Chapter 8 Treasury Securities

TYPES OF TREASURY SECURITIES

What is a treasury security?

What is their risk level?

• Debt that is issued by the US treasury

• They are essentially risk free

What is a non-marketable vs marketable treasury?

• Marketable: can be traded in the secondary market

• Non-marketable: cannot be traded in the secondary market

INTEREST BEARING SECURITES

What are the two types of interest paying treasuries and what separates them?

When is interest paid on these?

• Notes: maturity of 2-10 years

• Bond: maturity of 10+ years

• SA like other types of fixed income

What kind of risks to these securities have?

• No default risk

• But do have inflation, reinvestment, and interest rate risk

What does it mean to be held in book entry issuance?

• Don’t actually receive a paper certificate

• Instead the Fed will keep your name on file

How are the prices for these securities displayed?

What does 99.08 or 99-08 mean?

• Quoted as a percentage of par and in 1/32 instead of 1/8

• 99 8/32 = 99.25% = $972.50

What is a TIPS and how they work?

• Treasury inflation protected securities

• They have a fixed coupon rate but the principal changes with the CPI rate so the coupon payments change as well

What kind of risks do TIPS have?

• No inflation risk, but still have some interest rate and reinvestment risk

What happens at maturity if the principal falls below $1,000 due to a drop in inflation?

How are any gains on the principal taxed?

• The principal may fall below $1,000 during the life of the bond to calculate the coupon, but ATLEAST $1,000 will always be returned to the customer

• The interest paid is still federally tax exempt but the gains are taxable

NON INTEREST BEARING SECURITES

What is a treasury bill?

Are there any risks?

• Short term securities that mature in 1 year or less

• There are essentially no risks with these

How do investors get interest from these?

• There are no coupon payments made through its life, instead it is issued at a discount

How are T-Bill Prices quoted?

How does this effect the appearance of the bid ask spread?

• Quoted on a discount yield basis rather than percentage of par

• The bid will look higher since it is in yield which really means the dollar price is lower

What is a STRIPPED security?

What kind of risks do these securities have?

• It takes a bond/note and separates the interest/principal payments into their own zero coupon bonds

• They have no reinvestment risk but do have interest rate risk

Are STRIPS still backed by the treasury?

How are they quoted?

• Yes, they are backed by the treasury

• Quoted on a yield basis like bills

What is the difference between a true STRIP and a treasury receipt?

• STRIPs are issued by the government while receipts are issued by BDs

ACCRUED INTEREST

What day counts do treasuries use?

• actual days in a month and 365 days a year

What is the timeline for calculating accrued interest?

• From the last coupon date through settlement date but not including settlement date

THE PRIMARY MARKET FOR US TREASURY SECURITES

What process is used to auction off treasuries?

• A Dutch auction

What is the difference between a competitive and non competitive bid?

• Competitive are bids placed by securities firm that actually partake in the Dutch process

• Non-Competitive are placed by individuals who just say the amount they want and accept whatever yield it comes in at

AGENCY SECURITES

What is an agency security?

What is their credit profile?

How are they quoted?

• Debt issued by federal agencies and GSEs

• Although not direct obligations of the US government, they are still very low credit risk

• In 1/32s like treasuries

What is a federal agency?

Example?

• A direct extension of the US Government, so they are backed by the US Government

• Ginnie Mae

What is a GSE?

Example?

• Publicly chartered but privately owned so they are not guaranteed by the US government

• Freddie Mac and Fannie Mae

MORTGAGE BACKED SECURITIES

What is a mortgage backed security?

• A security backed by a pool of underlying mortgages

What is a pass through certificate?

How does the payment structure work?

• An agency will buy a pool of mortgages then sell interests in that pool to investors

• There is no return of principal at the end, there are just monthly P&I payments that flow through

What is the Federal Home Loan Mortgage Corp (Freddie Mac)?

Are they guaranteed by the US gov?

How are they taxed?

• Provides liquidity to lending institutions through buying mortgages from them

• No

• Full taxable at all levels

What does the Federal National Mortgage Association (Fannie Mae) do?

Are they guaranteed by the US gov?

How are they taxed?

• Buys FHA, VA, and conventional mortgages from lending institutions

• No

• Full taxable at all levels

What does the Government National Mortgage Association do?

Are they guaranteed by the US gov?

How are they taxed?

• They guarantee MBS

• Yes, they are directly part of the US government

• Full taxable at all levels

PREPAYMENT RISK

What is prepayment risk?

How does this effect investors?

• This is the risk that the underlying mortgages are paid off early

• It leaves them with reinvestment risk and can cause volatile monthly payments

What is the prepayment rate?

What is the average life?

• Measures how fast mortgages in the pool are being paid off

• Measures the average number of years the principal is expected to remain outstanding

Who are agency securities for?

• People looking for conservative investments that may pay a little more than treasuries and pay monthly

COLLATERALIZED MORTGAGE OBLIGATIONS

What is a CMO?

What kind of ratings do they have?

• Takes various P&I payments from mortgages and organizes them into tranches

• They are usually pretty good since they are collateralized by securities that are put into a trust

Are these securities subject to registration?

How are they taxed?

• Yes, because they are privately issued

• Fully taxable

What is the significance of the PSA model and CMO prepayments?

• The PSA model attempts to break up the pool into tranches based off when they believe the mortgages will be prepaid

What do ratings of more, less, and equal to 100 mean on the PSA model scale?

• 100: Means prepayments will remain stable

• +100: Prepayment speed will be faster than normal

• -100: Prepayment speed will be lower

What is a “vanilla” CMO?

When would tranche B get paid back?

• Each tranche will receive interest payments until principal is paid back which happens at different times

• After tranche A, this is the point of the PSA model estimation above

What is a Planned Amortization Class (PAC)?

How do they work?

• A type of CMO tranche that has a predetermined schedule for repayments (safest)

• They add in companion tranches to help reduce prepayment and extension risk

What is a Targeted Amortization Class (TAC)?

• Similar to PACs there is a companion tranche added to protect against prepayment risk but not enough to protect against extension risk

What is a Z-Tranche?

How do they work?

• They are a deferred interest tranche that has the longest average life

• They have interest payments that compound, but the interest and principal aren't paid back till all other tranches paid

What is a floating rate tranche?

• Some tranches provide interest payments based off a floating rate like SOFR

What is a private label CMO?

• Private institutions may issue their own MBS that include mortgages that don’t qualify as agency backed

COLLATERAL DEBT OBLIGATIONS

What is a CDO?

• A privately issued asset backed security that can be booked by a pool of bonds or loans

  • Can be mortgages, credit cards, student loans, etc…

Who are CDOs good for?

How are they taxed?

• Bad for retail investors because of complexity

• Fully taxable

TAXATION

How are treasuries taxed?

• No state or local tax

When is the interest on T-bills taxed

What about Notes/Bonds?

• At maturity

• The year it was received

How are STRIPs taxed?

• They are accreted and reported on taxes each year

For a high earner, would a treasury or muni be better?

• Munis may still be better because they may fully tax free