Treasury Securities

U.S. Treasury securities are debt obligations issued by the federal government to finance its operations. They are considered the safest investments in the world because they carry the full faith and credit backing of the U.S. government—meaning virtually zero default risk.

Why Treasury Securities Matter

For the Series 7 exam, you need to understand:

• The different types of Treasury securities and their characteristics
• How Treasury auctions work
• Pricing mechanisms (discount vs. coupon)
• Tax treatment at federal, state, and local levels

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Types of Treasury Securities

Treasury Bills (T-Bills)

T-Bills are short-term securities with maturities of one year or less.

Key Characteristics:

• Sold at a discount to face value (no coupon payments)
• Investor receives full face value at maturity
• The difference between purchase price and face value is the "interest"
• Minimum denomination: $100
• Quoted on a discount yield basis

Example: You buy a $10,000 T-Bill for $9,800. At maturity, you receive $10,000. Your return is $200.

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Treasury Notes (T-Notes)

T-Notes are medium-term securities with maturities of 2 to 10 years.

Key Characteristics:

• Pay semiannual interest (coupon payments)
• Sold at, above, or below par value
• Quoted as a percentage of par with fractions in 32nds
• The 10-year T-Note yield is widely watched as a benchmark rate

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Treasury Bonds (T-Bonds)

T-Bonds are long-term securities with maturities of 20 to 30 years.

Key Characteristics:

• Pay semiannual interest (like T-Notes)
• Currently issued in 20-year and 30-year terms
• Subject to greater interest rate risk due to longer duration
• Quoted the same way as T-Notes (percentage of par in 32nds)

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Treasury Pricing Convention

Treasury notes and bonds are quoted as a percentage of par value, with fractions expressed in 32nds.

Example: A quote of 99-16 means:

• 99 = 99% of par
• 16 = 16/32 = 0.50%
• Total price = 99.50% of par value

For a $1,000 bond quoted at 99-16:

• Price = $1,000 × 0.9950 = $995.00

Exam Tip: Remember that Treasury quotes use 32nds, not decimals. A quote of 100-08 means 100 and 8/32, or 100.25% of par.

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Special Treasury Securities

Treasury Inflation-Protected Securities (TIPS)

TIPS protect investors against inflation by adjusting the principal based on changes in the Consumer Price Index (CPI).

Key Characteristics:

• Available in 5-year, 10-year, and 30-year maturities
• Principal adjusts with inflation (CPI-U index)
• Pays a fixed coupon rate on the adjusted principal
• At maturity, investor receives the greater of: adjusted principal or original principal
• Interest payments vary because they're based on the changing principal

How TIPS Work:

Tax Consideration: The annual increase in principal is taxable as income in the year it occurs, even though you don't receive it until maturity. This is called "phantom income" taxation.

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Treasury STRIPS

STRIPS (Separate Trading of Registered Interest and Principal Securities) are zero-coupon securities created by separating Treasury notes and bonds into their individual components.

How STRIPS Are Created:

1. A broker-dealer "strips" a Treasury note or bond
2. Each coupon payment becomes a separate zero-coupon security
3. The principal payment becomes another zero-coupon security
4. Each component trades separately with its own CUSIP

Key Characteristics:

• Sold at a deep discount to face value
• No periodic interest payments (zero-coupon)
• Created by broker-dealers, NOT issued directly by Treasury
• Must be purchased through a broker (not TreasuryDirect)
• Subject to phantom income taxation (annual accrued interest is taxable)

Example: A 10-year Treasury note paying semiannual coupons would be stripped into:

• 20 separate coupon STRIPS (one for each payment)
• 1 principal STRIP (the face value at maturity)

Exam Tip: STRIPS are popular with pension funds and investors who need predictable future cash flows at specific dates.

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Treasury Auctions

The Treasury sells marketable securities through a competitive auction process.

Auction Schedule

Types of Bids

Non-Competitive Bids:

• Maximum: $10 million per auction
• Bidder agrees to accept the rate determined at auction
• Guaranteed to receive securities
• Used by individual investors via TreasuryDirect

Competitive Bids:

• Maximum: 35% of the offering amount
• Bidder specifies the rate, yield, or discount margin they will accept
• May or may not receive securities depending on the auction results
• Used by institutional investors

How Winners Are Determined

1. Treasury first accepts all non-competitive bids
2. Competitive bids are ranked from lowest to highest yield
3. Bids are accepted until the offering amount is filled
4. All winners pay the same price (highest accepted yield)

This is called a single-price auction or "Dutch auction."

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Tax Treatment of Treasury Securities

Key Point: All Treasury securities are exempt from state and local taxes, but fully taxable at the federal level.