This is lesson 4 in my basic finance bootcamp series. I hope you are not getting bored to death. Again, think of this as the foundation for many of the more exciting, exotic topics we discuss in the futre.
In the last lesson, we talked about bonds. Bonds can be issued by private companies but they can also be issued by governments. So, that’s what it means when you hear on the news that Moody’s is threatening to downgrade the credit rating of the United States.
In addition to our tax revenues, the United States government supports its operations by issuing debt in the form of Treasury bills, notes, bonds, and TIPS. You can purchase new issues of these securities through your bank, your broker, or the Treasury Direct website, www.treasurydirect.gov. The minimum purchase required for all of these securities via the Treasury Direct website is $100, but the other institutions may require a higher minimum purchase amount.
Treasury securities can also be purchased in the secondary market—i.e., from other investors—through your bank, broker, or a bond dealer. If you want to sell any Treasury security prior to its maturity date, the transaction will have to be handled by a bank, broker, or bond dealer. If you purchased the security on the Treasury Direct website, you must first transfer the security to one of these entities by following the directions found on Treasurydirect.gov since Treasurydirect.gov no longer offers that service.
So, how do all these different securities differ from one another? Let’s take a look.
Treasury bills (T-bills) are short-term debt of the U.S. government and mature 4, 13, 26, or 52 weeks from the date of issue. Treasury bills do not make any interim interest payments. Instead, they sell at a discount from face value. For example, a Treasury bill that is currently selling in the secondary market and matures in 5 weeks is selling for $99.99 per $100 of face value. This means it will cost you $99.99 to buy it today, and you will receive $100 in 5 weeks when it matures. Therefore, you will earn $0.01 in interest at the end of 5 weeks for every $100 you invest. Not a huge amount, to be sure, but then, Treasury bills are considered to be close to risk free.
Treasury notes (T-notes) are intermediate-term debt of the U.S. government, with maturities of 2, 3, 5, 7, or 10 years when originally issued. Unlike Treasury bills, Treasury notes pay interest every 6 months and the face value at maturity. As with corporate bonds, the coupon rate is stated as an annual rate. For example, if you were to invest $1,000 in a Treasury note that matures in two years and pays a 4% coupon, you would receive 3 interest payments of $20 each and $1,020 (principal plus last interest payment) at the end of two years. Treasury notes may sell at par value (face value), a discount (below face value), or a premium (above face value).
Like Treasury notes, Treasury bonds (T-bonds) pay interest every 6 months and the face value at maturity and can sell at par, a discount, or a premium. The primary difference between the two instruments is that Treasury bonds are issued with an initial maturity of 30 years.
TIPS are Treasury Inflation-Protected Securities. They are issued with initial maturities of 5, 10, and 30 years. Like Treasury notes and bonds, they pay a fixed coupon rate, but the principal (aka, face value) is adjusted for inflation, which is defined as a general increase in price levels as measured by changes in the Consumer Price Index (CPI), and since the dollar amount of interest you receive is equal to the coupon rate times the principal, the interest payment you receive is also affected.
To illustrate, let’s assume you invest $1,000 in a new TIPS that pays a 4% coupon and has a face value of $1,000. If the inflation rate in the first six months is 0.5%, the principal value of your TIPS is adjusted to $1,005. Interest is paid semiannually, so you will receive an interest payment equal to 2% of $1,005, or $20.10. Now let’s assume that inflation over the next 6 months is 0.6%. The adjusted principal value will now be $1,011.03, and at 2% of this, your interest payment will be $20.22. This process will continue until your TIPS matures.
If you sell your TIPS before maturity, the price you will receive will reflect these inflation adjustments. For example, a TIPS that pays a 3.375% coupon and matures on 4/15/2032 is currently selling for $163.914 per $100 of face value in the secondary market.
Of course, if we experience deflation, which is a decrease in general price levels, the principal value of your TIPS will be adjusted downward, which means your interest payments will also decrease. This being said, at maturity you will receive the original face value (principal value) of the bond, which in our example is $1,000, regardless of what adjustments have been made to it in the interim.
STRIPS are Separate Trading of Registered Interest and Principal Securities, which makes them sound a lot more complicated than what they are. Think of them essentially as zero-coupon Treasury notes and bonds. In other words, they do not make interest payments. Instead, like T-bills, they sell at a discount, and the investor receives the face value at maturity.
As an example, a STRIP with a maturity date of 8/15/2025 is selling for $74.05 per $100 of face value on 1/15/2013. An investor who invests $740.50 in this STRIP will receive $1,000 on 1/15/2013, but nothing in the interim. The downside is that the investor will have to pay taxes on the interest he has accrued each year, even though he will not receive a dime until the STRIP matures.
STRIPS are not direct issues of the federal government. Instead, they are created by financial institutions, such as investment banks and brokerage firms. Essentially, the aggregate interest and principal payments of individual Treasury security issues are “stripped,” and the rights to receive a portion of these payments are sold off separately.
Federal Government Agency Securities
Treasury securities are backed by “the full faith and credit of the U.S government.” Translated, this means “taxing power.” They are generally viewed as free from default risk, although they have recently experienced a credit rating downgrade, with threats of a further downgrade if the powers that be in the federal government fail to get their act together.
Federal government agencies, such as the Tennessee Valley Authority (TVA), Small Business Administration (SBA), the Federal Home Loan Bank, and the Government National Mortgage Association (GNMA), also issue both short-term notes and long-term bonds. Some of these are backed by the full faith and credit of the U.S. government while others are not. Regardless, most experts believe that, given the parent/child relationship between the federal government and these agencies, the U.S. government would not let them default on their debt obligations. You can get more details and purchase these federal agency bonds through your broker or a bond dealer.
The interest paid on U.S. Treasury bills, notes, bonds, TIPS, and STRIPS is fully taxable at the federal level, but is typically exempt from state and local income taxes. Some, but not all, of the federal agency bonds also pay interest that is free from state and local taxes. As with Treasuries, federal income tax must be paid on the interest received on all these agency bonds.
That’s it for lesson 4. Would love to get your comments and/or questions. I really want all my readers to have the background to enjoy the more fun and exciting stuff I will be writing about in the future. I know this isn’t exciting, but I hope you are finding it useful. Also, sign up for my newsletter. I’ll have exciting stuff on there as well.