Module 3 - Government Securities Flashcards
U.S. GOVERNMENT SECURITIES
Debt securities issued by the
government to raise capital for past indebtedness and the day-to-day functioning of the federal government. In general, U.S. government securities are considered safe, stable, and highly marketable securities.
The federal government has issued three major types of debt securities in the past and has recently issued a fourth one:
Bills, notes, bonds, and TIPS (the newest of the securities). A fifth security, STRIPS, is thought to be issued by the federal government, but it is not. A broker/dealer using Treasury notes or bonds issues it.
• Government securities used to be issued in certificate form, but today are only issued in book-entry form.
• This means that the investor does not get a piece of paper describing the issue.
• The customers receive a confirmation from the government, or broker/dealer through which the trade was executed, and the government keeps track of the name of the person who owns the securities.
Treasury Bills
- TREASURY BILLS (T-BILLS) have maturities of no more than one year and are currently sold as 4-, 13-, 26-week, and 52-week maturity instruments. These are also known as 1-month, 3-month, 6-month, and 1-year Treasury bills. Note that the U.S. government does not issue 9- month T-bills.
Because of their short maturity, T-bills react more quickly to changes in other short-term debt instruments such as repurchase agreements, banker’s acceptances, and negotiable CDs; therefore, they are considered to be more volatile than longer-term debt issues - Treasury bills are sold by the DEPARTMENT OF THE TREASURY (the DOT) at the direction of the FEDERAL OPEN MARKET COMMITTEE (FOMC). The FOMC is made of members of the Federal Reserve Board. The T-bills are sold at a discounted purchase price, which translates into a “yield” to the investor. Bills are not quoted in dollars, but on an annualized discounted yield to maturity basis, commonly called BASIS. This means that they have no stated interest rate but are purchased at a discount and mature at face value.
When are Treasury Bills Sold
Treasury bills are sold at a weekly auction on Mondays and Tuesdays and settle on the Thursday of the same week provided it is not a holiday. If it is a holiday, they settle on Friday, but generally this happens only once or twice a year.
Since 1998 the awarding of all Treasury issues is as a single-priced offering — all buyers pay the same price and get the same yield. Noncompetitive buyers receive their Treasury bills at the highest yield, the same as the competitive bidders. This is known as a single-priced auction.
Remember for Test
Treasury Notes
TREASURY NOTES are securities sold with a maturity from 1-10 years. They are actually issued with of 2-, 3-, 5-, 7-, and 10-year maturities, but for test purposes, the answer is 1-10 years. Notes are issued in minimum denominations of $1,000, but are usually sold in $5,000 increments up to $1 million. They are issued at a fixed rate of interest that is paid semiannually.
Treasury Bonds
TREASURY BONDS or T-BONDS are sold with a maturity of 30 years. Similar to Treasury notes, these securities are issued in minimum denominations of $1,000, and are usually sold in $5,000 denominations up to $1 million. They are issued with a fixed rate of interest that is paid semiannually. The interest on U.S. government bonds is computed by using the actual number of days in a month based on a 365-day year. They may be CALLABLE, but they must have a call date in addition to the maturity date. Not all Treasury bonds are callable, though. Callable means the right of the Treasury to redeem outstanding bonds before their scheduled maturity. This way the Treasury Department may refinance its debt if interest rates fall.
Treasury Inflation-Protected Securities
TREASURY INFLATION-PROTECTED SECURITIES (TIPS) were first introduced by the U.S. Treasury in 1997 as a variable rate government security. TIPS are the newest of the securities issued by the U.S. government
TIPS are characterized as follows:
• The interest rate is set at the time the TIPS is issued and remains the same until maturity.
• The principal amount of the TIPS is adjusted for inflation and/ or deflation, but never below the par amount.
• The value of the principal at maturity is the amount that will be paid, even if it is more than the original amount paid.
• The semiannual interest payments are based on the inflation-
adjusted principal at the time the interest is paid, and when the interest rate is applied to the adjusted principal value, the amount of the payment increases.
• The inflation rate is based on the Consumer Price Index (CPI).
• At maturity, the securities will be redeemed at the greater of their
inflation-adjusted principal or par amount at original issue.
Treasury Strips
TREASURY STRIPS or ZERO-COUPON securities are thought to be issued by the federal government, but are actually issued by broker/dealers and backed by U.S. government securities. Treasury
STRIPS are also known as TREASURY RECEIPTS.
• CATS, TIGRS, and LIONS are some well-known STRIPS
from the past.
• STRIPS is an abbreviation for Separate Trading of Registered
Interest and Principal Securities. These are notes or bonds, issued by broker/dealers and some banks that have had the interest component separated from the principal component of the investment.
– A financial institution or broker/dealer will purchase the bond or note and “strip” the interest from the principal for separate trading. The bond or note is sold at a discount, with the discount equal to the interest that would have been paid on the bond.
– The interest payments are traded separately, so a 10-year Treasury note will be converted into 21 separate securities, representing the semiannual interest payment and the final payment of the principal of the note.
• The principal of the note or bond is then resold as a ZERO- COUPON debt security, and does not make any periodic interest payments.
– Instead, the appreciation becomes the interest and is realized
by the investor upon maturity at face value. The difference between the discount price and the face value of the bond is the amount of interest that is paid to the investor.
• The interest that has been stripped off is also resold as a zero- coupon security with maturities on each of the interest payment dates.
– The investors holding the STRIPS that correspond to the
respective interest payment dates are paid at the same time as the interest is paid by the government to the holder of the original Treasury securities.
– The appreciation becomes the interest and is realized by the investor upon maturity of the STRIPS at face value.
• The amount of the discount for the STRIPS must be amortized (averaged) over the life of the bond and claimed as income on each year’s tax return during the time the bond is held, just as if the interest had been received each year.
– At the time of maturity, the holder receives the face value, but only has to pay taxes on the final year’s interest, rather than paying them on the total appreciation of the bond.
The STRIPS, or zero-coupon bonds, may be a suitable investment for a minor’s college fund, because the bond interest is taxed at the minor’s income tax rate. Additionally, a zero-coupon bond may be suitable for an IRA account, because the interest will not have to be reported each year.
Government Treasury securities have the following maturities:
- Treasury bills — known as T-bills, have maturities of 1 month, 3 months, 6 months, and 1 year. These securities are actually issued as 4- week, 13-week, 26-week, and 52-week maturities
- Treasury notes — issued for 1-10 years, though most are
- issued with maturities of 2, 3, 5, 7, and 10 years. Treasury bonds — issued for 30 years
- **To remember the order of their maturities, remember the phrase: “BILLS NOT BONDS” for “bills,” “notes,” and “bonds.”
The operation of the U.S. government is supported by financial obligations that are completely guaranteed. When the federal government issues Treasury bills, notes, or bonds, it guarantees the principal and interest of these securities. They are backed by the “full faith and credit” of the U.S. government.
Remember for Test
GUARANTEED DEBT
Guaranteed debt means that the securities (bonds) are guaranteed by the full faith and credit of the U.S. government.
Below are a handful of the agencies and corporations that issue guaranteed debt.
- EXPORT-IMPORT BANK (EXIMBANK): The securities from this agency are used for financing trade between the United States and foreign countries.
- SMALL BUSINESS ADMINISTRATION: This agency provides loans and management assistance to small businesses.
- GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA): Also known as GINNIE MAE
**GNMA is an agency under the jurisdiction of the U.S. government.
**GNMA issues PASS-THROUGH CERTIFICATES (types of bonds) that represent a pool of mortgages, including mortgages from the Department of Veterans Affairs and from the Federal Housing Administration. (The GNMA is guaranteed, but the mortgages that are included in the GNMA are not guaranteed by the government.)
GNMA bonds are issued with interest that is comparable to the loans that are pooled, except that the GNMA bond is issued at a yield that is 50 basis-points less than the pooled mortgages as a guaranty and service fee. Remember that basis equals yield to maturity.
**They are issued in $25,000 minimum quantities.
The investor receives monthly payments of interest and principal based on their ownership of the securities. Therefore, they are commonly known as MONTHLY PASS- THROUGHS.
**The receipt of payments from borrowers of mortgage loans affects the principal and interest that is paid to the investor. A portion of the principal is paid down each month by borrowers, and refinancing of mortgages affects the amount of interest being paid to investors.
**When people buy these securities in the secondary market, they do not have to pay the full $25,000 principal. Instead, they pay a percentage of the $25,000 face value, depending on how much has been paid in prepayments and in the monthly payments.
The federal government does not guarantee the debt of the following agencies:
- FEDERAL HOUSING ADMINISTRATION (FHA) LOANS: These loans are guaranteed by the Federal Housing Administration, not the government, and are specifically allocated for low-income housing and first time homebuyers.
- FEDERAL HOME LOAN BANKS (FHLB): This agency issues debt securities that provide money to savings and loans, which lend to homebuyers, small business, rural development, and agriculture.
- FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA): This agency began as a government-sponsored enterprise and is now a private corporation with stock that trades on the NYSE.
• FNMA issues bonds to finance the Department of Veterans Affairs, FHA, and conventional mortgage loans.
• FNMA is commonly called FANNIE MAE. - FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC), or Freddie Mac: This is a stockholder corporation that provides funds for mortgage lenders. The corporation purchases mortgages that collateralize mortgage-backed securities.
- FEDERAL LAND BANKS issue farm loans, mainly long-term loans. BANK FOR COOPERATIVES issues loans to farmers’ co-ops.
- FEDERAL INTERMEDIATE CREDIT banks issue short-term farm loans.
- FARM CREDIT SYSTEM (formerly known as the Federal Farm Credit Consolidated System-Wide Bank)
• This is a system of banks composed of the last three banks discussed above: the Federal Land Bank, the Bank for Cooperatives, and the Federal Intermediate Credit Bank.
• These banks issue equity securities for their own use and expansion.
• They are not backed by the government, although some people feel the government would jump in and help if many farmers began having trouble, much like the government did with the savings and loans in the 1980s.
• The Farm Credit System issues mortgage securities and discount notes and bonds for farm loans that are an obligation of all member banks in the Farm Credit System, but are ultimately backed by the mortgages on the farms and ranches. - STUDENT LOAN MARKETING ASSOCIATION (SLMA), or SALLIE MAE, generates debt securities used to fund the SLMA loans to students for higher education. SLMA began as a government- sponsored enterprise and is now a private corporation. SLMA is a publicly owned company whose stock trades on the NYSE. SLMA issues debt securities, such as discount notes, long-term bonds, and zero-coupon bonds.
The government’s long-term marketable and non-marketable debt is subject to purchasing power risk (today’s dollar versus the dollar 10 or 20 years from now when they mature) because of their length of time to maturity. Purchasing power risk is also associated with inflation. If goods cost more in the future, the same amount of dollars will purchase less.

Remember for Test
Obligations of U.S. marketable and non-marketable debt:
• MARKETABLE DEBT means an issue that may be traded in the
open market. Investors can purchase T-bills, T-notes, and T-bonds
or sell these securities through broker/dealers.
• NON-MARKETABLE DEBT means an issue that may only be
bought from, or redeemed by, the government (e.g., Series EE bonds).