Treasury and Agency Securities

Treasury securities are the debt of the U.S. federal government, and every other bond is priced against them. Section 2 is 44% of your exam, and debt instruments take a large share of it. This lesson covers Treasuries and the agency securities beside them.

Treasuries: the safest debt on the exam

The U.S. Department of the Treasury issues Treasury securities to fund the federal government. They carry the full faith and credit of the U.S. government, which means the government pledges its taxing power to pay you back. No other issuer on the exam has that backing.

Sort them by maturity:

• Treasury bills (T-bills) mature in one year or less. The Treasury issues them in 4, 6, 8, 13, 17, 26, and 52 week terms. T-bills pay no periodic interest.
• Treasury notes (T-notes) mature in 2 to 10 years and pay interest every six months.
• Treasury bonds (T-bonds) mature in 20 to 30 years and pay interest every six months.

A T-bill sells at a discount, meaning below its par value. Par value is the amount the issuer repays at maturity. Buy a 26-week bill with a $10,000 par value for $9,800 and you collect $10,000 in six months. Your $200 return is the interest.

A note or a bond pays a coupon instead, the fixed interest payment stated on the security. A 5-year note with a 4% coupon and $1,000 par pays $40 a year, sent as $20 every six months.

STRIPS and Treasury receipts: the government backs one, a dealer backs the other

Treasury STRIPS are zero-coupon securities made by separating a Treasury note or bond into its individual payments. A zero-coupon security pays no periodic interest. STRIPS stands for Separate Trading of Registered Interest and Principal of Securities.

Strip a 10-year note and you get 21 securities: one per coupon, plus one for the principal.

Treasury receipts came first. A broker-dealer built one by holding Treasuries in trust and selling claims on the individual payments. A receipt is an obligation of that broker-dealer. A STRIP is a direct obligation of the U.S. government. The exam tests that difference.

The auction: one price for every winner

The Treasury sells every new issue at auction, and every auction is a single-price auction. All winning bidders pay the same price and earn the same yield, the annual return the security pays at that price. That yield is the highest one the Treasury accepts.

Bidders come in two kinds:

• A competitive bidder, usually an institution, states the yield it will accept. The bid may fill in full, in part, or not at all. No single bidder may take more than 35% of the offering.
• A noncompetitive bidder states a dollar amount and takes whatever yield the auction produces. Noncompetitive bids fill first, and they always fill, up to $10 million per bidder per auction.

The Treasury fills the noncompetitive bids first, then works up the competitive bids from the lowest yield. The last yield it accepts sets the price for everyone.

Agency securities: same job, different guarantee

An agency security is debt issued by a federal agency or by a government-sponsored enterprise (GSE). A GSE is a private company that Congress chartered to support a lending market. Ask one question about every agency security: does it carry full faith and credit?

• Ginnie Mae (GNMA, the Government National Mortgage Association) is a government agency. Its securities carry the full faith and credit of the U.S. government.
• Fannie Mae (FNMA, the Federal National Mortgage Association) and Freddie Mac (FHLMC, the Federal Home Loan Mortgage Corporation) are GSEs. Their securities carry each company's own guarantee, not the government's.
• The Federal Home Loan Banks and the Federal Farm Credit Banks are GSEs too. They issue agency bonds rather than mortgage pools.

The government put Fannie Mae and Freddie Mac into conservatorship in 2008 and covered their debts. Their securities still do not carry full faith and credit.

Mortgage-backed securities and prepayment

A mortgage-backed security (MBS) is a share in a pool of mortgages. Homeowners make their monthly payments, and the pool passes them through to you. That structure is called a pass-through. Each payment carries interest plus a piece of principal, so your principal comes back slowly instead of in one lump at maturity.

An asset-backed security (ABS) does the same job over a different pool: auto loans, credit card receivables, or student loans.

Borrowers may pay off a loan whenever they want, and that creates prepayment risk. Say you hold an MBS paying 6% and market rates fall to 4%. The homeowners refinance, the pool hands your principal back, and you can only reinvest it at 4%. You lose the 6% income exactly when you most want to keep it.

Rising rates do the opposite. Prepayments slow, and your money stays parked at the old lower rate.

Taxation: Treasury interest is exempt from state and local tax

Treasury interest is taxable at the federal level and exempt from state and local income tax. In a high-tax state you keep more of a Treasury coupon than of a corporate coupon paying the same rate.

Mortgage-backed securities from Ginnie Mae, Fannie Mae, and Freddie Mac are taxable at every level: federal, state, and local. A government issuer does not make the income tax-free.

STRIPS pay you nothing until maturity, and the IRS still taxes the annual growth in value. The industry calls that phantom income.

How this gets tested

Most items here are sorting questions. Which security pays no periodic interest? The T-bill and the STRIP. Which maturity goes with which name? Bills one year or less, notes 2 to 10 years, bonds 20 to 30 years. Which agency carries full faith and credit? Ginnie Mae, and only Ginnie Mae. Which risk belongs to a loan pool and not to a plain corporate bond? Prepayment risk.

One trap runs the other way. The market treats the Treasury yield as the risk-free rate, because Treasuries carry no meaningful credit risk. They still carry interest rate risk and inflation risk. A 30-year Treasury bought at a 3% coupon falls in price when new bonds pay 5%. Risk-free means free of default risk, and nothing else.