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 taxes, not federal taxes. The exam may try to reverse this.
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
| Type | Maturity | Coupon | Issued At | Key Feature |
|---|---|---|---|---|
| T-Bills | Up to 1 year (4, 8, 13, 17, 26, 52 weeks) | None (zero coupon) | Discount | Short-term; return = discount earned |
| T-Notes | 2-10 years | Semiannual | Par | Medium-term; most actively traded |
| T-Bonds | 20-30 years | Semiannual | Par | Long-term; highest interest rate risk |
| TIPS | 5, 10, or 30 years | Semiannual (fixed rate) | Par | Principal adjusts with inflation |
| STRIPS | Varies | None (zero coupon) | Discount | Created from T-Notes/Bonds |
Treasury TIPS (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
- Interest payment = 2% x $1,030 = $20.60 (instead of $20.00)
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 or T-Bonds
- 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
Phantom Income: Even though STRIPS pay no cash until maturity, the IRS requires investors to pay tax on the annual accretion of the discount (the yearly increase in value toward par). This creates a tax liability without any cash to pay it; hence "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 and T-Bonds.
- Both T-Bills and STRIPS create phantom income for tax purposes, even though no cash is received until maturity.