Treasury Securities

The U.S. Treasury market is the foundation of fixed-income investing. Every other bond is priced relative to Treasuries, making this the logical starting point.

Why Treasuries Are the Benchmark

• Issued by the U.S. federal government - considered the safest securities available
• Backed by the full faith and credit of the U.S. government
• Virtually zero credit (default) risk
• Used as the "risk-free rate" benchmark in finance

Tax Treatment

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

Exam Tip: Gotchas

• Treasury interest is exempt from state and local taxes but is fully taxable at the federal level (the opposite of municipal bonds).

How Treasuries Are Sold

• Sold at auction by the U.S. Treasury Department
• Competitive bids - institutional investors specify the yield they'll accept
• Non-competitive bids - retail investors accept whatever yield is determined (guaranteed to receive securities)

Exam Tip: Gotchas

• Non-competitive bidders are guaranteed to receive securities at auction. Competitive bidders may be shut out if their bid yield is too high.

Types of Treasury Securities

Treasury TIPS (Inflation-Protected Securities)

Treasury Inflation-Protected Securities (TIPS) are designed to protect investors against inflation risk (purchasing power risk):

• The coupon rate is fixed at issuance and does not change
• The principal adjusts up or down based on the Consumer Price Index (CPI)
• Because interest payments = fixed rate x adjusted principal, the dollar amount of interest changes over time
• At maturity, the investor receives the greater of the adjusted principal or the original par value
• This floor protects against deflation

Example: A TIPS with a 2% coupon and $1,000 par value:

• If CPI increases 3%, principal adjusts to $1,030
• Annual interest = 2% x $1,030 = $20.60 (instead of $20.00), paid as two semiannual payments of $10.30

Exam Tip: Gotchas

• TIPS adjust the principal, not the coupon rate. The rate stays fixed; only the dollar amount of interest changes because it is calculated on the adjusted principal.

Treasury STRIPS

STRIPS stands for Separate Trading of Registered Interest and Principal of Securities:

• Created by separating (stripping) the coupon payments and principal payment of T-Notes, T-Bonds, or TIPS
• Each individual payment becomes its own zero-coupon security
• Purchased at a discount to face value, matures at par
• No periodic interest payments; the return is the difference between purchase price and par

Why STRIPS exist

A T-Note or T-Bond throws off two kinds of cash flows: semiannual coupon payments (the periodic interest) and a single principal payment at maturity (the face value, also called par).

Institutional investors, especially pension funds, often need an exact dollar amount on a specific future date to match a known liability, like a retiree benefit due in year 10. A standard coupon bond does not fit that need cleanly:

• Reinvestment risk: the semiannual coupons have to be reinvested at whatever rate is available when each payment arrives, which is unpredictable
• Cash flow mismatch: the pension fund needs one large payment on a specific date, not a stream of small coupons plus a principal

Broker-dealers solve this by stripping each cash flow apart. Every coupon and the principal each become a separate zero-coupon security with a known maturity date and a known dollar payoff.

Cash flow example

A 10-year T-Note with $1,000 face value paying 4% semiannually generates 21 cash flows:

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

When stripped, that one bond becomes 21 separate zero-coupon securities. Each strip is its own standalone bond with one job: pay its specific cash flow on its specific date.

What you receive from one strip: Buying the year 7 coupon strip means you pay a discounted price today and receive exactly $20 at year 7. That single $20 is your entire return from that security. You do not receive coupons from years 1 through 6 (those are separate strips owned by other investors), and you do not receive the $1,000 principal (that is the principal strip, sold separately). To get cash in multiple years, an investor buys multiple strips: each one only pays once, on its own maturity date.

Phantom Income: In a taxable account, long-term STRIPS generate taxable interest through the annual accretion of the discount even though they pay no cash until maturity. Long-term zero-coupon corporate bonds receive the same annual discount treatment. Both can create a tax liability without a cash payment; this is called "phantom income."

Exam Tip: Gotchas

• T-Bills are short-term (up to 1 year), sold at a discount, and have no coupon. STRIPS are also zero-coupon but can have long maturities (up to 30 years). These are often confused since both are zero-coupon, but T-Bills are original Treasury issues while STRIPS are created from existing T-Notes, T-Bonds, and TIPS.
• STRIPS create phantom income for tax purposes: tax is owed on the annual accretion of the discount even though no cash is received until maturity. T-Bills are short-term (one year or less), so their discount is taxed as interest income at maturity and they do not create phantom income.
• STRIPS eliminate reinvestment risk (no interim coupons to reinvest) but carry very high interest rate risk. Zero-coupon bonds have the highest interest rate risk of any bond at the same maturity because the entire return arrives in a single payment at the end.

What Should You Check on Exam Day?

• Can you explain why Treasury interest is exempt from state and local tax but not federal tax?
• Do you know why non-competitive bidders are guaranteed securities at a Treasury auction?
• Can you state what part of a TIPS adjusts with inflation, the coupon rate or the principal?
• Can you explain the difference between a T-Bill and a Treasury STRIP?
• Do you know why STRIPS carry very high interest rate risk despite having no reinvestment risk?