U.S. Government Securities

This section covers the two main categories of government-backed debt you need to know: Treasury securities (direct obligations of the U.S. government) and agency securities (issued by government-sponsored enterprises). Understanding their differences in backing, tax treatment, and risk profiles is frequently tested exam material.

Treasury Securities

Treasury securities carry the full faith and credit of the U.S. government. For exam purposes, they have no default risk and serve as the benchmark for the "risk-free rate."

• Issued and sold at auction by the U.S. Treasury (competitive and non-competitive bids)
• Interest is subject to federal income tax but exempt from state and local taxes

T-Bills in Detail

• Short-term obligations (up to 1 year)
• Sold at a discount to par; investor receives par at maturity
• Difference between purchase price and par is the investor's return
• No periodic interest payments
• Most liquid government security
• Example: Buy a $10,000 T-Bill for $9,700, receive $10,000 at maturity = $300 return

Treasury Pricing in 32nds

Treasury notes and bonds are quoted in 32nds of a percent, not eighths. A quote of "98:16" (or 98-16) means 98 + 16/32 = 98.50% of par, or $985 per $1,000 of face value. The use of 32nds (a finer increment than the eighths used for corporate bonds) reflects the enormous trading volume in Treasuries, where small price increments matter on large transactions.

Exam Tip: Gotchas

• T-Bills pay no interest. They are sold at a discount and mature at face value. The difference is your return. Only T-Notes and T-Bonds pay semiannual coupon interest.

T-Notes and T-Bonds

• T-Notes: intermediate-term (2-10 years)
• T-Bonds: long-term (20-30 years)
• Both pay semiannual fixed coupon interest
• T-Bonds carry the most interest rate risk among coupon-bearing Treasuries (longest maturity)

Treasury Inflation-Protected Securities (TIPS)

TIPS protect investors against purchasing power risk (inflation risk). Available in 5, 10, or 30-year maturities.

• Fixed interest rate: The coupon rate never changes
• Adjustable principal: Par value adjusts semiannually based on the Consumer Price Index (CPI)
• Interest calculation: Fixed rate x adjusted principal
• During inflation: Principal increases, so interest payments increase
• During deflation: Principal decreases, so interest payments decrease
• Deflation floor: At maturity, you receive the greater of the adjusted principal or the original par value (you never get back less than your original investment)

TIPS Tax Treatment

• Interest payments are taxable at the federal level (exempt from state and local)
• Annual principal adjustments are taxable as income even though the cash is not received until maturity
• This creates phantom income that must be reported each year

Think of it this way: The IRS treats the increase in your TIPS principal as if you received that money today, even though you will not see it until the bond matures. You owe tax on income you have not actually collected yet.

Exam Tip: Gotchas

• TIPS create phantom income because principal adjustments are taxed annually even though the cash is not received until maturity.

Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities)

STRIPS are created by separating (stripping) the coupon and principal payments of T-Notes and T-Bonds. Each component is sold separately as a zero-coupon security.

• Purchased at a deep discount, matures at par
• No periodic interest payments
• Highest interest rate risk among Treasuries (zero coupon + long maturity = longest duration)
• Subject to phantom income - annual accretion of discount is taxable as ordinary income even though no cash is received
• Best suited for tax-deferred accounts (IRAs, 401(k)s) to avoid phantom income taxation

Exam Tip: Gotchas

• TIPS protect against inflation risk by adjusting principal with CPI. STRIPS have the highest interest rate risk because zero-coupon bonds have the longest duration. Both generate phantom income - taxable annually despite no cash received.

Treasury Tax Treatment

• Interest is exempt from state and local income taxes
• Interest is subject to federal income tax
• This tax advantage makes Treasuries especially attractive for investors in high-tax states

Agency Securities

Agency securities are issued by government-sponsored enterprises (GSEs) or federal agencies. They are not directly backed by the full faith and credit of the U.S. government (with one exception: GNMA). They carry slightly more credit risk than direct Treasuries.

• Interest is generally subject to federal and state income tax (unlike Treasuries)

• GNMA is the only agency with an explicit U.S. government guarantee
• FNMA and FHLMC have an implied "moral obligation" but no legal guarantee of repayment
• Because FNMA and FHLMC lack the explicit guarantee, their securities carry slightly higher yields than Treasuries to compensate for the added credit risk

Exam Tip: Gotchas

• Only GNMA has the full faith and credit of the U.S. government. If a question asks which agency security has government backing, GNMA is the only correct answer. Fannie Mae and Freddie Mac have only an implicit (moral obligation) backing.

Mortgage-Backed Securities (MBS) Pass-Throughs

Pools of residential mortgages packaged into securities. Pass-through certificates pass principal and interest payments from underlying mortgages through to investors.

• Payment frequency: Monthly (not semiannual), because homeowners make monthly mortgage payments
• Investors receive both interest and principal each month

Think of it this way: Imagine 1,000 homeowners each making their monthly mortgage payment. Those payments flow into a pool and get distributed proportionally to the investors who own that pool. You receive your share of interest and principal every month, just like a landlord collecting rent from many tenants.

Exam Tip: Gotchas

• MBS pass-throughs pay monthly, not semiannually. They pass through homeowner mortgage payments.

Prepayment Risk and Extension Risk

MBS investors face two unique, opposing risks:

• Prepayment risk is a form of reinvestment risk
• Prepayment risk and extension risk move in opposite directions
• When one increases, the other decreases

Think of it this way: When mortgage rates drop, homeowners rush to refinance, just like anyone would jump at a lower car loan rate. Investors get their money back sooner than planned and can only reinvest at the new, lower rates. When rates rise, nobody refinances, so investors are stuck holding the security longer than they expected.

Exam Tip: Gotchas

• Prepayment risk and extension risk are opposites. Falling rates trigger prepayment risk; rising rates trigger extension risk.

Agency Securities Tax Treatment

This is a frequently tested exam distinction:

• Agency securities are fully taxable at all levels: federal, state, and local
• Treasuries have a tax advantage because their interest is exempt from state and local taxes
• This difference explains part of the yield spread between Treasuries and agency securities

Exam Tip: Gotchas

• Agency securities are taxable at all levels (federal, state, and local). These are often confused with Treasuries, which are exempt from state and local taxes. This distinction is frequently tested.