U.S. Treasury Securities
U.S. Treasury securities are issued by the Department of the Treasury of the United States government and are direct obligations of the government. They are considered free of credit risk. In fact, Treasuries are used as a measure of the current risk-free rate when pricing other securities or in calculating risk premiums. For American investors, Treasuries are exempt from state and local taxes, but not federal tax.
Quick Facts on the National Debt
The US debt is financed mostly by selling U.S. Treasury securities. The United States has carried debt since the American Revolution. Only during the presidency of Andrew Jackson has the United States been truly debt-free. As of the end of March 2016, the US debt slightly exceeded $13.4 trillion. You often see in publications that the debt exceeded $19 trillion, but more than $5 trillion of that debt is what the government owes to other government agencies, such as the Social Security trust fund.
- The annual deficit is the amount the government takes in taxes minus the amount it spends during the year.
- A budget surplus occurs when tax collections exceed expenditures for the year. The only budget surplus that has occurred in recent times was during the presidency of Bill Clinton, when the government started to tax the rich more. Since then, beginning with the Bush presidency, taxes on the wealthy have been greatly reduced, resulting in greatly increased annual deficits, exacerbated by the Iraqi and Afghanistan wars and by the Great Recession of 2007 to 2009.
- An annual deficit increases the national debt while a budget surplus decreases it.
- The debt limit is the amount the Treasury could borrow without asking Congress. Before 1917, the Treasury had to ask Congress every time it wanted to increase the debt. Since then, the Treasury must ask Congress to authorize more debt only if the debt is expected to exceed the debt ceiling.
- To see the absolute latest statistics, and to see how quickly the US debt is growing, check out U.S. National Debt Clock : Real Time. In March, 2018, the US passed the $21 trillion mark, and will continue to grow even more rapidly because of the tax cuts passed by Donald Trump and the Republican Congress at the end of 2017.
Source: National Debt
There are 4 major types of marketable Treasury securities: bills, notes, bonds, and Treasury-Inflation Protected Securities (TIPS). T-bills are discount securities, issued at a discount, and notes, bonds, and TIPS are coupon bonds, which pay interest every 6 months until maturity. At maturity, all Treasury securities redeem at face value. The yields are determined by competitive bidding in periodic auctions.
Treasuries are now sold by TreasuryDirect, a website operated by the Department of the Treasury, in multiples of $100, with a $100 minimum, using an electronic book-entry system.
Treasury bills (T-bills) are issued in denominations of $100 to $5 million, and have terms with the following issued maturities: 4, 8, 13, 17, 26, and 52 weeks. T-bills are also issued as cash-management bills with maturities ranging from a few days to 1 year. Cash management bills are issued for short-term borrowing needs by the government, so their auctions are not set by a recurring schedule.
T-bills are issued at a discount, with the interest = the difference between the face value paid at maturity and the discount price. T-bills are quoted in yield rather than price, so the bid is higher than the ask price, the reverse of the usual relationship with securities. T-notes mature at par, but, instead of paying cash for the maturing note, they can be refunded, where the government offers the investor a new security with a new interest rate and maturity date.
Treasury notes (T-notes) are issued with maturities exceeding 1 year, but ≤ 10 years, but currently issued with terms of 2, 3, 5, 7, and 10 years years.
Treasury bonds have terms exceeding 10 years. Though some are callable, callable bonds have not been issued since 1984. The Treasury stopped issuing bonds, especially the 30-year bond, in August 2001, but has resumed their sale in August 2005. Treasury bonds are currently issued with 20-year and 30-year terms.
Floating Rate Notes (FRNs)
Interest rates on a FRN vary with the discount rates for 13-week T-bills. FRNs are only issued with a 2-year term, paying interest quarterly.
The FRN interest rate is a composite rate of an index rate and a spread rate:
- The index rate is based on the highest accepted discount rate of the most recent 13-week Treasury bill, which is auctioned every week, so the FRN index rate is reset every week.
- The spread rate, which never changes during the FRN term, is applied to the index rate, based on the highest accepted discount margin for the most recent 13-week T-bill auction when the FRN is 1st offered.
- Interest is added every day.
FRN Interest Rate = Index Rate + Spread Rate
Treasury-Inflation Protected Securities (TIPS)
Treasury-Inflation Protected Securities (TIPS) pay a fixed rate of interest every 6 months on the principal, which is adjusted for inflation as measured by the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U) for the 3rd previous month, published monthly by the Bureau of Labor Statistics (BLS). The interest rate remains fixed — only the principal is adjusted. The principal can decline during deflation, but at maturity, the greater of the face value or the adjusted principal is paid.
The Treasury created TIPS in 1997, structured similarly to the Real Return Bonds issued by the Canadian government, and have terms of 5, 10, and 30 years. Unlike most other Treasuries, the initial coupon rate is based on the real interest rate when the bond is issued, which is the nominal interest rate minus an inflation component. Thereafter, the coupon rate does not change, only the principal amount changes according to inflation. If the inflation component exceeds the real interest component, as it often does, then the stated interest rate could actually be negative.
Note that while the principal amount is adjusted to calculate interest payments, the inflation-adjusted principal is not received by the bondholder until maturity, only the interest payments are received semiannually, but taxes must be paid annually on the increased principal as well as the interest. This increased principal is often called phantom income because the bondholder does not receive that income until maturity.
The interest rate on TIPS is determined at auction.
Interest = Annual Interest Rate × Adjusted Principal
Federal taxes must be paid on both the interest and on increases in the adjusted principal in the year earned.
Taxable Income = Interest + (Annual Principal Adjustment at Yearend − Annual Principal Adjustment at Previous Yearend)
Like other Treasuries, TIPS have interest rate risk, and since the Federal Reserve often buys these bonds, prices in the secondary market can fluctuate according to Federal Reserve purchases.
The securities are eligible for stripping into their principal and interest components in the Treasury's Separate Trading of Registered Interest and Principal of Securities (STRIPS) program, discussed below.
The Treasury provides TIPS Inflation Index Ratios to ease calculations of the change to principal resulting from changes in the Consumer Price Index. More information: TIPS: Rates and Terms.
One way to avoid many of the problems with TIPS is to invest in TIPS exchange-traded funds. These ETFs are diversified and pay both interest and inflation adjustments monthly, so there is no phantom income. Note that some of these funds may advertise an SEC yield, which is the annualization of dividends and interest earned per share during the prior 30 days, less expenses, but since inflation can change rapidly, the SEC yield may differ significantly from the actual annual yield.
Zero Coupon Treasury Securities
Zero coupon Treasury securities are created from issued Treasury securities, mostly bonds, by stripping the coupons and selling each coupon payment and principal payment as a zero coupon bond. They are sold at a discount, and, thus, the interest paid is the difference between the face value of the coupon or principal and the discounted price. Zeros are not issued by the Treasury, but are created by the dealers for those customers who want to buy zeros.
For instance, a 10-year bond can be stripped to yield 20 coupons — coupon strips — and 1 principal strip. The maturities of the coupon strips would range from 6 months to 10 years, and the principal strip has an initial maturity equal to the term of the bond. The longer the maturity, the greater the discount.
Zero coupon treasury securities allow pension funds and insurance companies to better match the cash flows from their investments to their liabilities. Zeros also appeal to speculators, because they have greater volatility, and therefore a greater profit potential.
STRIPS — Separate Trading of Registered Interest and Principal Securities
The Treasury does not issue zeros — it creates them from issued Treasury securities through its Separate Trading of Registered Interest and Principal Securities (STRIPS) program, started in February 1985 that allowed the creation of zeros from coupon securities. This became possible with the advent of storing Treasury securities as electronic records in the commercial book-entry system of the Federal Reserve, where a record of a security can be easily altered to change its form from a coupon bond to a number of zero coupon bonds, with each interest payment and the principal payment becoming a separate zero-coupon security. Coupon zeros were called C-STRIPS, and all C-STRIPS that matured on the same date were given the same CUSIP number. Zeros that were stripped from the principal were called P-STRIPS, and each were issued with its own CUSIP number for separate identification.
STRIPS can be purchased and held only through financial institutions and government securities brokers and dealers — they are not issued directly to investors.
When a financial institution wants to create strips from its Treasury securities held at a Federal Reserve bank, it simply notifies the Federal Reserve. The Federal Reserve creates the STRIPS by issuing new CUSIP numbers that uniquely identify each STRIP, allowing the STRIPS to be traded independently in the secondary market. The Federal Reserve can also reconstitute the strips at the request of the owner into a note or bond.
Why would a financial institution want to create STRIPS? Because most financial institutions control interest rate risk by matching the duration of assets and liabilities, such as through the bond strategy of immunization. However, it is difficult to match the duration of liabilities with the duration of coupon bonds, since their duration is more limited. For instance, a 30-year Treasury bond with a 5% coupon rate and a market rate also = 5% will have a modified duration slightly longer than 15 years. The same Treasury bond, stripped, would yield 61 zero-coupon bonds, with durations ranging from 6 months to 30 years, which offers considerably greater flexibility in matching assets to liabilities, thus lowering interest rate risk.
The same commercial book-entry system can also reassemble the STRIPS components into a fully constituted coupon security. To reconstitute a security, a financial institution or government securities broker or dealer must obtain the appropriate principal component and all unmatured interest components. The principal and interest components must be in the appropriate minimum or multiple amounts for a security to be reconstituted.
The primary reason for reassembling STRIPS is to profit from arbitrage, when the sum of the prices of the components of the Treasury bond was less than the price of a fully reconstituted Treasury bond.
Interest earned from STRIPS and from inflation adjustments to principal on TIPS must be reported in the year when earned, even though income is not received until maturity or until the STRIPS or TIPS are sold.
Hence, STRIPS and TIPS are attractive investments for tax-deferred accounts, such as individual retirement accounts and 401(k) plans, and for non-taxable accounts, which include pension funds.
Every investor in STRIPS or TIPS receives a report each year displaying the amount of interest income from the financial institution, government securities broker, or government securities dealer that maintains the account in which the securities are held.
Brokerage firms can also create a type of zero-coupon bond known as Treasury receipts, by buying T-notes and T-bonds, then placing them in a trust. The broker can then sell separate receipts against the principal and coupon payments of these Treasuries. Although these Treasury receipts are collateralized by Treasuries, unlike STRIPs, they are not backed by the full faith and credit of the United States government.
Treasury receipts are named by the brokers that create them, such as Certificates of Accrual on Treasury Securities (CATS) and Treasury Income Growth Receipts (TIGRs). Treasury receipts are often quoted in yield rather than price.
Holding Treasury Securities
Investors have choices about how they purchase U.S. Treasury securities and where they are held. They can buy from a bank, broker, or dealer and hold their securities in their commercial book-entry system.
Investors can also buy directly from the U.S. Treasury at TreasuryDirect and hold their securities in accounts maintained by the Treasury. Online access to accounts is provided and there are no fees for purchases, reinvestments, or most other transactions.
TreasuryDirect is a web-based system that provides online access to accounts held directly with the United States Treasury. Treasury bills, notes, bonds, TIPS, electronic Series EE Savings Bonds, and electronic Series I Savings Bonds can be purchased through the account.
However, only individuals may hold accounts at TreasuryDirect, although it will soon be available to fiduciaries and organizations.
Legacy Treasury Direct
Legacy Treasury Direct is the older version of TreasuryDirect that allows participation by fiduciaries and organizations, as well as individuals.
Legacy Treasury Direct offers U.S. Treasury bills, notes, and TIPS (except for the 20-year maturity). Beginning in January 2007, the 30-year Treasury bond and the 20-year TIPS will not be available in Legacy Treasury Direct.
A paper application must be submitted to open an account, then most transactions can be conducted online or through an automated phone system.
This account also charges a $45 fee if a security is sold before maturity, and an annual $100 fee if the account has more than $100,000.
Commercial Book-Entry System
The commercial book-entry system, used by both the Federal Reserve and TreasuryDirect, is a multi-tiered automated system for holding and transferring marketable securities, a delivery and payment system that provides for the simultaneous transfer of securities against the settlement of funds, and replaces paper securities with electronic records.