The U.S. Department of Treasury manages the finances of the U.S. government. The Treasury prints money, collects taxes through the IRS, and issues securities to fund federal projects and spending. The U.S. government often runs a budget deficit (it spends more than it collects in taxes). That ongoing need to borrow is a major reason the U.S. government debt market is so large.
Treasury products also have a unique minimum denomination. While many debt securities have a minimum investment of $1,000, Treasuries generally have a minimum denomination of $100.
There are five U.S. Treasury products primarily used to finance the federal government. They range from short to long maturities and come with different features and risks:
Treasury bills are short-term, zero coupon debt issued by the Treasury. They’re the most commonly offered Treasury security. T-bills can be issued weekly (depending on funding needs), while the Treasury auctions other products monthly or quarterly.
The U.S. government offers Treasury bills in these maturities:
Treasury bills are typically issued at a slight discount. Because they’re short-term, they don’t pay semi-annual interest like most other bonds. Instead, the investor’s interest is the difference between the purchase price and the par value paid at maturity.
For example, an investor buys a one-year Treasury bill for $970. One year later, the U.S. government pays $1,000 (par), so the investor earns $30 of interest.
Treasury notes are interest-paying, intermediate-term U.S. government bonds. Like most other Treasury products (except Treasury bills), they’re usually issued monthly. Treasury notes are typically issued at par*, pay semi-annual interest, and mature within 2-10 years of issuance.
*Treasury notes can be issued at a discount or premium depending on how the U.S. Treasury structures the offering.
Treasury bonds are interest-paying, long-term U.S. government bonds. Like Treasury notes, they’re usually issued monthly. Treasury bonds are typically issued at par*, pay semi-annual interest, and mature within 30 years of issuance.
*Like Treasury notes, Treasury bonds can be issued at a discount or premium depending on how the U.S. Treasury structures the offering.
You don’t need to memorize the acronym for the exam, but STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. In practical terms, STRIPS are long-term (up to 30 years), zero coupon bonds issued by the U.S. government. They’re issued at deep discounts and mature at par.
For example, assume 30-year STRIPS are offered for $400. You buy the security, hold it for 30 years, and then receive $1,000 at maturity. Your total return over 30 years is $600, which is equivalent to $20 per year in interest ($600 / 30 years).
STRIPS (and any zero coupon bond) aren’t suitable for investors seeking current income. With a traditional coupon bond, you can receive semi-annual interest payments. With STRIPS, all the interest is effectively paid at maturity, which may be decades after purchase.
A related product is similar to STRIPS, but it isn’t a direct obligation of the U.S. government. Treasury Receipts are created by financial institutions such as banks and investment firms. Like STRIPS, Treasury receipts are long-term, zero coupon bonds. To create them, institutions buy Treasury notes and Treasury bonds, place them into a portfolio, strip the coupons, and then resell the pieces as zero coupon bonds.
You don’t need to know the mechanics of creating a Treasury receipt. The key point is that they resemble STRIPS but have a different issuer. Also remember that Treasury receipts don’t have the same default risk-free status as U.S. government securities because they’re created by private financial institutions (which can go bankrupt).
STRIPS and Treasury receipts are subject to annual taxation even though investors don’t receive cash interest until maturity. This is called phantom tax. If you buy 30-year STRIPS at $400, you’ll receive a tax bill each year for $20 of interest ($600 discount / 30 years = $20 annualized interest). The IRS taxes the interest as it accrues, not when you receive the cash.
We first discussed price volatility in the bond fundamentals chapter. Bonds with long maturities and low coupons tend to move the most when interest rates change. STRIPS and Treasury receipts are especially volatile because they combine both features: long maturities (up to 30 years) and low coupons (0%). Investors should understand this potential price volatility before investing.
To be clear, even though STRIPS and Treasury receipts have a 0% coupon, they’re still highly exposed to interest rate risk. Interest rate risk measures how much a bond’s market price can fall when interest rates rise. A bond doesn’t need to pay ongoing interest to have interest rate risk.
In the bond fundamentals chapter, we covered the risks of inflation. Fixed income securities (preferred stock and bonds) are especially vulnerable to inflation because their payments are often fixed.
For example, a $1,000 par bond with a 5% coupon pays $50 per year in interest. $50 might buy a reasonable amount today, but if inflation stays high, that same $50 may buy much less in the future.
Now scale that up. Suppose a retired investor builds a bond portfolio that generates $50,000 per year in interest to cover living expenses. If inflation averages 3% per year, about 20 years later they’ll need roughly $90,000 per year to maintain the same purchasing power. But if the investor bought 20-year fixed-rate bonds, the portfolio still pays the same $50,000 each year. That gap is the problem inflation creates for fixed payments.
One way to address inflation is to keep part of a portfolio in stocks, which tend to outpace inflation over long periods. If the stock market is too risky for the investor, another option is TIPS.
Treasury Inflation Protected Securities (TIPS) are long-term (up to 30 years) U.S. government debt securities that pay semi-annual interest. Unlike standard Treasury bonds, TIPS are designed to increase payments when inflation rises. A concrete example makes this easier to see.
30-year TIPS issued
TIPS are typically issued at par with a fixed coupon. In this example, the 30-year TIPS has a 3% coupon, and that coupon rate stays fixed. Initially, the bond pays $15 twice per year ($30 annually).
What changes is the principal (par) value. The principal is adjusted every six months based on Consumer Price Index (CPI) levels. CPI is the government’s measure of inflation, published by the U.S. Bureau of Labor Statistics. Each month, it tracks price changes for goods and services across the United States.
When inflation rises, TIPS pay more interest because the adjusted principal is higher. For example, here’s what happens if CPI rises by 2% over six months.
30 year TIPS adjustment (+2% CPI)
The semi-annual interest payment increases because the principal increased. The coupon rate (3%) stays the same, but it’s applied to a larger principal amount.
This adjustment continues throughout the life of the TIPS. TIPS are issued in 5-, 10-, and 30-year maturities, so over long periods the adjusted par value can become much larger than the original par.
At maturity, the investor receives the greater of:
That feature benefits the investor because if inflation has risen over time, the maturity payout can be higher.
The exam usually tests the core ideas rather than detailed calculations. Make sure you know these key points about TIPS:
Here’s a quick visual summary of the Treasury products we just discussed:
| Security | Maturity | Interest paid |
|---|---|---|
| Treasury bill | 1 year or less | At maturity |
| Treasury note | 2 - 10 years | Semi-annually |
| Treasury bond | Up to 30 years | Semi-annually |
| STRIPS | Up to 30 years | At maturity |
| TIPS | Up to 30 years | Semi-annually |
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