U.S. Government Securities

The exam tests two things about these securities: which entity backs each one, and how the interest is taxed. Get those two facts straight for every security type below and most questions on this topic answer themselves.

What Are Treasury Securities?

Treasury securities carry the full faith and credit of the U.S. government. For exam purposes, they have no default risk and set 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

How Do T-Bills Work?

• 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

Exam Tip: Gotchas

• T-Bills pay no interest. They are sold at a discount and mature at face value. The difference is your return. T-Notes, T-Bonds, and TIPS all pay semiannual coupon interest; only T-Bills and STRIPS are zero-coupon.

How Do T-Notes and T-Bonds Differ?

• 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)

How Are Treasury Notes and Bonds Quoted?

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 finer 32nds increment (versus the eighths used for corporate bonds) reflects the enormous trading volume in Treasuries, where small price increments matter on large transactions.

What Are TIPS and How Are They Taxed?

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 daily by an index ratio derived from the Consumer Price Index for All Urban Consumers (CPI-U). Interest is paid semiannually, which is what makes students think the principal adjusts semiannually too
• Interest calculation: Fixed rate x adjusted principal, paid semiannually
• 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)

Exam Tip: Gotchas

TIPS principal adjusts daily, not semiannually. Only the interest payment is semiannual; do not confuse the payment schedule with how often the principal itself changes.

How Are TIPS Taxed?

• 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.

What Are Treasury STRIPS?

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.

How Are Treasury STRIPS Created?

Think of a normal T-Bond as a bundle of scheduled cash payments. STRIPS unbundle those payments so each one can trade on its own:

Coupon bond before stripping:

  Interest  Interest  Interest  Interest  Principal
     |         |         |         |          |
     v         v         v         v          v
  Year 1    Year 2    Year 3    Year 4    Maturity

After stripping:

  Each arrow becomes its own zero-coupon security.
  The investor buys one piece at a discount and receives only that piece's scheduled payment.

How Do STRIPS Cash Flows Work?

A 10-year T-Note with $1,000 face value and a 4% coupon paid semiannually creates 21 separate cash flows:

• 20 coupon payments of $20 each (one every six months for 10 years)
• 1 principal payment of $1,000 at maturity

After stripping, those 21 payments become 21 separate zero-coupon securities. Buying one coupon STRIP does not give the investor all future coupon payments. It gives the investor only that one coupon payment on that one payment date. Buying the principal STRIP gives the investor only the final principal payment at maturity.

• 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.

How Are Treasury Securities Taxed?

• 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

What Are 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.

How Do MBS Pass-Throughs Work?

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.

What Are 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.

What Is a Collateralized Mortgage Obligation (CMO)?

A CMO is a more complex mortgage-backed security that divides MBS cash flows into tranches (slices) with different maturities and risk profiles.

• Prepayment and extension risk are redistributed across tranches, not eliminated
• Generally not suitable for most retail investors because of their complexity

Exam Tip: Gotchas

A CMO does not remove prepayment or extension risk from a mortgage pool; it reshuffles that risk unevenly across tranches, so some tranches carry more of it and others less.

How Are Agency Securities Taxed?

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.

What Should You Check on Exam Day?

• T-Bills pay no coupon; T-Notes and T-Bonds pay semiannual fixed coupons
• Treasury interest is federal-taxable, state-and-local-exempt; agency interest is taxable at every level
• Only GNMA carries the full faith and credit of the U.S. government among the agencies
• TIPS adjust principal for inflation; STRIPS carry the highest interest rate risk; both create phantom income
• MBS pass-throughs pay monthly; prepayment risk rises when rates fall, extension risk rises when rates rise
• Treasury notes and bonds are quoted in 32nds, not eighths