U.S. Treasury Securities
U.S. Treasury securities are issued by the Department of the Treasury of the United States government and are direct obligations of the government. They are considered free of credit risk. In fact, Treasuries are used as a measure of the current risk-free rate when pricing other securities or in calculating risk premiums. For American investors, Treasuries are exempt from state and local taxes, but not federal tax.
Security Types
There are 4 major types of marketable Treasury securities: bills, notes, bonds, and Treasury-Inflation Protected Securities (TIPS). Bills are discount securities, which are issued at a discount, and notes, bonds, and TIPS are coupon bonds, which pay interest every 6 months until maturity. At maturity, all Treasury securities redeem the face value. The yields are determined by competitive bidding in periodic auctions.
Treasuries are now sold by TreasuryDirect, a website operated by the Department of the Treasury, in multiples of $100, with a $100 minimum, using an electronic book-entry system.
Treasury Bills
Treasury bills (T-bills) have terms equal to or less than 1 year, with the following issued maturities: 4 weeks, 13 weeks, 26 weeks, and cash-management bills with varying maturities. They are issued at a discount, with the interest being equal to the difference between the face value paid at maturity and the discount price.
Treasury Notes
Treasury notes (T-notes) are issued with maturities that are greater than 1 year, but less than or equal to 10 years, but currently are issued with terms of 2, 5, and 10 years.
Treasury Bonds
Treasury bonds have terms greater than 10 years. Though some are callable, callable bonds have not been issued since 1984. The Treasury stopped issuing bonds, especially the 30-year bond, in August 2001, but has resumed their sale in August 2005.
Treasury-Inflation Protected Securities (TIPS)
Treasury-Inflation Protected Securities (TIPS) pay a fixed rate of interest every 6 months on the principal which is adjusted for inflation as measured by the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U), published monthly by the Bureau of Labor Statistics (BLS). The interest rate remains fixed—only the principal is adjusted. The principal can decline during deflation, but at maturity, the greater of the face value or the adjusted principal is paid.
The Treasury created TIPS in 1997, structured similarly to the Real Return Bonds issued by the Canadian government, and have terms of 5, 10, and 20 years.
The interest rate on TIPS is determined at auction.
Interest = Annual Interest Rate × Adjusted Principal
Federal taxes must be paid on both the interest and on increases in the adjusted principal in the year earned.
The securities are eligible for stripping into their principal and interest components in the Treasury's Separate Trading of Registered Interest and Principal of Securities (STRIPS) program, discussed below.
The Treasury provides TIPS Inflation Index Ratios to allow you to easily calculate the change to principal resulting from changes in the Consumer Price Index. To learn more about determining how inflation adjustments affect your security, please see TIPS: Rates and Terms.
Zero Coupon Treasury Securities
Zero coupon Treasury securities are created from issued Treasury securities, mostly bonds, by stripping the coupons and selling each coupon payment and principal payment as a zero coupon bond. They are sold at a discount, and, thus, the interest paid is the difference between the face value of the coupon or principal and the discounted price. Zeros are not issued by the Treasury, but are created by the dealers for those customers who want to buy zeros.
For instance, a 10-year bond can be stripped to yield 20 coupons—coupon strips—and 1 principal strip. The maturities of the coupon strips would range from 6 months to 10 years, and the principal strip has an initial maturity equal to the term of the bond. The longer the maturity, the greater the discount.
Zero coupon treasury securities allow pension funds and insurance companies to better match the cash flows from their investments to their liabilities. Zeros also appeal to speculators, because they have greater volatility, and therefore a greater profit potential.
STRIPS — Separate Trading of Registered Interest and Principal Securities
The Treasury does not issue zeros—it creates them from issued Treasury securities through its Separate Trading of Registered Interest and Principal Securities (STRIPS) program, started in February 1985 that allowed the creation of zeros from coupon securities. This became possible with the advent of storing Treasury securities as electronic records in the commercial book-entry system of the Federal Reserve, where a record of a security can be easily altered to change its form from a coupon bond to a number of zero coupon bonds, with each interest payment and the principal payment becoming a separate zero-coupon security. Coupon zeros were called C-STRIPS, and all C-STRIPS that matured on the same date were given the same CUSIP number. Zeros that were stripped from the principal were called P-STRIPS, and each were issued with its own CUSIP number for separate identification.
STRIPS can be purchased and held only through financial institutions and government securities brokers and dealers—they are not issued directly to investors.
When a financial institution wants to create strips from its Treasury securities held at a Federal Reserve bank, it simply notifies the Federal Reserve. The Federal Reserve creates the STRIPS by issuing new CUSIP numbers that uniquely identify each STRIP, allowing the STRIPS to be traded independently in the secondary market. The Federal Reserve can also reconstitute the strips at the request of the owner into a note or bond.
Why would a financial institution want to create STRIPS? Because most financial institutions control interest rate risk by matching the duration of assets and liabilities, such as through the bond strategy of immunization. However, it is difficult to match the duration of liabilities with the duration of coupon bonds, since their duration is more limited. For instance, a 30 year Treasury bond with a 5% coupon rate and a market rate also equal to 5% will have a modified duration slightly longer than 15 years. The same Treasury bond, stripped, would yield 61 zero-coupon bonds, with durations ranging from 6 months to 30 years, which offers considerably greater flexibility in matching assets to liabilities, thus lowering interest rate risk.
Reassembly
The same commercial book-entry system can also reassemble the STRIPS components into a fully constituted coupon security. To reconstitute a security, a financial institution or government securities broker or dealer must obtain the appropriate principal component and all unmatured interest components. The principal and interest components must be in the appropriate minimum or multiple amounts for a security to be reconstituted.
The primary reason for reassembling STRIPS is to profit from arbitrage, when the sum of the prices of the components of the Treasury bond was less than the price of a fully reconstituted Treasury bond.
Tax Considerations
Interest earned on STRIPS and inflation adjustments to principal on TIPS must be reported in the year in which it is earned, even though no income is actually received until maturity or until the STRIPS or TIPS are sold.
Hence, STRIPS and TIPS are attractive investments for tax-deferred accounts, such as individual retirement accounts and 401(k) plans, and for non-taxable accounts, which include pension funds.
Every investor in STRIPS or TIPS receives a report each year displaying the amount of interest income from the financial institution, government securities broker, or government securities dealer that maintains the account in which the securities are held.
| Security Issue | Amount (in millions) | Percentage |
|---|---|---|
| Bills | $1,025,716 | 10.94% |
| Notes | $2,540,745 | 27.09% |
| Bonds | $571,829 | 6.10% |
| TIPS | $490,272 | 5.23% |
| Federal Financing Bank | $14,000 | 0.15% |
| Domestic Series | $29,995 | 0.32% |
| Foreign Series | $4,886 | 0.05% |
| REA Series | $1 | 0.00% |
| State & Local Government Series | $286,818 | 3.06% |
| U.S. Savings Securities | $195,327 | 2.08% |
| Government Account Series | $4,213,642 | 44.93% |
| Other | $4,326 | 0.05% |
Holding Treasury Securities
Investors have choices about how they purchase U.S. Treasury securities and where they are held. They can buy from a bank, broker, or dealer and hold their securities in the commercial book-entry system.
Investors can also buy directly from the U.S. Treasury at TreasuryDirect and hold their securities in accounts maintained by the Treasury. Online access to accounts is provided and there are no fees for purchases, reinvestments, or most other transactions.
TreasuryDirect
TreasuryDirect is a web-based system that provides online access to accounts held directly with the United States Treasury. Treasury bills, notes, bonds, TIPS, electronic Series EE Savings Bonds, and electronic Series I Savings Bonds can be purchased through the account.
Investors only pay a fee, $45, if they send instructions to their account to sell a U.S. Treasury bill, note, bond, or TIPS before it matures.
However, only individuals may hold accounts at TreasuryDirect, although it will soon be available to fiduciaries and organizations.
Legacy Treasury Direct
Legacy Treasury Direct is the older version of TreasuryDirect that allows participation by fiduciaries and organizations, as well as individuals.
Legacy Treasury Direct offers U.S. Treasury bills, notes, and TIPS (except for the 20-year maturity). Beginning in January 2007, the 30-year Treasury bond and the 20-year TIPS will not be available in Legacy Treasury Direct.
A paper application must be submitted to open an account, then most transactions can be conducted online or through an automated phone system.
This account also charges a $45 fee if a security is sold before maturity, and an annual $100 fee if the account has more than $100,000.
Commercial Book-Entry System
The commercial book-entry system, used by both the Federal Reserve and TreasuryDirect, is a multi-tiered automated system for holding and transferring marketable securities, a delivery and payment system that provides for the simultaneous transfer of securities against the settlement of funds, and replaces paper securities with electronic records.
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