Characteristics, Uses and Taxation of Investments - U.S. Government Bonds and Agency Securities

a. U.S. Government bonds and agency securities
  1. Treasury Notes and Bonds: both of these types of bonds are issued by the U.S. Department of the Treasury and are backed by the full faith and credit of the U.S. government. Unlike Treasury bills, Treasury notes are coupon securities (e.g. they make a semi-annual coupon or interest payment) with maturities of between two and ten years (they are commonly issued in 2, 3 and 5 and 10 year maturities); Treasury bonds are coupon securities with maturities of greater than ten years. As with T-bills, notes and bonds are part of the Treasury market as well and the rules of the primary and secondary markets for these securities apply similarly. Interest is exempt from local and state income tax, but is subject to federal income tax.
  2. Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities): these are zero-coupon treasury notes and bonds created by the private sector. The United States Treasury does not issue zero-coupon bonds. This program enables investors to hold and trade the individual interest and principal pieces of eligible Treasury notes and bonds as separate zero-coupon bonds. Financial institutions and government securities dealers that create these bonds sell them to individual investors.
    Example: a ten year Treasury note consists of the principal repayment and twenty interest payment. Once converted to STRIPS form, this single bond becomes twenty one separate fixed income securities.
  3. Treasury Inflation-Protected Securities (TIPS)[The United States Treasury refers to these types of bonds as Treasury inflation indexed securities (TIIS).]: issuance dates only from January, 1997. These are notes and bonds designed to provide protection against inflation. The fixed rate coupon is set at auction. The inflation adjustment is calculated using the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U). Principal is adjusted semi-annually (the inflation-adjusted principal). The process works as follows.

January 1 Inputs
Par value $100,000
coupon rate 3.5%
annual inflation rate 3%.
$100,000 bond purchased on January 1, 200X
Principal Adjustment
on July 1, principal is adjusted by the semi-annual inflation rate as follows: $100,000 x 1+3.00/2 = 101,500
Coupon Calculation
$101,500 x 3.5/2 = $1,776.25
July 1 Inputs
Bond price $101, 500
coupon rate 3.5%
annual inflation rate 2%
Principal Adjustment
On January 1, principal is adjusted by the new semi-annual inflation rate as follows: $101,500 x 1 + 2.00/2=$102,515
Coupon Calculation
$102,515 x 3.5/2=$1,794.01

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