Chapter 3 - Government and Government Agency Issues

Question 1

who is the largest issuer of debt?

Answer 1

The US government is the largest issuer of debt with the least amount of default risk

Question 2

Interest earned on US government bonds are taxed how?

Answer 2

only taxed at the federal level

Question 3

treasury bills

Answer 3

• Range in maturity from 4 -52 weeks
• Auctioned off by the treasury department through weekly competitive auction
• Large banks/brokers dealers (aka primary dealers) submit competitive bids (or tenders) for the bills being sold
• Treasury awards the bills to the bidders who submitted the highest bid and work their way down to lower bids until all the bills are sold
• They pay no semiannual interest
• Issued at a discount from par
  
  • Because of this a higher dollar price represents a lower interest rate for the purchaser
• Bill appreciates up to par at maturity and the appreciation represents the investor’s interest
• Any noncompetitive tenders are filled before any competitive tenders are filled
• A bidder who submits a non competitive tender agrees to accept the average of all the yields accepted by the treasury and does NOT try to get the best yield
• All competitive tenders are limited to a maximum of $500,000.
• All bids that are accepted and filled by the treasury are settled in fed funds
• Treasury bills range in denominations from $100 to $1,000,000.
• NOTE: a quote for a treasury bill has a bid that appears to be higher than the offer, but remember that the bills are quoted on a discounted yield basis. The higher bid actually represents a lower dollar price than the offer

Question 4

Treasury notes

Answer 4

• They are the US government’s intermediate-term security
• They range from 1 year to 10 years
• They pay semiannual interest
• They are auctioned off by the treasury every 4 weeks
• Issued in denominations from $100 to $1,000,000
• May be refunded by the government
  
  • If this happens, they will offer the investor a new treasury note with a new interest rate and maturity
  • The investor may also elect to receive their principal payment instead of accepting the new note

Question 5

Treasury bonds

Answer 5

• They are the government’s long term bonds
• Maturities range from 10 years to 30 years
• Like notes, they pay semiannual interest and issued from $100 to $1,000,000
• They may be called in at par by the treasury
  
  • If this happens, they must give holders 4 months notice

Question 6

Treasury bond and note pricing

Answer 6

• They are quoted as a percentage of par
• Unlike their corporate counterparts, treasury notes and bonds are quotes as a percentage of par to 32nds of 1%
• EXAMPLE
  
  • A treasury bond quote of 92.02 translates to:
    
    • 92 2/32% x $1000 = $920.625
  • A quote of 98.04 translates to:
    
    • 98.125% x $1000 = $981.25
• IMPORTANT to remember that the number after the decimal points represents 32nds of a percent
• Minimum to purchase bill, note or bond from treasurydirect.gov is $100
• All quotes in the secondary market are based on $1000 per value
• NOTE: they do not currently sell 1 year bills, BUT may elect to do so as it recently decided to reissue 30 year bonds

Question 7

STRIPs

Answer 7

Treasury strips (STRIPs)

• Stands for separate trading of registered interest and principal securities
  
  • It is a zero-coupon bond that is backed by the US government securities
• Treasury securities are separated into 2 parts
  
  • A principal payment
  • Semiannual interest payments
• An investor may purchase the principal payment component of $1000 due on a future date at a discount
• An investor seeking some income may wish to purchase the semiannual coupon payments due over the term of the treasury securities
• May be purchased by an investor who needs to have a certain amount available ona known date in the future (like when a child is going to college)
• By purchasing a STRIP, the investor will be guaranteed to have $1000 on that date in the future for each STRIP purchased

Question 8

Treasury receipts

Answer 8

• Similar to STRIPs, except that the broker dealers and banks create them
  
  • They will purchase large amounts of treasury securities, place them in trust, and sell off the interest and principal payments to different investors

Question 9

TIPS

Answer 9

Treasury inflation protected securities (TIPS)

• Offers the investor protection from inflation
• They are sold with a fixed interest rate and their principal is adjusted semiannually to reflect changes in the consumer price index
• During times of inflation
  
  • The principal amount if the TIP will be increased and the investor’s payments will rise
• During times of falling prices
  
  • The principal amount of the bond will be adjusted down and the investor will receive a lower interest payment
• EXAMPLE
  
  • A conservative investor purchased a TIP with a coupon rate of 4%. Prior to taking inflation into consideration the investor will receive 4% x $1000 or $40 per year paid $20 or 2% every 6 months. TIPS pay interest every 6 months based on the adjusted principal amount. If inflation is running at 6% per year over the next 2 years the investor’s principal and interest payments will be as follows:
  • Because inflation was running at 6% per year the principal was increased by 3% every 6 months.
  • The adjustment to the principal and interest compound semiannually and results in the continued increase in the principal amount and payment received
  • To determine the amount of principal
    
    • Half coupon rate x adjusted principal
  • To approximate the answer
    
    • Take the inflation rate over the given time and multiply it by the principal
      
      • This is only going to result in a number that is near the actually answer
      • Only used to check real answer
• NOTE: because the principal amount of the TIP is adjusted every 6 months to account for inflation the real return of the inflation adjusted return will always be equal to the coupon rate

Question 10

Agency issues

Answer 10

• These are authorized agencies and certain quasi agencies to issue debt securities
• Revenues generated through taxes, fees, and interest income back these agency securities
• Investors who purchase these securities are offered interest rates that generally fall in between the rates offered by similar term treasury and corporate securities
• Investors who purchase these in secondary market will be quoted prices for the agency issues that are based on a percentage of par just like corporate issue

Question 11

GNMA

Answer 11

Government national mortgage association (GNMA)

• Often referred to as “Ginnie Mae”
• Its a wholly owned government corporation and is the only agency whose securities are backed by full faith and credit of the US government
• The purpose is to provide liquidity to the mortgage markets
• They buy up pools of mortgages that have been insured by the federal housing administration (FHA) and the mortgages then is sold off to private investors in the form of pass-through certifications
  
  • They receive monthly interest and principal payments based on their investment
  • As people pay down their mortgages, part of each payment is interest and part of each payment is principal and both portions flow through to the investor on a monthly basis
  • Issued with a minimum of $1000
  • Interest earned is taxable on all levels
    
    • Fed, state, local
• Yield quotes are based on a 12 year prepayment assumption because most mortgages are repaid early as a result of refinancing, moving, or homeowner simply paying off their mortgage
• The only real risk
  
  • Early refinancing
    
    • When refinanced during a period of low interest rates, the investor will not receive the higher interest rates for as long as they had hoped.

Question 12

FNMA

Answer 12

Federal national mortgage association (FNMA)

• Often referred to as “Fannie Mae”
• Is a public for-profit corporation
• Its stock trades publicly
• Its in business to realize a profit by providing mortgage capital
• Its called an agency security because they have a credit facility with the government and receives certain favorable tax considerations
• They purchase mortgages and bundles them up into mortgage backed securities
  
  • These notes are issued from $5000 to $1,000,000
  • They pay interest semiannually
• Also issues debentures
  
  • minimum of $10,000 that matures in 3 to 25 years
  • Interest paid semiannually
  • Interest earned is taxed on all levels

Question 13

FHLMC

Answer 13

Federal home loan mortgage corporation (FHLMC)

• Also known as “Freddie Mac”
• It is a publicly traded company in business to earn a profit on its lons
• They purchase residential mortgages from lenders and them package them into pools and sells off the interests on those pools to investors
• Interest earned is taxable on all levels
• NOTE: Fannie Mae and Freddie Mac have been placed in receivership by the US government

Question 14

FFCS

Answer 14

Federal farm credit system (FFCS)

• It is a group of privately owned lenders that provide different types of financing for farmers
• They sell off farm credit securities in order to obtain the funds to provide to the farmers
• The securities are the obligations of all the lenders in the system
• They are NOT backed by the US government
• Pay interest every 6 months
• Only available in book-entry form
• Some lenders to be aware of:
  
  • Federal land bank provides mortgage money
  • Bank of the cooperatives provides money for feed and grain
  • Federal intermediate credit bank provides money for tractors and equipment

Question 15

CMO

Answer 15

Collateralized mortgage obligation (CMO)

• It is a mortgage-backed security issued by private finance companies
  
  • As well as by FHLMC and FNMA
• They are structured much like a pass-through certificate
• Their term is set into different maturity schedules
  
  • Known as tranches
• Pools of mortgages on 1 to 4 family homes collateralize CMOs
• Considered relatively safe investments and are given AAA rating
• The only real risk
  
  • The owner of a CMO could experience early refinance
  • They pay interest and principal monthly
    
    • BUT pay principal to only one trache at a time in $1000 payments
  • CMO pays off each tranche until the final trache (aka Z tranche) is paid off.
    
    • Z tranche is the most volatile CMO tranche

Question 16

CMOs and interest rates

Answer 16

• They are affected by a change in the interest rate and experience these things if the interest rate changes:
  
  • If interest rates fall
    
    • Homeowners will refinance more quickly and the holder of the CMO will be paid off more quickly than they hoped
  • Rate of principal payments may vary
  • If interest rates rise
    
    • Refinancing may slow down and the investors will be paid off more slowly than they hoped
• Most have an active secondary market and are considered relatively liquid securities
  
  • BUT more complex CMOs may not have an active secondary market and may be illiquid
• Interest earned by investors from CMOs is taxable at all levels

Question 17

Types of CMOs

Answer 17

• Principal only (PO)
• Interest only (IO)
• Planned amortization class (PAC)
• Targeted amortization class (TAC)
• Private-label

Question 18

Principal only CMO

Answer 18

• Principal only (PO)
  
  • Receives the principal payments made on the underlying mortgage
  • Receive both the scheduled principal payments as well as any prepayments made by the home owners in the pool
  • Does NOT receive any interest payments
  • It is sold at a discount to its face value
  • The appreciation up to face value is the investor’s return
  • They are sensitive to interest rates
    
    • As rate fall
      
      • Value will rise as prepayments accelerate
    • As rates rise
      
      • Value will fall as prepayments decelerate

Question 19

Interest only CMO

Answer 19

• Interest only (IO)
  
  • They receive interest payments made by homeowners in the pool of underlying mortgages
  • Also sell at a discount to their face value due to amortization of the underlying mortgages
  • They are sensitive to interest rates
    
    • As interest rates rise
      
      • these will increase in value
      • Prepayments will slow, thus increasing the number of interest payments the investor receives
    • As interest rates fall
      
      • these will decrease in value
  • The changes in the prepayments on the underlying mortgages will affect the number of interest payments the holder of the CMO will receive
  • The more interest payments the CMO holder receives, the more valuable the CMO becomes

Question 20

Planned amortization class CMO

Answer 20

• Planned amortization class (PAC)
  
  • They are paid off first and offer the investor the most protection against prepayment risk and extension risk
  • If prepayments come in too quickly
    
    • those principal payments will be deferred to another CMO known as a support class to protect the owner of the PAC from prepayment risk
  • If principal payments are made more slowly
    
    • Principal payments will be taken from a support class to protect the investor against extension risk

Question 21

Targeted amortization class CMO

Answer 21

• investor against extension risk
• Targeted amortization class (TAC)
  
  • Only offers the investor protection from prepayment risk
  • If principal payments are made more quickly
    
    • They will be transferred to a support class
  • If principal payments come in more slowly
    
    • Payments will not be taken from a support class and will be subject to extension risk

Question 22

Private-label CMO

Answer 22

• Are issued by investment banks and payment of interest and principal payments are the responsibility of the issuing investment bank
• The payments due to a holder of a private-label CMO are NOT guaranteed by any government agency
• Credit rating of the private label CMOs are based on the collateral that backs the CMO and the credit rating of the issuer
• If they use agency issues as collateral of the CMO, those agency issues still carry the guarantee of the issuing government agency

Question 23

The secondary market for complex CMOs may be what?

Answer 23

illiquid