prices the bond can trade at.

US Government debt quotes will look different, but the process of converting them to a price is the same as with corporate bonds.

An investor finds three separate quotes for the same bond:

• 95-8
• 95:8
• 95.8

US Government quotes can be presented with a dash, colon or period. Although you don’t see a fraction above, the quote translates to a bond price of 95 and $\frac{\text{8}}{\text{32}}$ percent of par. The number on the right side of the quote (after the dash, colon, or period) is always assumed to be in 32nds. Unlike corporate bonds, there is no reduction of the fraction.

If you utilize the same “fraction-boot-scoot” method we used with corporate bonds, you can convert the quote to a price. The only difference is how the fraction is presented. Let’s look at a few examples.

A US Government bond is quoted at 95-8. What is its price?

Step 1: calculate the fraction

• $\frac{\text{8}}{\text{32}}$ = 0.25

Step 2: boot the decimal back to the big number

• 95 + 0.25 = 95.25

Step 3: scoot the decimal once over to the right

• $952.50

Think you can do it on your own? Give it a try!

A US Government bond is quoted at 103:20. What is its price?

As you can see, the process is very similar to the way we approach corporate bond quotes. Yes, the quotes look and feel different, but the method is the same. Both corporate and US Government securities are quoted in percentage of par format.

Treasury bill quotes are an exception to this process. Due to their short-term zero coupon nature, they are quoted in “discount yield” form. Treasury bill quotes are provided in yield form, reflective of the rate of return the bill provides.

For example, a Treasury bill quote might look like 3.2%. Instead of providing an actual price, the investor knows that they will achieve an overall return (yield) of 3.2% based on the discount of the bond. Remember, Treasury bills are bought at discounts, mature at par, and do not have a coupon.

Key points

US Government

• Largest and most active securities issuer in the world
• Primarily funds activities through deficit spending

US Government debt denominations

• Minimum of $100

Treasury bills

• Short-term zero coupon debt
• Issued at discounts and mature at par
• Available maturities:
  • One month (4 weeks)
  • Two months (8 weeks)
  • Three months (13 weeks)
  • Four months (17 weeks)
  • Six months (26 weeks)
  • One year (52 weeks)

Cash management bills (CMBs)

• Short-term, zero coupon treasury securities
• Issued to close short-term funding gaps
• Maturities as short as one day

Treasury notes

• 2-10 year maturities
• Pay interest semi-annually

Treasury bonds

• Up to 30-year maturities
• Pay interest semi-annually

STRIPS

• Issued by US Government
• Long-term zero coupon bonds

Treasury Receipts

• Issued by financial institutions
• Long-term zero coupon bonds

STRIPS and Treasury Receipts

• Not suitable for investors seeking income
• Subject to phantom taxes
• High price volatility
• Very susceptible to interest rate risk

Treasury Inflation Protected Securities (TIPS)

• Inflation-adjusting debt securities
• Principal (par) value adjusts to CPI
• Coupon stays fixed
• Issued in 5, 10, and 30-year maturities
• Investor receives greater of original par or adjusted par at maturity

Mortgage agencies

• Issue mortgage-backed securities
• Buy mortgages from financial institutions

Mortgage-backed securities

• Make monthly payments of interest and principal
• Subject to prepayment and extension risk

Prepayment risk

• Occurs when interest rates fall
• Homeowners pay off mortgages earlier than expected

Extension risk

• Occurs when interest rates rise
• Homeowners pay off mortgages later than expected

US Government debt market

• Treasury auctions new issues
• Traded in OTC markets after issuance

US Government debt quotes

• Percentage of par quotes (generally)
• Quoted in 32nds using a:
  • Dash
  • Colon
  • Period

Treasury bill quotes

• Discount yield form