Introduction to Treasury Securities

Treasury securities represent one of the safest and most liquid investments available. Issued by the U.S. Department of the Treasury, these debt instruments are backed by the full faith and credit of the United States government. Treasury securities come in various forms, including bills, notes, bonds, and inflation-protected securities, each catering to different investment needs, such as capital preservation, predictable income, and protection from inflation.

Why does the government sell these at all? The answer is that they spend lots of money. To fund federal programs, like the Department of Defense and Medicaid, they need to bring in lots of money. They do that primarily taxation and through selling securities.

While treasury securities are only back the by the "full faith and credit of the United States", it turns out that this means a lot. Treasury securities are extremely liquid, meaning that there are always investors looking to purchase them, and has no default risk (unless you ask my always-worried mother...☺️). Being the institution that prints its own currency, the government can always repay its debts. What that means for inflation is another thing entirely.

There are three firms responsible for rating securities: Fitch, Moody's, and Standard and Poor's. AAA has the highest rating with AA+ following closely. For the longest time, the US government was always considered AAA. However, both Fitch and Standard and Poor's downgraded it to AA+. For the purposes of the SIE exam, the US government debt is still rated at AAA.

Types of Treasury Securities

While there are other securities, (like I and EE bonds), the five securities we will cover include:

• Treasury Bills (T-Bills)
• Treasury Notes (T-Notes)
• Treasury Bonds (T-Bonds)
• Treasury Inflation-Protected Securities (TIPS)
• Separate Trading of Registered Interest and Principal of Securities (STRIPS)

Treasury Bills (T-Bills)

Treasury bills, notes, and bonds, are all pretty much the same, just with different maturities and when they pay interest. T-Bills mature within one year, are purchased at a discount, and pay interest only at maturity (also called a zero coupon). New T-Bills are issued weekly. An example would be a $10,000 T-Bill sold for $9,000 and redeemed in 52 weeks for the face value of $10,000.

Treasury Notes (T-Notes)

T-Notes mature between two years and five years. Unlike T-Bills, they are issued at par and pay interest semi-annually (twice a year). New T-Notes are issued monthly. An example would be a 5-year T-Note with a 2% coupon rate.

Treasury Bonds (T-Bonds)

T-Bonds hold the longest maturities between ten years and thirty years. Like T-Notes, they are issued monthly at par and they pay interest semi-annually. An example would be a 30-year T-Bond with a 3% coupon rate.

Treasury Inflation-Protected Securities (TIPS)

TIPS are the first product we'll discuss that varies significantly from the earlier three. TIPS are designed to hedge an investment against the risks of inflation. For instance, if you purchased a 3% T-Bond years ago, but inflation is now at 9%, you'd be losing purchasing power. TIPS protect this by issuing the security at par with a fixed coupon rate, but periodically adjusting the par value every six months based on changes in the Consumer Price Index (CPI). If the CPI increases, so does the adjusted par amount. If it lowers, the par value lowers as well.

As an example, consider a 10-year TIPS with an initial par of $1,000 with a fixed coupon of 3%. If inflation were to rise by 5% (as measured by the CPI), the par value would rise proportionally to $1,050 (a five percent increase over par). When the investor is paid semi-annual interest, they'll now receive 3% of the adjusted par value ($31.50 annually or $15.75 semi-annually).

Separate Trading of Registered Interest and Principal of Securities (STRIPS)

STRIPS are Treasury securities that have been separated into their individual interest and principal components, allowing them to be sold separately. This means that STRIPS do not pay interest. They're a zero-coupon security purchased at a discount to the face value. Though the underlying securities are issued by the U.S. Treasury, STRIPS themselves are not directly issued by the Treasury but are created in the secondary market.

The maturity of a STRIP corresponds to the original payment dates of the stripped Treasury security. They're highly liquid and available in a variety of different denominations. An example would be a STRIPS purchased for $500, maturing in 30 years, and paying $1,000 at maturity.

The perks of STRIPS are that they have a fixed maturity and provide certainty about the amount received then. Additionally, they have no reinvestment risk, as they don't renew at maturity. However, since they're zero-coupon, their market value fluctuates greatly and they face significant interest rate risk. Investors must also pay taxes annually on the imputed interest, despite the fact that interest isn't received until maturity. How do you like paying taxes on money you don't even have yet!

Treasury Receipts

Just as a side note, treasury receipts are similar to STRIPS, but with underlying assets made by institutions other than the government. They are subject to default risk because the underlying assets are not backed by the US government. They are also subject to annual taxation despite only paying at maturity.