U.S. Government Securities

Quick Answer

Treasury securities carry the full faith and credit of the U.S. government and are exempt from state and local tax. GNMA is the only major mortgage agency with the same federal guarantee. GNMA, FNMA, and FHLMC securities are taxable at every level, but FHLB bonds are exempt from state and local income tax.

The exam tests two things about these securities: which entity backs each one, and how the interest is taxed. Get those two facts straight for every security type below and most questions on this topic answer themselves.

What Are Treasury Securities?

Treasury securities carry the full faith and credit of the U.S. government. For exam purposes, they have no default risk and set the benchmark for the "risk-free rate."

Issued and sold at auction by the U.S. Treasury (competitive and non-competitive bids)

Interest is subject to federal income tax but exempt from state and local taxes

T-Bills: Maturity 4, 6, 8, 13, 17, 26, 52 weeks (up to 1 year); Interest None (zero coupon); issued at discount; Key Features Most liquid government security

T-Notes: Maturity 2-10 years; Interest Semiannual fixed coupon; Key Features Intermediate term; auctioned near par (price may be above, at, or below par depending on yield vs. coupon)

T-Bonds: Maturity 20-30 years; Interest Semiannual fixed coupon; Key Features Longest maturity; auctioned near par (price may be above, at, or below par depending on yield vs. coupon)

How Do T-Bills Work?

Short-term obligations (up to 1 year)

Sold at a discount to par; investor receives par at maturity

Difference between purchase price and par is the investor's return

No periodic interest payments

Most liquid government security

Example: Buy a $10,000 T-Bill for $9,700, receive $10,000 at maturity = $300 return

Exam Tip: Gotchas

T-Bills pay no interest. They are sold at a discount and mature at face value. The difference is your return. T-Notes, T-Bonds, and TIPS all pay semiannual coupon interest; only T-Bills and STRIPS are zero-coupon.

How Do T-Notes and T-Bonds Differ?

T-Notes: intermediate-term (2-10 years)

T-Bonds: long-term (20-30 years)

Both pay semiannual fixed coupon interest

T-Bonds carry the most interest rate risk among coupon-bearing Treasuries (longest maturity)

What Are Treasury Floating Rate Notes (FRNs)?

FRNs are the only Treasury marketable security whose interest rate floats instead of staying fixed for the life of the security.

Maturity: 2 years, tied with the 2-year T-Note for the shortest maturity among coupon-paying Treasuries

Interest paid: Quarterly (every three months), not semiannually like T-Notes and T-Bonds

Rate: An index rate tied to the most recently auctioned 13-week T-Bill discount rate (reset weekly) plus a fixed spread set when the FRN is first auctioned

Carries the same full faith and credit backing as other Treasury securities

Exam Tip: Gotchas

FRNs are the only Treasury security with a rate that changes after issuance. Every other Treasury coupon security (T-Notes, T-Bonds, TIPS) locks in its rate at auction.

What Are TIPS and How Are They Taxed?

TIPS protect investors against purchasing power risk (inflation risk). Available in 5, 10, or 30-year maturities.

Fixed interest rate: The coupon rate never changes

Adjustable principal: The principal (not the original par value) adjusts daily by an index ratio derived from the Consumer Price Index for All Urban Consumers (CPI-U). Interest is paid semiannually, which is what makes students think the principal adjusts semiannually too

Interest calculation: Fixed rate x adjusted principal, paid semiannually

During inflation: Principal increases, so interest payments increase

During deflation: Principal decreases, so interest payments decrease

Deflation floor: At maturity, you receive the greater of adjusted principal or original par value. This protects original principal, not a premium purchase price. Selling before maturity can also produce a market loss.

Exam Tip: Gotchas

TIPS principal adjusts daily, not semiannually. Only the interest payment is semiannual; do not confuse the payment schedule with how often the principal itself changes.

How Are TIPS Taxed?

Interest payments are taxable at the federal level (exempt from state and local)

Annual principal adjustments are taxable as income even though the cash is not received until maturity

This creates phantom income that must be reported each year

Each year's taxed adjustment is added to your cost basis, so the amount you receive at maturity is not taxed a second time

Think of it this way: The IRS treats the increase in your TIPS principal as if you received that money today, even though you will not see it until the bond matures. You owe tax on income you have not actually collected yet.

Exam Tip: Gotchas

TIPS create phantom income because principal adjustments are taxed annually even though the cash is not received until maturity.

What Are Treasury STRIPS?

STRIPS are created by separating (stripping) the coupon and principal payments of eligible T-Notes, T-Bonds, and TIPS. Each component is sold separately as a zero-coupon security.

How Are Treasury STRIPS Created?

Think of a normal T-Bond as a bundle of scheduled cash payments. STRIPS unbundle those payments so each one can trade on its own:

Original Treasury bond, Semiannual coupon payment 1 becomes Interest STRIP, Sold at a discount; pays that coupon amount at its own maturity date

Original Treasury bond, Semiannual coupon payment 2 becomes Interest STRIP, Sold at a discount; pays that coupon amount at its own maturity date

Original Treasury bond, Semiannual coupon payment 3 becomes Interest STRIP, Sold at a discount; pays that coupon amount at its own maturity date

Original Treasury bond, Final principal repayment becomes Principal STRIP, Sold at a discount; pays the face value at final maturity

Coupon bond before stripping:

Interest, Interest, Interest, Interest, Principal, Year 1, Year 2, Year 3, Year 4, Maturity

After stripping:

Each arrow becomes its own zero-coupon security.

The investor buys one piece at a discount and receives only that piece's scheduled payment.

How Do STRIPS Cash Flows Work?

A 10-year T-Note with $1,000 face value and a 4% coupon paid semiannually creates 21 separate cash flows:

20 coupon payments of $20 each (one every six months for 10 years)

1 principal payment of $1,000 at maturity

After stripping, those 21 payments become 21 separate zero-coupon securities. Buying one coupon STRIP does not give the investor all future coupon payments. It gives the investor only that one coupon payment on that one payment date. Buying the principal STRIP gives the investor only the final principal payment at maturity.

Purchased at a deep discount, matures at par

No periodic interest payments

Highest interest rate risk among Treasuries (zero coupon + long maturity = longest duration)

Subject to phantom income: annual accretion of discount is taxable as ordinary income even though no cash is received. The taxed accretion is added to your cost basis, so the face value received at maturity is not taxed again

Best suited for tax-deferred accounts (IRAs, 401(k)s) to avoid phantom income taxation

Exam Tip: Gotchas

TIPS protect against inflation risk by adjusting principal with CPI. STRIPS have the highest interest rate risk because zero-coupon bonds have the longest duration. Both generate phantom income, taxable annually despite no cash received.

How Are Treasury Securities Taxed?

Interest is exempt from state and local income taxes

Interest is subject to federal income tax

This tax advantage makes Treasuries especially attractive for investors in high-tax states

What Are Agency Securities?

Agency securities are issued or guaranteed by government-sponsored enterprises (GSEs) or federal agencies. Among the three major mortgage agencies compared below, only GNMA-backed MBS carry the full faith and credit of the U.S. government; FNMA and FHLMC securities do not. FHLB obligations also lack that backing. Securities without the guarantee generally carry slightly more credit risk than direct Treasuries.

Interest is subject to federal income tax; state and local treatment depends on the issuer

GNMA (Ginnie Mae): Full Name Government National Mortgage Association; Government Backing Full faith and credit (federal agency, not a GSE; the only one of the three with this backing); Issued Securities Mortgage-backed securities (MBS) pass-throughs

FNMA (Fannie Mae): Full Name Federal National Mortgage Association; Government Backing Implied only (not explicit); Issued Securities MBS, bonds

FHLMC (Freddie Mac): Full Name Federal Home Loan Mortgage Corporation; Government Backing Implied only (not explicit); Issued Securities Participation certificates, bonds

FHLB: Full Name Federal Home Loan Banks; Government Backing Not full faith and credit; Issued Securities Consolidated bonds and discount notes

Among GNMA, FNMA, and FHLMC, only GNMA-backed MBS have an explicit U.S. government guarantee

FNMA and FHLMC have an implied "moral obligation" but no legal guarantee of repayment

Because FNMA and FHLMC lack the explicit guarantee, their securities carry slightly higher yields than Treasuries to compensate for the added credit risk

Exam Tip: Gotchas

When a question compares GNMA, Fannie Mae, and Freddie Mac mortgage securities, only GNMA-backed MBS carry the full faith and credit of the U.S. government. Fannie Mae and Freddie Mac have only implicit (moral obligation) backing.

How Do MBS Pass-Throughs Work?

Pools of residential mortgages packaged into securities. Pass-through certificates pass principal and interest payments from underlying mortgages through to investors.

Payment frequency: Monthly (not semiannual), because homeowners make monthly mortgage payments

Investors receive both interest and principal each month

Think of it this way: Imagine 1,000 homeowners each making their monthly mortgage payment. Those payments flow into a pool and get distributed proportionally to the investors who own that pool. You receive your share of interest and principal every month, just like a landlord collecting rent from many tenants.

Exam Tip: Gotchas

MBS pass-throughs pay monthly, not semiannually. They pass through homeowner mortgage payments.

What Are Prepayment Risk and Extension Risk?

MBS investors face two unique, opposing risks:

Prepayment risk: When It Occurs Interest rates fall; What Happens Homeowners refinance at lower rates; Impact on Investor Principal returned early; must reinvest at lower rates

Extension risk: When It Occurs Interest rates rise; What Happens Homeowners keep their low-rate mortgages; Impact on Investor Prepayments slow; MBS lasts longer than expected

Prepayment risk is a form of reinvestment risk

Prepayment risk and extension risk move in opposite directions

When one increases, the other decreases

Think of it this way: When mortgage rates drop, homeowners rush to refinance, just like anyone would jump at a lower car loan rate. Investors get their money back sooner than planned and can only reinvest at the new, lower rates. When rates rise, nobody refinances, so investors are stuck holding the security longer than they expected.

Exam Tip: Gotchas

Prepayment risk and extension risk are opposites. Falling rates trigger prepayment risk; rising rates trigger extension risk.

What Is a Collateralized Mortgage Obligation (CMO)?

A CMO is a more complex mortgage-backed security that divides MBS cash flows into tranches (slices) with different maturities and risk profiles.

Prepayment and extension risk are redistributed across tranches, not eliminated

Generally not suitable for most retail investors because of their complexity

Exam Tip: Gotchas

A CMO does not remove prepayment or extension risk from a mortgage pool; it reshuffles that risk unevenly across tranches, so some tranches carry more of it and others less.

How Are Agency Securities Taxed?

This is a frequently tested exam distinction:

Treasury securities: Federal Tax Taxable; State and Local Tax Exempt

GNMA, FNMA, and FHLMC securities: Federal Tax Taxable; State and Local Tax Taxable

FHLB bonds: Federal Tax Taxable; State and Local Tax Exempt for domestic U.S. investors

GNMA, FNMA, and FHLMC securities are taxable at all levels: federal, state, and local

FHLB bond interest is an agency exception: it is federally taxable but exempt from state and local income tax for domestic U.S. investors

Treasury interest is also exempt from state and local tax, but Treasuries carry the full faith and credit of the U.S. government

Exam Tip: Gotchas

Do not apply one tax rule to every agency issuer. GNMA, FNMA, and FHLMC securities are taxable at all levels, while FHLB bonds are exempt from state and local income tax for domestic U.S. investors.

What Should You Check on Exam Day?

T-Bills pay no coupon; T-Notes and T-Bonds pay semiannual fixed coupons; FRNs pay quarterly and are the only Treasury with a floating rate

Treasury interest and FHLB bond interest are federally taxable and state-and-local-exempt; GNMA, FNMA, and FHLMC securities are taxable at every level

Among GNMA, FNMA, and FHLMC mortgage securities, only GNMA-backed MBS carry the full faith and credit of the U.S. government

TIPS adjust principal for inflation; STRIPS carry the highest interest rate risk; both create phantom income

MBS pass-throughs pay monthly; prepayment risk rises when rates fall, extension risk rises when rates rise