THIS CHAPTER DESCRIBES marketable bonds and other securities issued by the U.S. Department of the Treasury. Popularly known as Treasuries, these securities are all backed by the full faith and credit of the U.S. government. With the United States rise to world economic dominance, such backing represents the strongest safety guarantee available. Accordingly, these securities have less default, event, liquidity, and political risk than any other investment. That backing does not mean that they're without risk. Longer-term Treasuries still have substantial market risk.
Marketable securities, as the name implies, can be sold to other individuals or entities. Thus, if you buy a 5-year Treasury note on a Monday morning, you can sell it that Monday afternoon. However, you can never have physical possession of a marketable Treasury bill, note, or bond. In other words, you never receive a certificate from the government with your name on it. Rather, all Treasuries are available in what is known as book-entry form. These entries, with your name, are recorded in the books (or, in today's more modern terms, the accounting records) of commercial firms, such as banks or brokerage houses or in the records of the U.S. government itself if you participate in the TreasuryDirect Program. However, you do receive a statement confirming your ownership of a Treasury.
Before 1985, the government issued 30-year Treasury bonds that it could call—that is, buy back—should it choose to do so. The Treasury could demand redemption of these bonds five years prior to their maturity date. In 2000 and 2001, when the government was running budget surpluses, many of these older bonds were called and, thus, retired from public circulation. Owners of 30-year Treasuries that were bought in 1976 with an annual 14 percent interest rate were not happy in 2001 when they were told by the government that the party was over and that they had to part with those bonds at a time when other Treasuries were yielding about 4.5 percent.
All Treasuries issued since 1985, however, are noncallable prior to their maturity date. The last callable bonds issued were the 30-year bonds that came to market in November 1984. These bonds have a guaranteed coupon of 11.75 percent, and the government can recall them on November 15, 2009, rather than waiting until November 15, 2014, to do so.
The interest rate on Treasury securities is initially set at public auction. Auction bids for Treasury securities may be submitted as noncompetitive or competitive bids. If you make a noncompetitive bid, you agree to accept the interest rate determined at auction. In that case, you are guaranteed to receive the full amount of the Treasuries that you bid on. Most individuals make noncompetitive bids when they buy Treasury securities. If you make a competitive bid, you specify the interest rate that's acceptable to you. This bid may be accepted in the full amount of your bid if the rate specified is less than the interest rate set by the auction. However, the bid may be accepted in part or rejected if the rate specified is higher than the interest rate set at the auction. To place a competitive bid, you must use a broker or financial institution. The bid may not be made from TreasuryDirect.
All Treasuries are issued with a minimum face value of $1,000 and in increments of $1,000 above that. You can purchase them at auction by using the TreasuryDirect system. TreasuryDirect is a book-entry securities system, operated by the U.S. Bureau of the Public Debt, which allows you to maintain accounts directly with the U.S. Treasury. Alternatively, you can purchase all Treasury securities from a bank or a brokerage firm, either in the open market or at a Treasury auction. You can transfer most types of Treasury securities you buy from your bank or broker to your TreasuryDirect account. Upon your instructions, TreasuryDirect will get three bids for you if you want to sell in the secondary market any Treasury securities you hold in your TreasuryDirect account.
There are two principal advantages of using TreasuryDirect. First, you pay no fee and no spread (the difference between the broker's buy and sell prices) to purchase Treasuries. Second, the custodian of your Treasury securities is the federal government. Thus, the possible risks associated with a failed brokerage firm holding your securities do not exist. The two principal disadvantages of using TreasuryDirect are that you can purchase Treasury securities only at the time of an auction and that Treasury-Direct will not make a margin loan. A more detailed discussion regarding TreasuryDirect and the purchase of bonds is found in chapter 13. You can find good information on all U.S. Treasuries at www.treasurydirect.gov.
Treasury notes and bonds both pay interest every six months and are initially sold at auction. Although both Treasury notes and bonds are issued to finance the longer-term needs of the U.S. government, they are distinguished by the terms of their maturities. The maturity of Treasury notes is set at a minimum of one year and does not exceed ten years. The government currently issues notes in 2-, 5-, and 10-year maturities. Auctions for the 2-year and 5-year notes are held monthly. The auction for the 10-year notes are held quarterly, and auctions for the 30-year bond are held quarterly beginning in 2007.
Although the maturity time frame makes it easy to distinguish between Treasury notes and bonds when they are first issued, it can be confusing when they are sold in what is known as the secondary market, or aftermarket. As noted, these issues can be freely traded much the way stocks are. You can buy Treasuries currently outstanding that will come due in any year. For example, a Treasury bond that was originally issued as a 30-year bond in 1993 would in effect be a 20-year bond in 2003 because it has been outstanding for ten years. It would still be known as the 1993 30-year bond.
All fixed-income investors should at least consider ownership of Treasury notes or bonds because of their safety and liquidity. Their rates are widely quoted on Web sites such as www.bloomberg.com, in the financial pages, and on television as an indicator of the rate and direction of all interest rates. The 10-year and the 30-year bond are quoted as major benchmarks for all fixed-income securities.
Treasury notes and bonds are the most liquid securities in the world. This means that you can easily buy or sell them, and the cost to purchase or sell is extremely low. When you sell, the cash proceeds of your sale post to your account the next day. This is called a one-day settlement. Generally, it takes longer to receive cash when you sell other types of securities.
Treasury notes and bonds are not immune to the market risks that affect all bonds. The interest rate volatility in the period from August 11, 2001, to January 10, 2002 (a period that included the tragic events of September 11), provides a clear example of how Treasuries can be affected by such swings. On August 11, 2001, the 10-year, 5 percent Treasury sold at par; on October 31, this Treasury sold at 103.5, reducing its yield to 4.25 percent; and on January 10, it again sold at par, to yield 5 percent. Those who bought this Treasury in October and sold it in January suffered a capital loss. Certainly the September 11 tragedy added to the market's volatility, but severe interest rate swings on long-term bonds are not unusual.
Interest income from Treasury notes and bonds is subject to federal income tax but not to state and local taxes. The interest paid at six-month intervals is taxable in the year received. In addition, if a Treasury bond is purchased for less than its face amount, in certain cases, the difference between the amount paid and its face value may be taxable as interest income over the period between the date of acquisition and the earlier of the maturity date or the date you sell the bond. If you pay more than the face amount for the bond, you may be entitled to deduct the difference between the amount paid and the face amount over the same period.
The fact that interest earned on Treasury securities is not subject to state and local taxes can provide significant after-tax advantages for those living in high-tax states, such as California or New York. For example, assume that you buy a $1,000 bank CD and a $1,000 Treasury that both pay 5 percent interest and that your state income tax rate is 10 percent. You would receive $50 in interest, pretax, on both investments. However, with a state income tax of 10 percent, you would have to pay $5 in state taxes on the CD and only net $45 on an after-tax basis. Since you would pay no state tax on the Treasury, you would net the full $50 and quickly appreciate the tax advantages of Treasury securities. Interest income from Treasuries and CDs are both subject to federal income tax. In addition, sellers of Treasury notes and bonds must report the interest accrued to the date of sale on their federal income tax return.
Unlike stocks and most bonds, which are priced in decimals, Treasury notes and bonds are priced in fractions as low as 1/32. Thus, a Treasury might be quoted as selling at 99 20/32. To convert 20/32 to a decimal, you divide 20 by 32 to get .625. Thus, 99 20 / 32 would be 99.625 when converted to a decimal.
Although Treasury notes and bonds are issued with face values at or in multiples of $1,000, the price you pay is subject to market conditions at the time. Thus, a $10,000 5-year note that was issued two years ago with a 7 percent coupon would be worth more than a $10,000 5-year note issued two months ago with a 3 percent coupon. Both bonds have the same face value, but investors will pay more than face value for the bond with the higher coupon rate because it will pay them more interest income.
Investors love that they can convert Treasuries so quickly to cash. In addition, there is always a market in which to sell them at a fair price, no matter what disasters are going on in the world. This cannot be said for many other securities. You can sell or transfer Treasuries as one lot or in part. For example, if you own a $10,000 bond, you can sell only $5,000 of it if you choose. You must, however, always sell in $1,000 multiples.
You can also use Treasuries as collateral (that is, security) for a loan from your broker. Depending on your brokerage firm, you may be able to borrow as much as 96 percent of the value at your broker's loan rate. For example, assume you have $10,000 of Treasuries in your brokerage account and need cash either for another investment or for a personal expense. Your brokerage firm might lend you up to $9,600 and use the Treasuries as collateral (security) for the loan. The interest rate charged on the loan would be a floating rate that would be much lower than a credit card loan because marketable Treasuries are considered such good security.
Treasury bills, popularly known as T-bills, are used to finance the short-term needs of the U.S. government. The 4-week bills, 13-week bills, and 26-week bills are each offered weekly and are available in commercial markets.
T-bills also differ from Treasury notes and bonds in that they do not pay interest every six months. Rather, they are sold at a discount to their face value. The difference between the discounted price you pay and the face value you receive at maturity is treated as interest income, rather than as a capital gain. Thus, T-bills pay interest only at maturity. In addition, although T-bills can be sold at any time without a penalty, you might realize a gain or a loss on the sale.
Very short-term T-bills are a cash equivalent. As with Treasury notes and bonds, you can easily buy and sell them at extremely low transaction costs.
Of all Treasuries, T-bills have the least market risk because of their short-term maturities. The 4-week T-bills, which the government first started selling on July 23, 2001, are the safest investment we know of.
As with Treasury notes and bonds, income from T-bills is subject to federal income tax but not to state and local income taxes. As discussed previously, this feature can provide significant advantages for those living in high-tax states. The interest income from T-bills is taxable in the year in which the T-bill is redeemed or sold.
Unlike Treasury notes and bonds, you can use T-bill purchases as a short-term tax planning strategy. This is done by taking advantage of the fact that you report interest income from T-bills only in the year in which the bill comes due. To move interest income from one year to the next, buy a T-bill that has a maturity date in the next year. For example, if you bought a 26-week bill on August 1, 2006, you would report your interest income as having been received on February 1, 2007. That interest income would not be subject to tax in your 2006 federal income tax return but would be subject to tax in your 2007 return.
STRIPS is the popularly used acronym for the U.S. Treasury's Separate Trading of Registered Interest and Principal of Securities Program. In many ways, the approach is similar to that of T-bills in that STRIPS are zero-coupon securities sold at a discount to their face value, with interest payments made only at maturity. As with T-bills, the difference between the purchase price of STRIPS and their face value provides the return.
The STRIPS program represents a unique partnership between the government and the private sector. In August 1982, Merrill Lynch became the first government dealer to create its own brand of zero-coupon government bond and gave it the catchy acronym of TIGRs (Treasury investment growth receipts). Salomon Brothers produced CATS (certificates of accrual on Treasury securities). LIONS (Lehman investment opportunity notes) and other acronyms soon jumped into the fray. There were two major drawbacks to these financial instruments: (1) Even though they were based on U.S. Treasury securities, the U.S. government did not guarantee them; and (2) their sponsoring firm determined their trading, thus, curtailing their liquidity.
In 1985, the U.S. Treasury announced STRIPS. In addition to more accurately describing the different types of zero coupons offered, the Treasury program also registered each one traded. With this registration, all STRIPS securities are the direct obligation of the U.S. government even though brokerage firms and other financial institutions create them.
STRIPS are constructed by taking a Treasury note or bond and stripping off the interest coupons. This process creates two different kinds of zeros: coupon strips, consisting of the interest coupons, and a principal payment strip, consisting of the principal payment. These are then sold separately. The number of interest payments determines the number of coupon strips created from any one Treasury security.
For example, assume that a brokerage firm buys a $1 million Treasury note with a 6 percent coupon rate that comes due in ten years. Over the lifetime of that bond it will annually yield $60,000, which is 6 percent of $1 million. Since interest payments are made semiannually, each coupon will be a strip with a face value of $30,000. When the coupons are stripped off, there will be twenty interest strips and one principal strip. Each $30,000 interest strip then becomes a separate $30,000 zero-coupon security, and the one principal strip becomes a separate ten-year zero-coupon security in the amount of $1 million. These strips may each be sold separately, with the price of each interest strip dependent on the time remaining to its maturity and the market interest rates at the date of sale.
Although STRIPS have the same backing of the U.S. government as other Treasuries, they may yield somewhat more than a note or bond with the same due date because the STRIPS are more thinly traded and, thus, harder to sell. This is an advantage for those who like to buy and hold their bonds. STRIPS are useful for investors who want to receive a known payment on a specific future date.
Another advantage is that the total return on STRIPS is known precisely at the date of purchase if you hold the STRIPS to their due date. In interest-paying bonds, such as Treasury bonds, the total return depends in part on the rate at which you reinvest your interest payments every six months. In addition, you can buy STRIPS to come due in any year that would be desirable for your retirement or college education program.
Since STRIPS are more volatile (they move up or down more) than other Treasuries, you can use STRIPS to speculate on interest rate movements. For example, if you want to place a bet that interest rates will go down, you might buy long-term STRIPS. Since STRIPS are more volatile than Treasury bonds, you would have a larger gain if you guessed correctly.
STRIPS have market risk. The longer the maturity of the STRIPS, the greater the risk of market volatility compared to equivalent interest-paying Treasuries. In addition, since STRIPS are traded less frequently than Treasuries, STRIPS will be slightly more expensive to buy and sell because the broker has a larger risk of a price decline.
Even though interest from STRIPS is exempt from state and local taxes, you should consider the advantages of holding these bonds in a tax-sheltered retirement account, such as an IRA, as opposed to a taxable account. Interest on STRIPS held in a tax-sheltered retirement account is not subject to federal income tax until there is a distribution of cash from the account. However, if you hold the STRIPS outside of a tax-sheltered retirement account, you must report interest on STRIPS annually on your federal income tax return as ordinary interest income, even though you receive no cash until you redeem or sell the STRIPS. Such interest is referred to as imputed interest or phantom income. As a result, most people purchase STRIPS in tax-sheltered retirement accounts.
With great fanfare and even more debate, the U.S. Treasury introduced a brand new security concept on January 29, 1997. It appears that the name of this security, Treasury inflation-indexed securities, escaped scrutiny by acronym coiners. The marketplace quickly corrected what could have been an awkward name of TIIS by dubbing the newcomers TIPS (Treasury inflation-protected securities). Five-year, ten-year and twenty-year TIPS are each auctioned twice a year.
Again, Treasury notes and bonds pay out a fixed amount of cash, based on the coupon rate, every six months. In contrast, every six months, TIPS pay out a variable amount of cash that is initially lower than the amount paid by Treasury notes and bonds. As described next, this generally more modest coupon is designed to allow for the substantial principal accrual that is supposed to match the variability of the future cost of living. In this way, TIPS are designed to provide a guaranteed return over and above the inflation rate. Although the value of the principal varies over time, all TIPS are initially sold at auction in minimum amounts of $1,000.
The return on TIPS, then, consists of two parts:
The dollar amount of the semiannual cash interest payment changes every six months and is computed as follows: Multiply the coupon interest rate that is fixed at the time of auction by the sum of (a) the original principal of the bond plus (b) any inflation adjustment to the bond's value.
The value of the TIPS principal increases daily at a rate of inflation based on the consumer price index for all urban consumers (CPI-U): The TIPS' accrual during any month is based on the difference between the two most recent monthly nonseasonally adjusted U.S. city average consumer price indexes for all urban consumer figures. There is a three-month lag in the application of the consumer price index (CPI-U) to the Treasury calculation of the TIPS principal amount.
If you hold the TIPS until it comes due, the Treasury will pay you the sum of (a) the face amount of the security plus (b) an amount equal to the inflation (as measured by the CPI-U) that has occurred over the life of the security. Think of the semiannual inflation adjustment as a bonus that is added to the face amount of the bond. These inflation adjustments are not paid out until the security comes due. If you sell your TIPS before its due date, you will get a price that is set by the bond market. This price may be higher or lower than the bond's face value plus the inflation adjustment.
The inflation adjustment works in reverse if there is deflation rather than inflation. Deflation is when the CPI-U basket literally drops in price each month, as it did for much of the 1930s. In contrast, the more common term disinflation refers to the situation where inflation, the increase in the price of the basket, becomes smaller over time. For example, in 1990, the basket increased in price by about 5 percent; by 1998, that increase dropped to 2 percent, which meant that there was disinflation, not deflation.
If there is deflation rather than inflation or disinflation, the value of the TIPS is adjusted downward, and the coupon interest payments that are paid in cash semiannually are calculated using the reduced principal value. However, in the case of deflation, all is not lost, because the Treasury guarantees that upon maturity, when the bond comes due, the minimum price that you will receive is the face value of the TIPS. This eliminates the risk that a severe deflation will substantially reduce the value of your TIPS.
These payment calculations sound more complicated than they actually are. Let's see how it works by using a simplified example. Assume that you bought a $1,000 TIPS on January 1 that has a fixed coupon rate of 4 percent. Further assume that the CPI-U increased by 1 percent for the period January 1 to June 30 (that is, about a 2 percent per annum inflation rate). As we said, the 4 percent coupon rate will stay the same for the life of the bond, while the amount of the semiannual interest payments to you will vary with inflation.
With the above assumptions, the calculation of the interest payment for the first six months that you own the bond is as follows: the value of the principal of your TIPS increases $10 from $1,000 to $1,010 because of the 1 percent inflation increase ($1,000 × .01). The actual amount of cash interest that you receive would be calculated as follows: multiply the adjusted principal amount of your bond ($1,010) by 2 percent (or, one-half the annual rate), because the calculation is for six months (or, one-half of the year). Thus, the amount of the first cash interest payment to you is $20.20 ($1,010 × .02).
If for the second six months of the year inflation remains the same, the inflation-adjusted principal amount of the TIPS rises to $1,020 and the interest payment for that period is $20.40 ($1,020 × .02). Therefore, if there were inflation every six months as measured by the CPI-U, the principal amount of your bond would increase, and the amount of interest paid to you in cash would also increase. If the bond was a 10-year TIPS and you held it until it came due, the Treasury would pay you the principal amount of the security as adjusted upward for inflation. In this case, the bond you paid $1,000 for would be worth about $1,344 if the rate of inflation increased and averaged 3 percent and about $1,790 if the rate of inflation increased further and averaged 6 percent. In addition, the interest payment paid to you semiannually would rise every six months in proportion to the CPI-U.
The market value of the TIPS fluctuates with the rise and fall of other interest rates, the inflation rate, and the supply and demand for the security.
TIPS provide a way to diversify your portfolio, as well as three levels of protection. First, interest payments rise with inflation. Second, the principal amount increases with inflation. Third, the Treasury guarantees that when the bond comes due, the minimum price that you will receive is the face value of the bond. Thus, the risk of a severe deflation reducing the value of the bond below its face value is eliminated. As a result, TIPS should be less volatile than other bonds with the same maturity. All primary dealers trade TIPS, though not as much as they trade other Treasuries.
What you gain in inflation protection, you lose in current cash flow. A TIPS coupon rate is typically lower than what you would receive from other interest-paying Treasury notes and bonds because the TIPS provide inflation protection. Furthermore, if inflation is low over the life of your TIPS, you would receive a lower overall return on this bond investment than if you purchased other Treasury securities. And, as mentioned, should deflation occur, the amount of your semiannual interest payment would decrease along with the security's principal value, although not below the face value. If you purchased TIPS in the secondary market at a price above its face value (say at 110) and there were a severe deflation, your TIPS might come due at 100 (its original face value) resulting in a loss of 10 (110 – 100). This is a reason to buy TIPS at the Treasury auction if they sell at face value.
Although TIPS protect you against inflation, they do not guard against market risk, the risk of selling at a loss. General increases in interest rates that are not accompanied by inflation may result in a decline in the value of your TIPS if you need to sell it before it comes due. In 1997, the first year the bonds were issued, they declined in value.
There is also the tax risk of phantom income (see "Tax Implications").
TIPS have tax consequences similar to those applicable to STRIPS. The upward adjustments to the principal of your TIPS will result in no current cash distributions to you until you either sell the bond or it comes due. However, unless you hold the TIPS in a tax-sheltered retirement account, such as an IRA, you must report this upward adjustment each year on your federal income tax return as taxable income even though you do not currently receive the value of the upward adjustment in cash. Correspondingly, a downward adjustment in the principal amount (in a period of deflation) will give rise to a deduction against the interest income paid to you. If you are in a low tax bracket, you might own these bonds in any account. However, if you are in a high tax bracket, you should consider owning TIPS only in a tax-sheltered retirement account.
There are different consequences if you own your TIPS through mutual funds. Please see chapter 15 for a discussion of TIPS owned in a mutual fund.
TIPS are not subject to state or local income tax.
Investors can use TIPS as collateral for a loan, and they allow investors the opportunity to benefit from inflation. TIPS also have a low correlation to other financial assets and, thus, may help investors reduce risk as part of their asset allocation.
Since 1926 inflation in the United States has averaged about 3 percent per year. For this same period, U.S. government bonds have yielded about 5 percent. Thus, the so-called real yield on U.S. government bonds has been about 2 percent. If you can get a real return on TIPS that exceeds 2 percent, you might consider TIPS favorably compared to other Treasuries of the same maturity.
Some advisers believe that TIPS are good for retirees, who can be hurt if their purchasing power starts to erode with inflation. Thirty-year-olds, by contrast, do not need as much inflation protection because their salaries are expected to go up over time, and the bulk of their earnings are ahead of them.
Jeff Metz, a financial adviser located in Marlton, New Jersey, says that his strategy in buying TIPS is to compare them to Treasuries of comparable maturity and to buy TIPS only at a Treasury auction. That way it is easier to compare the rate of return on the Treasury to the rate of return on TIPS, and you also save transaction fees because there is no cost to buy TIPS at a Treasury auction. Metz compares the coupon on the TIPS to the yield-to-maturity on the Treasuries and then makes an estimate for inflation. For example, if the yield-to-maturity on a 10-year Treasury bond is 4.5 percent and the coupon on the TIPS is 2 percent, it makes sense to buy the TIPS if you estimate that yearly inflation over the 10-year term of the TIPS will exceed 2.5 percent (4.5 percent minus 2 percent).
When is the next Treasury auction for the bond maturity I want?
What bond maturity makes sense for me?
What is my after-tax return on Treasuries?
Does it make more sense to purchase Treasury bonds or TIPS for me?
How much is the imputed income on which I will have to pay taxes annually if I purchase Treasury STRIPS or TIPS outside of a tax-sheltered retirement account?