US Government Debt Flashcards
Which statements are TRUE about CMBs?
A. CMBs are sold at par at a regular weekly auction
B. CMBs are sold at a discount at a regular weekly auction
C. CMBs are sold at par at a regular weekly auction
D. CMBs are sold at a discount on an “as needed” basis
The best answer is D.
CMBs are Cash Management Bills. They are sold at auction by the Treasury on an “as needed” basis to meet unexpected cash shortfalls, so they are not part of the regular auction cycle. They are the shortest-term U.S. government security, often with maturities as short as 5 days. They are sold in $100 minimums at a discount to par value, just like Treasury Bills.
Which statement regarding Treasury Bills is FALSE?
A. T-Bills are original issue discount obligations
B. T-Bills are auctioned off weekly by the Federal Reserve
C. When T-Bills mature, the difference between the purchase price and the redemption price is taxable as interest income
D. Treasury Bills are an agency security
The best answer is D.
Treasury Bills are original issue discount obligations. They are auctioned off weekly by the Federal Reserve acting as agent for the U.S. Treasury. When the bills mature, the difference between the purchase price and the redemption value at par is taxable as interest income. T-Bills are a direct obligation of the U.S. Government.
What is quoted in terms of yield and trades at a discount?
A. T-Bill
B. T-Note
C. T-Bond
D. Corporate Bond
The best answer is A.
Treasury Bills are short-term original issue discount obligations of the U.S. Government. They are quoted in a discount yield basis, aka a basis quote. Treasury Notes and Treasury Bonds are issued at par and are quoted as a percentage of par in movements of 32nds. Corporate bonds are issued at par and are quoted as a percentage of par in 1/8ths.
Which statement is TRUE regarding Treasury Bills?
A. T-Bills are issued at par
B. T-Bills are long term instruments
C. T-Bills pay interest weekly
D. No physical certificates are issued
The best answer is D.
The U.S. Government issues Treasury Bills in book entry form only. No physical certificates are issued.T-Bills are short term instruments that are issued at a discount and mature to par.
Which of the following investments is issued with a stated coupon rate and with a maximum maturity of 10 years?
A. Treasury Notes
B. Treasury Stock
C. Treasury Strips
D. Treasury Bonds
The best answer is A.
Treasury Notes are government obligations maturing between 1 year and 10 years which pay interest semi-annually.
New issues of Treasury Bonds, are issued by the U.S. Government in which form?
A. Book Entry
B. Bearer
C. Registered to Principal Only
D. Registered to Principal and Interest
The best answer is A.
All Treasury debt obligations are issued in book entry form only.
Which of the following investments is issued with a stated coupon rate and with a maximum maturity of 30 years? A. Treasury Notes B. Treasury Stock C. Treasury Strips D. Treasury Bonds
The best answer is D.
Treasury bonds are government obligations issued with initial 30 year maturities which pay interest semi-annually.
Which investment does NOT have purchasing power risk?
A. STRIPS
B. TIPS
C. Treasury Bonds
D. Treasury Receipts
The best answer is B.
Purchasing power risk is the risk that inflation will cause interest rates to increase; and therefore, bond prices will fall. “TIPS” are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher total payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities.
STRIPS are zero-coupon Treasury obligations - these have the highest level of purchasing power risk. If there is inflation, market interest rates are forced upwards, and zero-coupon bonds such as STRIPS fall dramatically in price (Treasury Receipts are broker-created zero-coupon bonds).
Long term T-Bonds are also susceptible to purchasing power risk, though not as badly as long-term zero-coupon bonds.
The bonds that have the lowest purchasing power risk are short term money market instruments and TIPS.
Which statement is TRUE about TIPS?
A. The coupon rate is less than the rate on an equivalent maturity Treasury Bond
B. The coupon rate is equal to the rate on an equivalent maturity Treasury Bond
C. The coupon rate is a market approximation of the inflation rate
D. The coupon rate is a market approximation of the discount rate
The best answer is A.
The interest rate placed on a TIPS (Treasury Inflation Protection Security) is less than the rate on an equivalent maturity Treasury Bond. For example, a 30 year Treasury Bond might have a coupon rate of 4%; but a 30 year TIPS has a coupon rate of 2.75%. The “difference” between the two is the current market expectation for the inflation rate (1.25% in this example).
The coupon rate on the TIPS approximates the “real interest rate” - the rate earned after factoring out inflation. If 30 year T-Bonds have a nominal yield of 4%; and the inflation rate is expected to be 1.25%; then the “real” interest rate is 2.75%.
The reason why the TIPS sells at a lower coupon rate is that, every year, the principal amount is adjusted upwards by that year’s inflation rate. So there are really 2 components of return on a TIPS - the lower coupon rate plus the principal adjustment equal to that year’s inflation rate.
Which statement is TRUE regarding Treasury Inflation Protection securities in periods of deflation?
A. The amount of each interest payment will stay the same and the principal amount received at maturity is unchanged at par
B. The amount of each interest payment will decline and the principal amount received at maturity is unchanged at par
C. The amount of each interest payment will stay the same and the principal amount received at maturity will decline
D. The amount of each interest payment will decline and the principal amount received at maturity will decline.
The best answer is B.
Treasury “TIPS” are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount.
In periods of deflation, the principal amount is adjusted downwards. Even though the interest rate is fixed, the holder receives a lower interest payment, due to the decreased principal amount. In the situation where the principal amount has been adjusted below par due to deflation, when the bond matures, the holder receives par - not the decreased principal amount - a real benefit if an investor is concerned about deflation.
Which statement is FALSE regarding Treasury Inflation Protection securities?
A. In periods of inflation, the coupon rate remains unchanged
B. In periods of inflation, the amount of each interest payment will increase
C. In periods of inflation, the principal amount received at maturity will be par
D. In periods of inflation, the principal amount received at maturity is more than par
The best answer is C.
Treasury “TIPS” are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount.
A customer buys a $1,000 par Treasury Inflation Protection security with a 4% coupon and a 10 year maturity. If the inflation rate during the first year of the security’s life is 5%, the:
A. principal amount remains at $1,000 and the coupon rate remains at 4%
B. principal amount remains at $1,000 and the coupon rate is adjusted to 5%
C. principal amount is adjusted to $1,050 and the coupon rate remains at 4%
D. principal amount is adjusted to $1,050 and the coupon rate is adjusted to 5%
The best answer is C.
Treasury “TIPS” are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities.
Which of the following is the most likely purchaser of STRIPS?
A. Pension fund
B. Money market fund
C. Individual seeking current income
D. Individual wishing to avoid purchasing power risk
The best answer is A.
Pension funds and retirement accounts are the large purchasers of STRIPS. These zero-coupon bonds are purchased at a deep discount and are held to maturity to fund future retirement liabilities. There is little credit risk, because the U.S. Treasury is a top credit. There is no current income because they don’t pay until maturity. They have a huge amount of purchasing power risk as a long-term zero coupon obligation, but this is not an issue if they are held to maturity.
Retirement plan managers like STRIPS because they don’t have to worry about reinvestment risk - there are no semi-annual interest payments to reinvest! It is an investment that can be “tucked away” for 20 or 30 years, with no further work or worry on the part of the retirement fund manager.
Which statement about Treasury STRIPS is TRUE?
A. Treasury STRIPS are suitable investments for individuals seeking current income
B. Treasury STRIPS are not suitable investments for retirement accounts
C. The holder is subject to default risk
D. The holder is not subject to reinvestment risk
The best answer is D.
Treasury STRIPS are government bonds that are “stripped” of coupons. Theses issues are very safe but do not provide current income. STRIPS are often placed into retirement accounts by conservative investors This is a zero coupon obligation with a “locked in” rate of return over the life of the bond (thus, it is not subject to reinvestment risk).
Which investment gives the LEAST protection against purchasing power risk?
A. 6 month Treasury Bill
B. 10 year Treasury Note
C. 10 year Treasury “TIPS”
D. 10 year Treasury “STRIPS”
The best answer is D.
Purchasing power risk is the risk of inflation - that the prices of goods and services rises faster than real economic growth. When there is significant inflation, interest rates rise. And this causes bond prices to fall.
Treasury “TIPS” are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. Thus, there is no purchasing power risk with these securities.
Treasury STRIPS are zero-coupon Treasury obligations - these have the highest level of purchasing power risk. If there is significant inflation and interest rates rise, these securities do not provide semi-annual interest payments that can be reinvested at higher and higher rates. Rather, all the value is in the single final payment. And if this is discounted to today’s value at increasing interest rates, its present value falls - rapidly.
In contrast, 6 month Treasury bills have a low level of purchasing power risk. Since they will mature at par in the near future, their value cannot fall very far below this if interest rates rise.
Series EE bonds:
A. are issued at a discount to face
B. are issued in minimum denominations of $100
C. pay interest semi-annually
D. pay interest at redemption
The best answer is D.
Series EE bonds are “savings bonds” issued by the U.S. Government with a minimum purchase amount of $25 (or more). This is the face value of the bond, and any interest earned is added to the bond’s value. The interest rate is set at the date of issuance. Interest is “earned” monthly and credited to the principal amount every 6 months. The bonds have no stated maturity - the holder can redeem at any time, however interest is only credited to the bonds for 30 years.
Savings bonds do not trade - they are issued by the Treasury and are redeemed with the Treasury.
No physical certificates are issued - the bonds are issued in electronic form.
Which security does not earn any form of interest?
A. Treasury Strip
B. Treasury Note
C. Treasury Bond
D. Treasury Stock
The best answer is D.
Treasury Stock does not earn interest, nor does it receive dividends. It is common stock that a corporation has repurchased and retired.
Treasury Notes and Bonds issued by the U.S. Government pay interest semi-annually.
Treasury STRIPS are zero-coupon Treasury obligations. The increase in value as it gets closer to maturity is the “interest” earned.
Which statement is TRUE when comparing Treasury Notes to Treasury STRIPS?
A. Treasury Notes pay interest annually
B. Treasury STRIPS pay interest at maturity
C. Treasury STRIPS pay interest semi-annually
D. Treasury Notes pay interest at maturity
The best answer is B.
Treasury Notes are government obligations maturing between 1 year and 10 years which pay interest semi-annually.
Treasury STRIPS are notes or bonds “stripped” of coupons, meaning all that is left is the principal repayment portion of the note or bond (sometimes called the “corpus” or body). STRIPS are zero coupon original issue discount obligations that do not have a stated interest rate. The accretion of the discount over the bond’s life represents the interest earned.
How is the interest income received from U.S. Government obligations taxed?
A. Subject to both federal and state income tax
B. Exempt from both federal and state income tax
C. Subject to federal income tax and exempt from state income tax
D. Exempt from federal income tax and subject to state income tax
The best answer is C.
The interest income received from U.S. Government obligations is subject to federal income tax, but is exempt from state and local income taxes (one level of government cannot tax the other’s obligations).
The Government National Mortgage Association:
A. buys conventional mortgages from financial institutions for repackaging as pass through certificates
B. buys FHA and VA guaranteed mortgages from financial institutions for repackaging as pass through certificates
C. gives its implied backing to the payment of interest and principal on mortgages purchased from financial institutions
D. issues mortgages directly on U.S. Government subsidized housing
The best answer is B.
Ginnie Mae buys FHA and VA guaranteed mortgages from banks and assembles them into pools. GNMA then sells undivided interests in these pools as pass-through certificates. The monthly mortgage payments are passed through to the certificate holders. GNMA guarantees the payment of interest and principal on the underlying mortgages and has the direct backing of the U.S. Government. The agencies that have an implied U.S. Government backing are Fannie Mae and Freddie Mac.
Which statement is TRUE regarding Government National Mortgage Association pass-through certificates?
A. GNMA securities have no reinvestment risk
B. Reinvestment risk for GNMAs is greater than that for equivalent maturity U.S. Government bonds
C. Reinvestment risk for GNMAs is the same as for equivalent maturity U.S. Government bonds
D. Reinvestment risk for GNMAs is less than that for equivalent maturity U.S. Government bonds
The best answer is B.
If the mortgages backing a Ginnie Mae Pass Through Certificate are prepaid (if interest rates have dropped), the certificate holders receive payments that are a return of principal, and that, when reinvested at lower current rates, produce a lower return (this is reinvestment risk). So, prepayment risk leads to reinvestment risk.
In contrast, payments received from other Treasury securities consist of interest only, so if interest rates drop over the time period these securities are held, only the interest must be reinvested at lower rates; there is no principal return that must be reinvested until maturity.
A security which gives the holder an undivided interest in a pool of mortgages is known as a:
A. unit investment trust
B. pass through certificate
C. first mortgage bond
D. face amount certificate
The best answer is B.
The question defines a pass through certificate - an undivided interest in a pool of mortgages, where the mortgage payments are passed through to the certificate holders.
A customer with $25,000 to invest could buy:
A. 1 mortgage backed pass through certificate at par
B. 2 mortgage backed pass through certificates at par
C. 10 mortgage backed pass through certificates at par
D. 50 mortgage backed pass through certificates at par
The best answer is A.
Mortgage backed pass through certificates are sold in minimum denominations of $25,000 (instead of the typical $1,000 for other bonds and $100 for Treasury issues). They have a much higher minimum to discourage small investors (who tend to be less sophisticated) from buying them - because they have difficult to quantify risks of shortening or lengthening maturities, due to interest rates falling or rising, respectively. A customer with $25,000 to invest could buy 1 of these certificates at par.
Payments to holders of Ginnie Mae pass-through certificates are made:
A. monthly and represent a payment of both interest and principal
B. monthly and represent a payment of only interest
C. semi-annually and represent a payment of both interest and principal
D. semi-annually and represent a payment of only interest
The best answer is A.
All pass-through certificates pass on the monthly mortgage payments received from the pooled mortgages to the certificate holders. Thus, payments are received monthly. These represent a payment of both interest and principal on the underlying mortgages.
All of the following statements are true about the Federal National Mortgage Association Pass-Through Certificates EXCEPT:
A. FNMA is a publicly traded company
B. interest payments are subject to state and local tax
C. certificates are issued in minimum units of $25,000
D. the credit rating is considered the highest of any agency security
The best answer is D.
FNMA is a publicly traded company. Its stock was listed for trading on the NYSE, but Fannie went “bust” in 2008 after purchasing too many “sub prime” mortgages and was placed into government conservatorship. Its shares were delisted from the NYSE and now trade OTC in the Pink OTC Markets.
Unlike GNMA, whose securities are directly U.S. Government guaranteed; FNMA only carries an “implicit” U.S. Government backing, so its credit rating is lower than that of GNMA.
Interest received by the holder of a mortgage backed pass through security is fully taxable by both federal, state, and local government.
Certificates are issued in minimum $25,000 denominations. For most investors this is too much money to invest, so they buy shares of a mutual fund that invests in these instruments instead.
