4.2 Treasury Securities

U.S. Treasury Securities

Treasury securities are debt obligations of the U.S. government, the safest fixed-income investments available. They are backed by the full faith and credit of the U.S. government and serve as the benchmark for other interest rates.

Why Treasuries Are the Safest

Credit Risk: Zero, U.S. government can print money to pay debts

Liquidity: Highest, largest bond market in the world

Benchmark: All other rates compared to Treasury rates

Safe Haven: Investors flee to Treasuries during market stress

Types of Treasury Securities

Treasury Bills (T-Bills)

Maturity: 4, 6, 8, 13, 17, 26, and 52 weeks

Minimum: $100

How Sold: At discount to par (no coupon payments)

Interest Rate Risk: Lowest (short maturity)

Quotation: Discount basis (basis point discount from par)

Discount Calculation Example:

- 26-week T-bill with 4% annualized discount

- Purchase price: $10,000 x (1 - 0.04 x 26/52) = $9,800

- Return: $200 over 6 months

Treasury Notes (T-Notes)

Maturity: 2, 3, 5, 7, and 10 years

Minimum: $100

Interest: Semi-annual coupon payments

Quotation: Percentage of par in 32nds (e.g., 99-16 = 99.5%)

Benchmark: 10-year note is most widely followed

The 10-year Treasury note yield is the most important benchmark in fixed income, used for mortgage rates, corporate bonds, and economic analysis.

Treasury Bonds (T-Bonds)

Maturity: 20 and 30 years

Minimum: $100

Interest: Semi-annual coupon payments

Interest Rate Risk: Highest (longest maturity)

Best For: Long-term investors; income-focused portfolios

Treasury Inflation-Protected Securities (TIPS)

TIPS protect against inflation by adjusting principal based on the Consumer Price Index (CPI).

Maturity: 5, 10, and 30 years

Principal Adjustment: Adjusts with the CPI (daily index ratio); interest is paid every 6 months on the adjusted principal

Coupon: Fixed rate applied to adjusted principal

Deflation Protection: At maturity, receive greater of adjusted or original principal

Inflation Protection: Direct, principal grows with inflation

TIPS Example:

- Buy $10,000 TIPS with 2% coupon

- CPI increases 1.5% over 6 months

- Principal adjusts to $10,150

- Semi-annual interest: 2%/2 x $10,150 = $101.50 (vs. $100 originally)

Tax Consideration: The principal adjustment is taxable in the year it occurs, even though you don't receive the cash until maturity ("phantom income").

Treasury STRIPS

STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon Treasury securities.

Created By: Stripping coupon and principal from regular Treasuries

Structure: Sold at deep discount; no periodic payments

Interest Rate Risk: Maximum (duration equals maturity)

Reinvestment Risk: Zero (no interim payments to reinvest)

Taxation: Annual "phantom tax" on imputed interest

STRIPS Duration: A 20-year STRIP has a duration of 20 years, the maximum possible. This means extreme price sensitivity to interest rate changes.

Tax Treatment of Treasuries

Federal Income Tax: Taxable

State Income Tax: Exempt

Local Income Tax: Exempt

This state tax exemption makes Treasuries particularly attractive for investors in high-tax states like California and New York.

Treasury Quotations

T-Bills (Discount Basis)

Quoted as annualized discount rate from par:

- Bid 4.05%, Ask 4.00% means dealer buys at 4.05% discount, sells at 4.00% discount

Notes and Bonds (32nds Pricing)

Quoted as percentage of par in 32nds:

- 99-16 = 99 + 16/32 = 99.5% of par = $995 per $1,000 face

- 101-08 = 101 + 8/32 = 101.25% of par = $1,012.50 per $1,000 face

Treasury Auctions

Competitive Bid: Specify yield; may not get filled

Non-Competitive Bid: Accept auction yield; guaranteed allocation

Most individual investors use non-competitive bids through TreasuryDirect.

In Practice: How Investment Advisers Apply This

Portfolio applications:

- Use T-Bills for short-term reserves and near-term liquidity needs

- Use T-Notes for intermediate-term objectives

- Use T-Bonds for long-term income (accept higher interest rate risk)

- Use TIPS for inflation-sensitive clients (retirees, pension plans)

Client considerations:

- High-tax state residents benefit from state tax exemption

- TIPS create taxable phantom income, better in tax-advantaged accounts

- STRIPS are best for specific future liabilities (e.g., college funding)

On the Exam

The Series 65 exam tests your understanding of:

1. Maturities: Bills (1 year or less), Notes (2-10 years), Bonds (20-30 years)

2. Tax treatment: Federal taxable, state and local exempt

3. TIPS: Principal adjusts with CPI; phantom income tax issue

4. STRIPS: Zero-coupon; maximum interest rate risk; zero reinvestment risk

5. Quotation: 32nds pricing for notes and bonds

Common formats include tax treatment and TIPS characteristics.

Key Takeaways

- T-Bills: Short-term (1 year or less), sold at discount, lowest interest rate risk

- T-Notes: 2-10 years, semi-annual coupons, 10-year is key benchmark

- T-Bonds: 20-30 years, highest interest rate risk

- TIPS: Principal adjusts with CPI; phantom income is taxable

- STRIPS: Zero-coupon; maximum interest rate risk; no reinvestment risk

- Tax treatment: Federal taxable; state and local exempt

- All Treasuries backed by full faith and credit of U.S. government