Government and Municipal Securities

Treasury securities

Treasury bills are short-term discount instruments issued in terms of 4, 6, 8, 13, 17, 26 and 52 weeks. They pay no coupon: they are sold below par and redeemed at par, and the difference is the interest. The minimum purchase is $100.

Treasury notes mature in two to ten years and pay a fixed coupon semiannually. Treasury bonds mature in twenty or thirty years and likewise pay semiannually. Both are quoted in thirty-seconds.

Treasury Inflation Protected Securities are issued in 5, 10 and 30-year terms. The principal adjusts with the Consumer Price Index, and the fixed rate is applied to the adjusted principal, so the payment moves with inflation. At maturity the holder receives the greater of the inflation-adjusted principal or the original principal. The annual upward adjustment is taxable in the year it occurs even though no cash is received.

STRIPS are created when a dealer separates a note or bond into its individual interest payments and its principal payment, each of which then trades as a zero-coupon security. They are government-guaranteed zeros: no reinvestment risk, maximum interest rate sensitivity, and annual accretion taxed without cash received.

All Treasury interest is subject to federal income tax and exempt from state and local income tax.

Agencies and mortgage-backed securities

The distinction the exam draws is credit standing.

The Government National Mortgage Association — Ginnie Mae — is a government corporation within the Department of Housing and Urban Development. Its guaranty of the timely payment of principal and interest is backed by the full faith and credit of the United States, and it is the only mortgage-backed issuer with that status.

The Federal National Mortgage Association — Fannie Mae — and the Federal Home Loan Mortgage Corporation — Freddie Mac — are shareholder-owned companies operating under congressional charters. They guarantee timely payment on the mortgages underlying their securities, but that guarantee is corporate rather than sovereign. A representative may not describe their securities as government-guaranteed.

A mortgage pass-through security represents an interest in a pool of mortgages, passing through both interest and returned principal monthly. Its characteristic risk is prepayment risk: when rates fall, homeowners refinance and principal comes back early, exactly when it can only be reinvested at lower rates. The mirror is extension risk, where rising rates slow prepayments and lengthen the security's life.

A collateralized mortgage obligation slices a mortgage pool's cash flow into tranches with different expected maturities and different risk profiles.

Municipal securities

Municipal securities are issued by states, cities, counties, school districts and other public authorities. They are exempt from Securities Act registration, which is why the MSRB writes rules for the dealers who sell them.

A general obligation bond is backed by the full faith, credit and taxing power of the issuer. Local GOs rely primarily on ad valorem property taxes; state GOs on income, sales and excise taxes, because states do not generally levy property taxes. GO issuance is usually constrained by a statutory debt limit and usually requires voter approval.

A revenue bond is paid only from the earnings of the facility it financed — a toll road, an airport, a water system, a hospital. There is no claim on tax revenue, so no referendum is usually required and the debt limit does not apply. The analysis rests on a feasibility study and on protective covenants rather than on the tax base.

Other types the outline names: short-term obligations, principally anticipation notes named for what will repay them — tax anticipation notes, revenue anticipation notes, bond anticipation notes; special tax bonds payable from a particular tax; double-barrelled bonds backed both by revenue and by taxing power; and taxable municipal securities such as Build America Bonds, whose interest is fully taxable.

Municipal fund securities — 529 college savings plans, ABLE accounts and local government investment pools — are a distinct category regulated under MSRB rules rather than under the Investment Company Act.

Municipal taxation

Interest on a municipal bond is generally exempt from federal income tax. States generally exempt their own bonds and tax other states', so an in-state buyer in a high-tax state gets a double exemption. Bonds issued by US territories — Puerto Rico, Guam, the US Virgin Islands — are exempt from federal, state and local tax everywhere.

Three consequences the exam tests.

Capital gains are fully taxable. The exemption covers interest, not appreciation. A municipal bond is not a tax-free investment; it is a tax-exempt-interest investment.

Interest on most private activity bonds is a tax preference item for the alternative minimum tax, so the exemption can be illusory for an exposed customer.

And a municipal bond does not belong in a tax-deferred account. The customer would be accepting a lower yield to buy an exemption the account already provides — and the eventual distribution is taxed as ordinary income anyway.

To compare a municipal with a taxable bond, compute the taxable equivalent yield: the municipal yield divided by one minus the investor's marginal tax rate. Because the value of the exemption rises with the bracket, municipals suit high-bracket investors and not low-bracket ones.