CH 7

Question 1

level of default risk in Treasury securities?

Answer 1

none; but that doesn’t mean investors can’t lose money. gov securities trade in the 2nd market (OTC) and are subj to interest rate risk just like other debt sec

Question 2

T bills

Answer 2

Rather than making regular cash int paym, bills/ST obligations are issued at a discount from par.

T bills are considered mm instruments.

the 13-week T-bill is commonly used in quant analysis as the risk-free investment.

Question 3

T notes

Answer 3

2, 3, 5, 7, 10 yrs

pays interest every 6 months; sold at auction every 4 weeks

Question 4

T bonds

Answer 4

LT securities (10-13 yrs in original maturity) that pays interest every 6 months.

historically, the 30-yr bonds are callable at par, give yrs before maturity date.

Question 5

STRIPs

Answer 5

Treasury Dept entered the 0 cpn bond market by designating certain Treasury issues as suitable for stripping into interest and principal components.

These sec, named separate trading of registered interest and principal of sec, became known as STRIPS. Altho the sec underlying T STRIPS are the US gov’s direct obligation, major banks and dealers perform the actual separation and trading.
0 coupon bonds have minimal reinvestm risk .

Question 6

***STRIPS vs TREASURY RECEIPTS

Answer 6

STRIPS: backed in full by US gov. Receipts are not.

Treasury receipts are created by BDs and sold under names like Certificates of Accrual on T Sec (CATS) and Treasury Income Growth Receipts (TIGRS).

Both are quoted in YTM and have not been issued since the late 1980s.

Question 7

Treasury receipts

Answer 7

brokerage firms can create a type of 0 coupon bond known as Treasury receiptts from US T-notes and bonds. BDs buy Treasury sec, place them in trust at a bank, and sell separate receipts against the principal and cpn payment.

Unlike T sec, T receipts are NOT backed by full faith and credit of US gov. Each T receipt is priced at a discount form the payment amount, like a 0 coupon bond.

Question 8

TIPS

Answer 8

Treasury Inflation-Protected Sec help protect investors against purchasing power (inflation) risk. These bonds are issued with a FIXED interest rate, but the principal amt is adjusted semiannually by an amt equal to the change in CPI.

This interest payment the investor receives every 6 months is equal to the fixed interest rate times the newly adjusted principal.

During times of inflation, int payments increase, while times of deflation, interest payments fall. These notes are sold at lower interest rates than conventional fixed-rate T notes bc of their adjustable nature.

Question 9

TIPS are exempt from…

Answer 9

state and local income taxes on the interest income is generated. (Like any other Treasury sec)

they ARE subject to federal taxation though!

however, in any yr when the principal is adjusted for inflation, that increase is considered reportable income for that yr even tho the increase will not be received until the note matures.

Question 10

*** Max T-bill maturities are subject to change, but are never longer than…

Answer 10

never longer than 52 weeks

52-week bills are auctioned every 4 weeks, and the others, such as the 4-week and 26-week bills, weekly.

Question 11

T Note Maturities and Denomin

Answer 11

issued in denomin of $100 tot $5M

T notes mature at parr, or they can be refunded. If a T-note is refunded, the gov offers the investor a new sec with a new interest rate and maturity date as an alternative to a cash payment for the maturing note.

Question 12

Pricing for T Notes

Answer 12

T notes are issued, quoted, and traded as % of part in 1/32.

Question 13

Maturities and Denomin of T Bond

Answer 13

issue in denomin of $100 to $5M and mature at least 10 yrs from the date of issue.

Question 14

Agency Issues

Answer 14

Congress authorizes the fed gov t issue debt sec to these agencies:

• farm credit admin
• GNA or Ginnie Mae

other agency-like organizations operated by private corps include the following

• Feddie Mac
• Fannie Mae
• Sallie Mae

Question 15

GNMA

Answer 15

gov-owned corp that support he Dept of Housing and Urban development

Question 16

Ginnie Mae

Answer 16

does NOT originate mortgage loans, nor does it purchase, sell, or issue securities. Instead, private lending institutions approved by GNMA originate eligible loans and pool them into securities, known as pass-thru certificates, and sell the GNMA MBS to investors.

Question 17

GNMA guarantees…

Answer 17

timely paym of interest and payment. GNMAs are backed directly by the gov, so risk of default = 0. GNMAs offer slightly higher interest rates than comparable Treasury securities.

price, yields, and maturities fluctuate in line w general interest-rate trends. If int rates fall, homeowners tend to pay off their mortgages early, which has the effect of acc the certificates’ maturities.

Int rates rising though can cause certificates to mature more slowly

Question 18

in addition tot interest rate risk, there are 2 other types of risks associated with MBS:

Answer 18

1. prepaym risk - risk that underlying mortgagees will be paid off earlier than anticipated; will occur if int rates fall, causing homeowners to refinance their mortgagees at lower rates.
2. extended maturity risk - underlying mortgages will remain outstanding longer than anticipated.
   - occur if int rates rise, the virtually eliminating any refinancing, also known as extension risk.

Question 19

***GNMA FEATURES

Answer 19

back by full by the US gov

• $1000 min
• monthly int and principal paym
• taxed at all levels
• pass-through certificates

Question 20

which is most susceptible to reinvestment risk?

Answer 20

MBS

When interest fall, mortgage holders typically refinance at a lower rate. This meant that they pay off their mortgages early, which causes a prepayment of principal to holders of MBS.

The early principal payments cannot be reinvested at a comparable return

Question 21

Farm Credit System (FCS)

Answer 21

national network of lending institutions that provides agricultural financing and credit.

System is privately owned, gov-sponsored enterprise that raises loanable funds through the sale of Farm Credit securities to investors.

They’re NOT obligations nor are they guaranteed, by the US gov or any fed agency.

Backed by Banks of the FCS

These funds are made available to farmers through a nationwide network of 4 banks and 68 Farm Credit lending institutions. The FCA (Fed Credit Admin), a gov agency, oversees the system. Included in the system are the Federal Land Banks, Fed Intermediate Credit Banks, and Banks for Cooperatives.

Question 22

federal FCS issues…

Answer 22

discount notes, floating rate bonds, and fixed rate bonds.

The proceeds from the sale of securities are used to provide farmers with real estate loans, rule home mortgage loans, and crop insurance.

Question 23

Freddie Mac

Answer 23

Federal Home Loan Mortgage Corp (FHLMC) is a public co.

It was created to promote the development of a nationwide secondary market in mortgages by buying resi mortgages from fin institutions and packaging them into MBS for sale to investors.

FHLMC sells 2 types of securities: mortgage participation certificates (PCs) and guaranteed mortgage certificates (GMCs).

Question 24

Mortgage participation certificates (PCs)

Answer 24

make principal and interest payments once a month

Question 25

GMCs

Answer 25

make interest payments 2x a year and principal payments once a year

Question 26

Fannie Mae

Answer 26

Fed National Mortgage Association (FNMA) is a publicly held corp that provides mortgage capital.

FNMA purchases conventional and insured mortgages from agencies such as the FHA and the VA. The sec it created are backed by FNMA’s general credits

Question 27

types of FNMA issues

Answer 27

debentures, ST discount notes, and MBS.

In the case of virtually all of the agencies, there are NO certificates delivered. Records of ownership are kept electronically.

Question 28

Sallie Mae

Answer 28

issues ST and LT sec. The proceeds from sec sales are used to provide student loans for higher ed.

Sallie Mae was once a agency in US gov but is now privately owned with its common stock trading on NASDAQ.

Question 29

Tennessee Valley Authority (TVA)

Answer 29

this is nation’s largest public power provider and a corp of the US gov.

TVA bonds are not backed by the US gov.
Instead, they are backed by rev generated by agencies’ projects. However, credit-rating agencies perceive that there are an “implicit gov guarantee of TVA bonds.”

One special characteristic of TVA bond is that they are frequently issued with maturities of 50 yrs.

Question 30

Pass-through certificates

Answer 30

created by pooling a group of mortgages and selling ce rep itnersts int he pool.

Pass-through erersr to the mechanism of passing homebuyers’ interest and rincipal paymetns from the mortgage holder to the investors.

Fannie, Freddie, and Ginne function this way. In some cases, GNMA makes paymetns monthly.

Question 31

Denominations of Agency Sec

Answer 31

sold in a variety of increments

min is geerally $10K with increments of $5K.

Question 32

GNMA MBS minimum denomin.

Answer 32

min denomin of $1K and multiples of $1 in excess of $1000.

Bc few mortgages last the full term, yield quotes are based on a 12-yr prepayment assumption; that is, a mortgage balance should be prepaid in full after 12 yrs of normally scheduled payments

Question 33

Farm Credit System (FCS)

Answer 33

NOT pass-thru securities

denominations: $1000 with $1000 increments

Question 34

FHLMC

Answer 34

offers variety of increments with different denominations. The discount notes with a maturity of 1 yr or less are offered in denom of $1000, with $1000 increments. FHLMC also offers ref notes with 2-10 yrs maturities in min denominations of $2000 with $1000 increments.

Question 35

FNMA

Answer 35

MBS sec are available in min denominations of $1000, with $1 increments after that.

Interest is paid semiannually.

Question 36

SLMAA

Answer 36

LT issues generally in $10K min denomin.

Question 37

Interest Income of Treasury Sec

Answer 37

interest earned on any sec issued by US gov is TAXABLE on fed gov.

Interest on any sec issued by US treasury is exempt from state and local taxation.

There is 1 taxation oddity that deals with TIPS bonds. Each 6 months, there’s an adjustm to the principal value based on inflation rate (CPI) Even tho the investor does not receive that increase until the bond matures, it’s reported as interest income each yr.

Question 38

Intrest Income on Agency Sec

Answer 38

1 constant about taxation of agency sec is that the interest is ALWAYS subj to fed income tax.

This parallels the taxation of Treasury issues.

***interest earned on GNMA, FHLMC, and FNMA certificates are taxable at fed, state, and local levels. That a portion of the payments on MBS is a return of principles. That is nontaxable.

Interest paid on Farm Credit System and Fed Home Loan Banks sec is taxable at fed level but exempt at state and local taxation in most states.

Question 39

Gain or Loss for Agency Sec

Answer 39

case of non-MBS, gains and losses are computed the same way as any other security.

Question 40

*** SUMMARY OF TAX TREATMENT OF INTEREST

Answer 40

• interest on corporate bonds are taxable on all levels (fed, state, local)
• interest on munis may be taxed by the muni level (state and local gov) but NOT fed gov
• interest on issues of fed gov (t bills, notes, and bonds) is taxed by fed gov but is exempt from taxation ta state and local levels
• interest on MBS is taxed on all levels (fed, state, and local)
• interest on issues of US territories qualifies for triple tax exemption (fed, state, local)