3.1 Treasury Securities

U.S. Treasury Securities

U.S. Treasury securities are direct debt obligations of the federal government, sold to finance deficits and refinance maturing debt. Because they are backed by the full faith and credit of the United States, the market treats them as carrying no default (credit) risk, and the yield on a Treasury of a given maturity is the risk-free rate against which every other fixed-income product is priced. On the Series 7 you are expected to know the four marketable types, how they are quoted, how auctions allocate them, and exactly how they are taxed.

Marketable Treasury Types

T-Bills are issued at a discount to the $100 par value and mature at par; the investor's return is the difference, and there are no coupon payments. A $10,000 bill bought for $9,850 returns $150 at maturity. T-Notes and T-Bonds pay a fixed coupon every six months and may trade at, above, or below par as rates move. The 10-year T-Note yield is the most-watched benchmark for mortgage and corporate pricing.

Quoting in 32nds

The single most common Series 7 calculation error is mishandling the 32nds convention. Notes and bonds are quoted as a percentage of par, with the fraction after the dash expressed in thirty-seconds of a point.

• A quote of 99-16 = 99 + 16/32 = 99.50% of par = $995.00 per $1,000.
• A quote of 100-08 = 100 + 8/32 = 100.25% = $1,002.50.
• A plus sign (e.g., 101-16+) adds a 64th: 16.5/32 = 101.515625%.

Exam Tip: Corporate and municipal bonds quote in eighths (decimals on the exam); Treasuries quote in 32nds. Read the question to see which security is involved before converting.

Treasury Tax Treatment

Treasury interest is fully taxable at the federal level but exempt from all state and local income taxes. This makes Treasuries attractive to investors in high-tax states. Capital gains from selling a Treasury before maturity are taxed normally (federal). Memorize this split: it is tested directly and as a distractor against municipal bonds (federal-exempt) and corporates (taxable at every level).

TIPS: Treasury Inflation-Protected Securities

Treasury Inflation-Protected Securities (TIPS) defend purchasing power by adjusting principal semiannually for changes in the Consumer Price Index for All Urban Consumers (CPI-U). They are issued in 5-, 10-, and 30-year maturities and pay a fixed coupon rate, but because that fixed rate is applied to a rising (or falling) principal balance, the dollar amount of each interest payment changes.

At maturity the investor receives the greater of the inflation-adjusted principal or the original par, so a deflationary stretch cannot reduce repayment below face value. The catch is phantom income: the annual upward principal adjustment is taxable as ordinary income in the year it accrues, even though the investor does not receive that cash until maturity. In deflation the principal adjustment is a deduction.

Exam Tip: TIPS protect against inflation/purchasing-power risk, the one risk fixed-rate bonds cannot hedge. They do NOT eliminate interest-rate (market) risk.

Treasury STRIPS

STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon instruments created when a broker-dealer separates the coupons and principal of a note or bond into individually tradable pieces, each with its own CUSIP. A 10-year note becomes 20 coupon STRIPS plus one principal STRIP.

• Sold at a deep discount; the entire return is the discount accreting to par.
• Created by dealers, not issued directly by the Treasury, and bought through a broker rather than TreasuryDirect.
• Subject to phantom income: accreted interest is taxed federally each year even though nothing is paid until maturity.
• Popular with pension funds and college-savings investors who need a known dollar amount on a known date.

The Treasury Auction Process

The Treasury sells securities through a single-price (Dutch) auction.

1. All non-competitive bids are accepted first (maximum $10 million per bidder per auction); these bidders accept whatever yield the auction sets and are guaranteed their full amount.
2. Competitive bids, each capped at 35% of the offering to any one bidder, are ranked from lowest yield to highest.
3. Competitive bids are filled from the lowest yield upward until the offering is exhausted; the highest accepted yield (the "stop-out") sets the price.
4. Every winning bidder, competitive and non-competitive, pays that same single price.

Exam Tip: Individuals at TreasuryDirect almost always bid non-competitively; primary dealers bid competitively.