Treasury Bills (T‐bills)

Treasury bills (T‐bills) are the shortest term debt obligations of the U.S. Treasury with maturities of one year or less. One‐month, three‐month, six‐month, and one‐year T‐bills are sold directly to the public by the Treasury. Treasury bills are sold at a discount from face value. At maturity, the investor redeems the bill for full face value. The difference between the purchase price and the amount that is paid at maturity represents the investor's interest. For example, if you buy a $100,000 (face or par value) 26‐week T‐bill for $99,250, at maturity you will receive $100,000. The difference of $750 represents your interest. Interest on T‐bills accrues based on the actual number of days between purchase and maturity and each year is assumed to contain 360 days.

Treasury Notes and Bonds

Notes mature in more than a year, but not more than 10 years from their issue date. The Treasury offers three kinds of notes: fixed rate, floating rate, and inflation linked. (For discussion of floating‐rate bonds, see the FRN section to follow. For discussion of inflation‐linked bonds see the TIPS section.) Fixed‐rate Treasury notes are currently issued in terms of 2, 3, 5, 7, and 10 years. Interest is paid semiannually with no call option prior to maturity. T‐notes are normally traded in multiples of $1,000 but can be traded in denominations as small as $100. The term Treasury bond refers generically to debt issued with a 30‐year maturity. Other than its tenor, the long bond has the same characteristics as Treasury notes.

TIPS

In January 1997, the Department of the Treasury introduced Treasury Inflation Indexed Securities, often referred to as Treasury Inflation Protected Securities (TIPS), a new form of notes and bonds whose principal is tied to the rate of inflation.

Simply stated, TIPS adjust the principal paid to the investor to keep pace with the rate of inflation. While these securities pay a fixed rate of interest, the principal amount of the bond is adjusted for inflation. In exchange for this inflation protection feature, the investor accepts an interest rate on the bond lower than traditional Treasuries of similar maturity. Over the life of the bond, semiannual interest payments are based on the new inflation‐adjusted principal, not the original face value. If consumer prices rise, the inflation‐adjusted principal will increase, as will the interest payments received. Conversely, if consumer prices fall, the inflation‐adjusted principal will decrease. In this instance, investors will receive smaller interest payments than they would have if the rate of inflation had increased or stayed the same. In the event that consumer prices actually decline (deflation), the Treasury offers a safeguard: Upon maturity, the bondholder will be paid the greater of either the inflation‐adjusted principal or the original face value, guaranteeing a return to the investor of at least the original principal amount invested.

The inflation rate used to adjust the principal is the Consumer Price Index (CPI), the Bureau of Labor Statistics' nonseasonally adjusted monthly measure of price changes in a basket of goods and services.

TIPS are currently issued with maturities of 5, 10, and 30 years and can be purchased in the new issue market by placing a competitive or noncompetitive bid through the standard Treasury auction process (see discussion of the auction process that follows). Secondary markets of previously issued TIPS exist but they are not traded as frequently as traditional on‐the‐run Treasuries.

Like all Treasury notes and bonds, TIPS are exempt from state and local income taxes. At the federal level, investors will be taxed both on the coupon payments and on any inflation increase to the principal value in the year that it occurs. Because of this tax treatment, investors should consider purchasing TIPS for their tax‐deferred accounts. It should be noted that if deflation causes a reduction in the principal amount, the IRS allows the investor to reduce his or her taxable interest income expense by the amount of the principal reduction. If the reduction exceeds the amount of semiannual interest payments for that year, the investor can carry forward the deduction to subsequent years until it is used up.

Investors considering an investment in TIPS generally begin their analysis by comparing the yield differential between TIPS and a comparable maturity fixed‐rate Treasury bond. That difference is sometimes called a breakeven inflation rate. If a traditional 10‐year Treasury yields 2.5 percent and a new 10‐year TIPS bond yields 2 percent, then the difference of 0.5 percent is the breakeven inflation rate. If the average annual inflation rate over the 10‐year life of the bond exceeds 0.5 percent, the TIPS bond should outperform the traditional 10‐year Treasury. So, the larger the breakeven inflation rate, the more expensive the TIPS bond.

Treasury STRIPS

Treasury STRIPS are the most common type of zero‐coupon bond derived from U.S. Treasury securities. Zero‐coupon bonds are issued at a discount to face value and pay no interest during the life of the bond. Instead, the interest payments are realized as incremental increases in the principal value of the bond and are payable at maturity. STRIPS are not issued by the U.S. Treasury; rather they are created by the Treasury by stripping the semiannual interest payments of existing coupon‐bearing bonds and repackaging them as new securities. Since the security of the new bond is derived from the full faith and credit pledge of the U.S. government to pay the interest on its debt, STRIPS are considered to be Treasury debt. STRIPS maturities range from one month to as long as 30 years.

FRNs

In January 2014 the Treasury began to issue floating‐rate notes (FRNs) in response to regulatory changes that encouraged money managers to allocate a greater portion of their assets to government securities, and the Treasury Department's desire to lower their borrowing cost. FRNs are a borrowing structure commonly used by corporations and GSEs, as well as some foreign governments, but the U.S. government had never utilized the structure before. Treasury FRNs are currently issued quarterly with a two‐year maturity and quarterly interest payments. Like other structures they are issued and mature at par and trade in minimum quantities of $100. Where FRNs differ from other Treasury bonds is in the way the quarterly interest payments vary each period depending on changes in the reference rate.

When the Treasury Borrowing Advisory Committee (TBAC) was originally discussing the idea of issuing FRNs there was considerable debate about what reference rate to use.¹ In corporate bonds the London Interbank Offered Rate (LIBOR) is the most commonly used reference rate, but as LIBOR is a credit based rate it would not be appropriate for Treasury debt. The TBAC considered using either the average price of general collateral (GC) repurchase trades or the stop level of the monthly three‐month T‐bill auction. In the end, it was decided to use the stop level of the monthly three‐month bill given its more extensive historical data, an expectation of lower rates, and the fact that GC is sometimes pushed higher by credit‐related problems. The auction process for FRNs is similar to the process for standard fixed‐coupon notes, with the major difference being that the bid is quoted as the premium over the reference rate that the bidder requires to lend to the Treasury. This spread over the benchmark rate is referred to as the discount margin (DM). As in every other auction, the Treasury seeks to minimize its borrowing cost and will award bonds to those bidders who submit the lowest DM.

The use of FRNs diversifies the structure of Treasury's borrowing, reduces its borrowing costs, and provides more stable funding. FRNs offer benefits to lenders as well. Chief among them is the measure of inflation protection that FRNs provide. If inflation rises, one would expect the rates on the three‐month T‐bill to rise as well, pushing up interest payments on all outstanding FRNs and easing the drag of higher inflation.