Fixed Income Investments - Government Bonds

The U.S. Government issues four types of securities:

1.Treasury Bills - Treasury bills have a maturity of less than 12 months, no coupon rate, are issued at a discount to par value, mature at par value and pay no coupon interest. The return the investor receives is the difference between the purchase price and the maturity price.

2.Treasury Notes - Treasury notes have a maturity of one to ten years. They have a coupon rate set by the market place at issue. They are issued approximately at par value and mature at par value.

3.Treasury Bonds - Treasury bonds are the same as treasury notes except that they have maturities that are greater than ten years. The U.S. Government has not issued this type of bond for a while, but there are still some issues that are outstanding.

4.Treasury Inflation Protected Securities (TIPS) - TIPS are issued as notes or bonds and help to protect the investor against inflation risk. The example below illustrates how these securities work.

Example:

  • The coupon rate on an issue is set at a fixed rate, which is determined when the bonds are auctioned.
  • This is considered the "real rate" because it is what the investor will earn over the inflation rate.
  • The inflation index the government uses is the non-seasonally adjusted U.S. City Average All Item Consumer Price Index for All Urban Consumers (CPI-U)
  • These indexes work in deflationary environments as well, but the government has structured them so that the investor receives the higher inflation-adjusted amount, or par value, when redeemed at a later date.

Now on to the number crunching part concerning TIPS:

Coupon Rate = 4%
Annual Inflation Rate = 2%
Investor buys 1,000,000.00 USD of TIPS

At the end of the first six months the investor's coupon she will receive:
Inflation rate (2%/2) =1%
Coupon rate (4%/2) = 2%

Answer:
Inflation adjusted principle amount = (par value x 1+ semi-annual inflation rate) = 1,000,000 x 1.01 = 1,010,000.00

Coupon Payment = (Inflation adjusted principle amount x semi-annual coupon rate) = 1,010,000 x .02 = 20,200.00

Now let's move ahead another six months:

Coupon rate= 4% or 2% in semi-annual terms
Inflation rate = 3 % or 1.5 % in semi-annual terms

Inflation adjusted principle amount = (new par value x 1 + semi-annual inflation rate) = 1,010,000 x 1.015 = 1,025,150

Coupon Payment = (Inflation adjusted principle amount x semi-annual coupon rate) = 1,025,250 x .02 = 20,503.00

On-the-run vs. Off-the-run Government Securities

On-the-run Securities
On-the-run securities are the most current security issued by the U.S.Treasury Department. These issues tend to be more liquid in the marketplace.

Off-the-run Securities
Off-the-run securities are the securities that are replaced by the on-the-run securities. These issues tend to be less liquid in the marketplace.

How Stripped Government Securities, & Coupon and Principal Strips Are Created
The U.S. government does not issue zero coupon notes and bonds and there is a strong demand for an instrument with no credit risk and a maturity of greater than one year. Based on consumer demand, therefore, the private sector created securities with these features.

  • Let's look at a treasury bond that has five years to maturity with a coupon rate of 7 %. This constitutes ten interest payments of US$70 based on $1,000 par value and one principal payment of $1,000 for a total of 11 payments.
  • You now can discount these 11 single payments and create zero coupon instruments with maturity dates that correspond with the payment dates of the Treasury securities.
  • These are issued through the Treasury's Separate Trading and Registered Interest and Principal Securities (STRIPS) program to facilitate the stripping process. The zero-coupon securities created are the obligations of the U.S. Government.

These securities come in two different forms:

1. Coupon Strips
Coupon strips come from the coupon payment part of the security.

2. Principal Strips
Principal strips come from the principal payment.

The difference between coupon strips and principal strips, besides maturity dates and amount received, has to do with taxes. Coupon strips accrue interest and are taxed each year even though interest is not paid until maturity. This causes negative cash flows for a taxable entity. Foreign investors often like principal strips because of the preferred tax treatments they can receive in their home countries.

Mortgage-Backed Securities (MBS)


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