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, 6, 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
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: 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.
- 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.