Treasury products

The U.S. Department of Treasury is responsible for running the finances of the U.S. government. The Treasury prints money, collects taxes through the IRS, and issues securities to pay for federal projects and expenditures. You’re probably aware that our government does a lot of deficit spending, which means they spend more than they bring in through taxes. This is the primary reason the U.S. government debt market is gigantic.

Treasury products share unique minimum denominations. While most debt securities have a minimum investment amount of $1,000, Treasuries maintain a minimum denomination of $100.

There are five U.S. Treasury products primarily utilized to finance the federal government, ranging from short to long-term in maturity, with various risks and features:

• Treasury bills
• Treasury notes
• Treasury bonds
• STRIPS
• TIPS

Treasury bills

Treasury bills are a form of short-term, zero coupon debt issued by the Treasury. They are the most commonly offered Treasury security. T-bills can be issued weekly (depending on need), while the Treasury auctions other products monthly or quarterly.

The U.S. 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)

Treasury bills are typically issued at slight discounts. Due to their short-term nature, Treasury bills do not pay semi-annual interest like most other bonds. Instead, investors receive interest at maturity. For example, an investor purchases a one-year Treasury bill for $970. One year later, the U.S. government pays them $1,000 (par), netting $30 in interest.

Treasury notes

Treasury notes are interest-paying, intermediate-term U.S. government bonds. Like most other Treasury products (except for Treasury bills), they are 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

Treasury bonds are interest-paying, long-term U.S. government bonds. Like Treasury notes, they are 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.

STRIPS

You don’t need to memorize the acronym for the exam, but STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. That’s a fancy way of saying STRIPS are long-term (up to 30 years), zero coupon bonds issued by the U.S. government. They are issued at deep discounts, then mature at par. For example, assume 30-year STRIPS are offered for $400. You purchase the security, hold it for 30 years, then receive $1,000 at maturity. Your return over 30 years would be $600, equivalent to $20 a year in interest ($600 / 30 years).

STRIPS, as well as any zero coupon bond, are not suitable for investors seeking income. An investor could purchase a set of “normal” bonds and live off the semi-annual income. This is impossible with STRIPS as they only pay interest at maturity, often decades after initially being purchased.

Another security is similar to STRIPS, but they’re not securities of the U.S. 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 similar to STRIPS but created by a different issuer. Also, remember that Treasury receipts don’t have the same default risk-free status as U.S. government bonds, as they are creations of private financial institutions (which can go bankrupt).

STRIPS and Treasury receipts are subject to annual taxation, even though their investors won’t receive interest until maturity. This is known as “phantom tax.” If you purchase 30-year STRIPS at $400, you’ll receive a tax bill for $20 of interest annually ($600 discount / 30 years = $20 annualized interest). The IRS prefers to get their tax money sooner rather than later!

We first discussed price volatility in the bond fundamentals 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 know the potential price volatility before investing in these securities.

To be clear, although 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. This type of risk measures how far market prices of a specific security decline when interest rates rise.

TIPS

In the bond fundamentals chapter, we learned about the risks of inflation. Fixed income securities (preferred stock and bonds) are particularly susceptible to inflation. For example, owning a $1,000 par, 5% bond would pay you $50 a year in interest. While $50 can buy a fair amount at a grocery store today, it’s possible $50 won’t buy a loaf of bread in the future if high inflation levels persist.

Now, let’s think in more significant numbers. Assume a retired investor purchases several bonds and receives $50,000 in annual interest. They need this amount of money now to pay for living expenses. Assuming 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!

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. If the stock market is too risky for the investor, they can consider investing in TIPS.

Treasury Inflation Protected Securities (TIPS) are long-term (up to 30 years) U.S. government debt securities 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 30-year TIPS have a 3% coupon, which stays fixed (doesn’t change). These securities are set initially to pay $15 twice yearly ($30 in annual interest). The principal (par) value changes over time to compensate investors for losses due to inflation. TIPS par values are adjusted every six months 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 inflation rates rise, TIPS make higher interest payments. For example, let’s look at what happens when CPI 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

The security made a higher semi-annual interest payment because inflation rates increased. While the coupon (3%) stays fixed, the adjusted principal value generates higher semi-annual interest payments. As the inflation rate rises by 2%, so does the par value (2% of $1,000 = $20). 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.

This adjustment occurs 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. At maturity, the investor will always receive the greater of the original par value (typically $1,000) or the adjusted par value. This greatly benefits the investor as they’ll receive a higher payout at maturity if inflation has risen.

All the numbers in the previous example may have your head spinning, but the exam will likely only test the basics. Be sure to know these concepts relating to TIPS:

• Long-term (up to 30-year maturities)
• Payments rise when inflation rises
• Par value is adjusted
• Coupon stays fixed

Summary

Here’s a quick visual summary of the Treasury products we just discussed: