Treasuries and Agencies

The marketable 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, in increments of $100. Bills are quoted on a discount basis rather than as a price, so a falling quoted rate means a rising price.

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 of a point, and both are issued in book-entry form with a $100 minimum.

Treasury Inflation-Protected Securities — TIPS — are issued in 5, 10 and 30-year terms. The principal is adjusted with the Consumer Price Index, rising with inflation and falling with deflation, and the fixed coupon rate is applied to the adjusted principal, so the semiannual payment moves with inflation even though the rate does not. At maturity the holder receives the greater of the inflation-adjusted principal or the original principal, so deflation cannot reduce the redemption below par. The tax wrinkle is significant and is a favourite exam point: the annual upward principal adjustment is taxable as income in the year it occurs, even though the cash is not received until maturity.

Floating Rate Notes are two-year securities whose rate resets against the 13-week bill auction, paying quarterly.

STRIPS — Separate Trading of Registered Interest and Principal Securities — are created when a dealer separates a Treasury note or bond into its individual interest payments and its principal payment, each of which then trades as an independent zero-coupon security. They are the government-guaranteed zero-coupon instrument, and everything from lesson 3.3 about zeros applies: no reinvestment risk, maximum interest rate sensitivity, and annual accretion taxed as income without cash received.

How Treasury interest is taxed

Interest on all US Treasury securities is subject to federal income tax and exempt from state and local income tax.

That exemption is worth real money in a high-tax state and it is the reason a Treasury and a corporate bond at the same nominal yield are not equivalent to a California or New York investor. It is also exactly half of the municipal picture: municipal interest is generally exempt from federal tax and taxable by other states, which makes Treasuries and municipals mirror images. Two useful sentences to hold together: Treasuries are federally taxable and state exempt; municipals are federally exempt and generally taxable outside the issuing state.

A gain on the sale of a Treasury before maturity is a capital gain and receives no special treatment. Accretion on a STRIP or a T-bill held past year end is ordinary income at federal level.

Agencies and government-sponsored enterprises

The exam draws a line here that is easy to state and easy to lose under pressure.

The Government National Mortgage Association — Ginnie Mae — is a wholly owned government corporation within the Department of Housing and Urban Development. Its guaranty of the timely payment of principal and interest on the securities it guarantees is backed by the full faith and credit of the United States, under 12 U.S.C. 1721(g). Ginnie Mae 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 the timely payment of principal and interest on the mortgages underlying their securities, but that guarantee is corporate, not sovereign; their obligations are not backed by the full faith and credit of the United States. They have operated under federal conservatorship since 2008, and the market prices their paper at a small spread over Treasuries as a result. Other GSEs the outline names include the Federal Home Loan Banks and the student-lending entity formerly known as Sallie Mae.

The practical selling consequence: a representative may not describe a Fannie Mae or Freddie Mac security as government-guaranteed. It is a government-sponsored enterprise security, and the distinction has to be made accurately to a customer who is buying on the strength of perceived safety.

Mortgage pass-throughs and prepayment risk

A mortgage pass-through security represents an undivided interest in a pool of mortgages. Homeowners make their monthly payments; a servicer collects them and passes through the investor's share of both interest and principal, monthly rather than semiannually.

That monthly cash flow contains returned principal, which produces the characteristic risk of the instrument. When rates fall, homeowners refinance and prepay, and the investor receives principal back early — precisely when it can only be reinvested at the new lower rates. This is prepayment risk, and it is why a mortgage-backed security underperforms a comparable straight bond in a falling-rate market: the upside is truncated.

The mirror risk is extension risk. When rates rise, prepayments slow, homeowners stay put, and the security's effective life lengthens exactly when the investor would prefer to get principal back and reinvest at the new higher rate. The combination — shortening when you want length, lengthening when you want brevity — is called negative convexity, and it means a mortgage security captures more of a rate rise than of a rate fall.

Pass-throughs are quoted in thirty-seconds like Treasuries, accrue on a 30/360 basis, and are analysed against an assumed prepayment speed rather than a fixed maturity; the expected life is stated as an average life. A representative must present the yield and average life as estimates conditional on prepayment assumptions rather than as a promise, which is a disclosure point FINRA takes seriously enough to have written a dedicated communications rule for collateralized mortgage obligations — covered in lesson 3.6.