Government Securities

U.S. Treasury Securities

U.S. Treasury securities are debt obligations issued by the U.S. Department of the Treasury to finance government operations and refinance maturing debt. They are backed by the full faith and credit of the U.S. government, making them the safest fixed-income securities available. Treasury securities have virtually no credit (default) risk, though they are still subject to interest rate risk, purchasing power (inflation) risk, and opportunity cost.

Treasury Bills (T-Bills)

Treasury bills are short-term government securities with maturities of one year or less. They are issued at maturities of 4 weeks, 8 weeks, 13 weeks, 17 weeks, 26 weeks, and 52 weeks. Key characteristics:

• Issued at a discount: T-bills do not pay periodic interest (coupons). Instead, they are sold at a discount from par ($1,000) and mature at full face value. The difference between the purchase price and par is the investor's return.
• Non-interest bearing: Because they are sold at a discount rather than paying coupons, T-bills are considered non-interest bearing (or discount instruments).
• Minimum denomination: $100 (via TreasuryDirect) or $1,000 in the secondary market.
• Quoted on a discount yield basis: Unlike coupon-bearing Treasuries, T-bills are quoted in terms of their discount yield (annualized discount divided by par).
• Most liquid money market instrument: T-bills are the benchmark for the risk-free rate of return and are the most actively traded money market security.

Treasury Notes (T-Notes)

Treasury notes are intermediate-term securities with maturities of 2, 3, 5, 7, or 10 years. Key characteristics:

• Semiannual coupon payments: T-notes pay interest every six months at a fixed coupon rate.
• Par value: $1,000 per bond.
• Quoted in points and 32nds: For example, a quote of 99:16 means 99 and 16/32 percent of par = 99.50% = $995.00 per $1,000 face value.
• Auctioned regularly: The Treasury conducts regular auctions for each maturity.
• Benchmark instruments: The 10-year Treasury note yield is widely used as a benchmark for mortgage rates, corporate bonds, and other long-term interest rates.

Treasury Bonds (T-Bonds)

Treasury bonds are long-term securities with maturities of more than 10 years, typically 20 or 30 years. Like T-notes, they pay semiannual coupons and are quoted in points and 32nds. T-bonds have the greatest interest rate risk among Treasury securities because of their long duration. They also carry the highest coupon rates to compensate investors for the extended maturity.

Tax Treatment of Treasuries

Interest income on all U.S. Treasury securities is subject to federal income tax but is exempt from state and local income taxes. This state tax exemption makes Treasuries especially attractive to investors in high-tax states. Capital gains on Treasuries, however, are subject to both federal and state taxes.

TIPS and STRIPS

Treasury Inflation-Protected Securities (TIPS)

TIPS are Treasury securities designed to protect investors against inflation (purchasing power) risk. They are issued with maturities of 5, 10, and 30 years. The unique feature of TIPS is that the principal value adjusts based on changes in the Consumer Price Index (CPI).

How TIPS work:

• Fixed coupon rate: TIPS pay a fixed percentage coupon rate (lower than comparable nominal Treasuries because of the inflation protection).
• Adjusted principal: The par value of TIPS is adjusted semiannually based on CPI changes. If inflation increases by 2%, the par value increases from $1,000 to $1,020.
• Growing interest payments: Since the coupon rate is applied to the inflation-adjusted principal, the actual dollar amount of interest payments grows with inflation. If the rate is 1.5% and the adjusted principal is $1,020, the semiannual payment is (1.5% x $1,020) / 2 = $7.65 (versus $7.50 on the original $1,000).
• Deflation floor: At maturity, TIPS are redeemed at the greater of the inflation-adjusted principal or the original par value. This means investors are guaranteed at least their original investment even if deflation occurs.
• Phantom income: The annual increase in principal is taxable as income in the year it accrues, even though the investor does not receive the additional principal until maturity. This makes TIPS best suited for tax-deferred accounts.

STRIPS (Separate Trading of Registered Interest and Principal of Securities)

STRIPS are zero-coupon Treasury securities created by "stripping" the interest payments and principal of a standard Treasury note or bond into separate securities. Each coupon payment and the final principal payment become individual zero-coupon instruments that can be traded separately.

• Created by financial institutions: The U.S. Treasury does not issue STRIPS directly. Instead, financial institutions purchase Treasury notes or bonds and strip them into components through the Federal Reserve's book-entry system.
• Sold at a deep discount: Like all zero-coupon instruments, STRIPS are purchased below par and mature at face value.
• No reinvestment risk: Because there are no periodic cash flows, investors know exactly what they will receive at maturity.
• Highest interest rate sensitivity: STRIPS have the longest duration of any Treasury security of similar maturity, making them highly sensitive to interest rate changes.
• Phantom income: The annual accretion of the discount (OID) is taxable as ordinary income each year, even though no cash is received. Like zero-coupon corporate bonds, STRIPS are best suited for tax-deferred accounts.
• Full faith and credit: Despite being created by financial institutions, STRIPS are still U.S. Treasury obligations backed by the full faith and credit of the U.S. government.

Agency Securities

Agency securities are debt obligations issued by government-sponsored enterprises (GSEs) and federal agencies. They typically fund housing, agriculture, and education programs. Agency securities offer slightly higher yields than direct Treasury obligations because most carry implied rather than explicit government backing.

Government National Mortgage Association (GNMA / Ginnie Mae)

GNMA is a government agency (part of the Department of Housing and Urban Development, HUD) that guarantees the timely payment of principal and interest on mortgage-backed securities (MBS) backed by federally insured or guaranteed loans (FHA, VA, USDA). Key distinction:

• Full faith and credit of the U.S. government: GNMA is the ONLY agency security that carries the explicit full faith and credit guarantee of the United States government, making it the safest agency security.
• GNMA does not issue MBS directly; it guarantees MBS issued by approved lenders.
• GNMA securities are backed by pools of government-insured mortgages.

Federal National Mortgage Association (FNMA / Fannie Mae)

FNMA is a government-sponsored enterprise (GSE) -- a publicly traded company with a congressional charter. FNMA purchases mortgages from lenders and either holds them in portfolio or packages them into MBS for sale to investors.

• NOT backed by the full faith and credit of the U.S. government. FNMA securities carry an implied government guarantee (the market assumes the government would support FNMA in a crisis, as demonstrated during the 2008 financial crisis when FNMA entered conservatorship).
• FNMA purchases conventional, FHA, and VA mortgages.
• FNMA issues debt securities (agency bonds) and mortgage-backed securities.

Federal Home Loan Mortgage Corporation (FHLMC / Freddie Mac)

FHLMC is also a GSE with a similar function to FNMA: it purchases mortgages from lenders and issues MBS (called "participation certificates" or PCs). Like FNMA, FHLMC is NOT backed by the full faith and credit of the U.S. government but carries an implied guarantee.

Other Federal Agencies

• Federal Home Loan Banks (FHLBanks): A system of 11 regional banks that provide liquidity to mortgage lenders. FHLBank debt is a GSE obligation (not backed by full faith and credit).
• Federal Farm Credit System: Provides credit to agricultural borrowers. GSE status (not full faith and credit).
• Student Loan Marketing Association (Sallie Mae): Originally a GSE that supported student lending. Now fully privatized.

Tax Treatment of Agency Securities

Interest on most agency securities is subject to federal, state, and local income taxes (fully taxable). However, interest on FHLB and FFCB (Federal Farm Credit Banks) securities is exempt from state and local taxes, similar to Treasury securities. GNMA, FNMA, and FHLMC interest is fully taxable at all levels.

Money Market Instruments

The money market refers to the market for short-term debt instruments with maturities of one year or less. These instruments are characterized by high liquidity, low risk, and relatively low returns. They are used by corporations, financial institutions, and governments to manage short-term cash needs.

Commercial Paper

Commercial paper is an unsecured, short-term promissory note issued by large, creditworthy corporations to finance short-term obligations (payroll, accounts payable, inventory). Key features:

• Maximum maturity of 270 days (to avoid SEC registration requirements under Section 3(a)(3) of the Securities Act of 1933).
• Issued at a discount from face value (like T-bills).
• Minimum denomination typically $100,000 (institutional instrument).
• Unsecured -- backed only by the issuer's credit. Investment-grade commercial paper is rated by agencies (A-1, P-1 are the highest short-term ratings).
• Not traded on exchanges; it is a money market instrument traded among institutional investors.

Banker's Acceptances (BAs)

Banker's acceptances are time drafts drawn on and accepted by a bank, typically used to finance international trade (import/export transactions). When a bank "accepts" the draft, it guarantees payment at maturity, making the instrument very safe. BAs typically mature in 30 to 180 days and are sold at a discount.

Repurchase Agreements (Repos)

A repurchase agreement is a short-term borrowing arrangement where a dealer sells government securities to an investor with an agreement to repurchase them at a higher price on a specified date. Key points:

• Repos are essentially collateralized short-term loans, with government securities serving as collateral.
• The difference between the sale price and repurchase price represents the interest (repo rate).
• Maturities range from overnight to several weeks (most are overnight or very short-term).
• Commonly used by primary dealers to finance their Treasury inventory and by the Federal Reserve in open market operations.
• Reverse repo: The opposite transaction -- the dealer buys securities and agrees to sell them back. From the lender's perspective, a reverse repo is an investment.

Federal Funds (Fed Funds)

Federal funds are overnight loans of reserves between depository institutions (banks). The federal funds rate is the interest rate charged on these loans and is the key benchmark rate influenced by the Federal Reserve through open market operations. Key characteristics:

• Unsecured overnight loans between banks.
• Used by banks to meet reserve requirements.
• The fed funds rate is the most important short-term interest rate in the U.S. economy -- it influences all other short-term rates.
• The Federal Open Market Committee (FOMC) sets a target range for the fed funds rate.

Negotiable Certificates of Deposit (Negotiable CDs)

Negotiable CDs (also called jumbo CDs) are large-denomination ($100,000 or more, typically $1 million+) time deposits issued by commercial banks. Unlike regular bank CDs, negotiable CDs can be traded in the secondary market before maturity. They pay a fixed interest rate and have specific maturity dates, usually ranging from 2 weeks to 1 year.

Mortgage-Backed Securities (MBS)

Mortgage-backed securities are fixed-income instruments backed by pools of residential or commercial mortgages. They allow mortgage originators to sell their loans to investors, freeing up capital to make new loans. MBS are a critical component of the U.S. housing finance system and represent a significant portion of the fixed-income market.

Pass-Through Securities

Pass-through certificates are the simplest form of MBS. A pool of mortgages is assembled, and investors receive a proportional share of the principal and interest payments made by homeowners (minus a servicing fee). The payments "pass through" from borrowers to investors.

• Monthly payments to investors include both interest and return of principal (unlike bonds that pay principal only at maturity).
• The most common issuers are GNMA, FNMA, and FHLMC.
• GNMA pass-throughs are backed by government-insured mortgages and carry the full faith and credit guarantee.

Prepayment Risk

Prepayment risk is the primary risk unique to MBS. Homeowners can prepay their mortgages at any time (by refinancing, selling the home, or making extra payments). Prepayment risk has two components:

• Contraction risk: When interest rates FALL, homeowners refinance at lower rates, returning principal to MBS investors faster than expected. Investors must reinvest this principal at the now-lower prevailing rates. This is similar to call risk in bonds.
• Extension risk: When interest rates RISE, homeowners hold their low-rate mortgages longer, slowing prepayments. MBS investors receive principal more slowly than expected, missing the opportunity to reinvest at higher rates. The MBS effectively has a longer maturity than anticipated.

Collateralized Mortgage Obligations (CMOs)

CMOs are complex structured MBS that redirect the cash flows from mortgage pools into multiple classes (called tranches) with different maturities, risk profiles, and payment priorities. CMOs were created to address the prepayment uncertainty of plain pass-throughs by redistributing prepayment risk among different investor classes.

CMO Tranche Structure

A typical CMO has several sequential-pay tranches (A, B, C, Z):

• Tranche A (shortest maturity): Receives all principal payments first (both scheduled and prepayments). Once Tranche A is fully paid, principal flows to Tranche B, and so on. Tranche A has the most prepayment certainty and shortest expected maturity.
• Tranche B and C (intermediate): Receive principal after the preceding tranches are retired. These have intermediate maturities and moderate prepayment risk.
• Tranche Z (longest maturity, accrual tranche): Receives no cash payments until all prior tranches are retired. Interest accrues and is added to the principal balance (similar to a zero-coupon bond). Tranche Z has the longest maturity and most interest rate risk.

Special CMO Tranches

• PAC (Planned Amortization Class): Designed to provide the most predictable cash flows and lowest prepayment risk. PAC tranches are "protected" by companion (support) tranches that absorb excess prepayments or shortfalls. PAC tranches are the safest CMO tranches and are most suitable for conservative investors.
• TAC (Targeted Amortization Class): Similar to PAC but protected against only contraction risk (fast prepayments), not extension risk. Less protection than PAC but more than plain sequential tranches.
• Companion (Support) Tranches: Absorb the prepayment variability that PAC and TAC tranches avoid. When prepayments are fast, companion tranches receive the excess principal. When prepayments are slow, companion tranches receive less. Companion tranches have the MOST prepayment risk and are the most volatile CMO tranches.