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When Uncle Sam Needs a Dime: U. S. Government Bonds
Like any business, governments need to raise money to pay for the services we ask them to provide. They have three sources of income:
- User fees (e.g., tolls).
- Bond issues.
One of the government's best-kept secrets is that you don't have to pay state income taxes on U. S. government bond interest. This is because back when our country was being formed and the federal and state governments were at loggerheads to see which would become the dominate power, they agreed not to tax the interest earned from each other's bonds. This is due to an agreement between the state and the federal governments. The guideline is known as mutual reciprocity. If there'd been no such agreement, one could tax the other's bonds so much it would be impossible for them to raise money, and they would be out of business.
The U. S. Treasury sells four types of fixed income securities to individual investors:
- 1. U. S. savings bonds.
- 2. U. S. Treasury bills.
- 3. U. S. Treasury notes.
- 4. U. S. Treasury bonds.
U.S. SAVINGS BONDS
When most people think of bonds, savings bonds are what they think of. (See Figure 1.1.) We buy savings bonds when babies are born for their college education or as gifts for our children when they graduate from high school, hoping to instill in them the importance of saving.
Series EE savings bonds are popular with retail investors because you only have to invest a fraction of the face value now. They are what is known as discount bonds or zero coupon bonds. For example, if I spend $500 today, in about 17 years when the bond matures, little Benjamin will redeem the bond for $1000. It's a great way to make people think you're spending tons of money on their kids because they see the face value and don't know what you really spent. The other benefit of a discount bond is that you don't incur reinvestment risk on the interest payments. This is because the interest is in essence reinvested internally at a constant yield, automatically compounding. These bonds are known as accrual bonds because the interest is added to the redemption value rather than being paid out. The interest is all paid out at maturity.
There are also Series HH savings bonds. These are coupon bonds that pay semiannual interest. They are not sold at a discount, nor are they included in the Education Savings Bond Program. They are sold in $500 denominations. (HH and EE don't stand for anything. They are just alphabetical designations assigned by the Treasury Department. The Federal Reserve Bank in Buffalo, one of the five that handle saving bonds, told me designations started at A and have gone as high as I.)
You can buy savings bonds at banks, credit unions, and savings and loans. Five of the Federal Reserve Banks also sell savings bonds. The minimum you can invest is $25 and the maximum is $5000 per bond. The purchase price is 50% of the face value. Savings bonds are available in $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000 face amounts. An investor is allowed to invest only $15,000 a year in savings bonds. A savings bond's beneficiary receives by mail a certificate that looks a lot like a check, with $1000 (or whatever the face value will be at maturity) printed on it.
Interest from Series EE savings bonds is exempt from state and local taxes. The difference between the purchase price and maturing face value is federally taxed as interest income. Unlike other taxable discount bonds, you have the option of not paying taxes on the interest until maturity or redemption. If the bond's proceeds are used to pay for college tuition and fees (not including room and board), the interest can also become federally tax-exempt. There are conditions: The bonds must be registered in the parent's name, purchased after 1990, and redeemed in the year the tuition is paid. There are parental income limits and married couples must file jointly.
Savings bonds have a unique characteristic in that if you buy the bond the last day of the month you are entitled to interest from that whole month! With all other bonds, you get only the interest that you earn on the days you own the bond.
There is another characteristic that makes savings bonds different from all other U. S. government bonds, and it is of crucial importance. Savings bonds are NOT a liquid investment. This means you cannot sell them; there is no secondary market for saving bonds. Some people say that savings bonds have no market risk; it is more correct to say there is no market for them (i.e., that they are not marketable). You may redeem them early, but there are severe penalties; you can forfeit a substantial amount of interest. It's a good idea to invest only money that you are sure you will not need before the maturity date of the savings bond.
U.S. TREASURY BILLS, NOTES, AND BONDS
Whether a security is a Treasury bill, note, or bond is determined by how many months or years will pass between its conception and its maturity. (See Figure 1.2.)
If you look in the newspaper and see some securities called T-notes that will mature in less than a year, that is because when a 10-year Treasury note (T-note) has been around for 9 years and has 1 year left until maturity, it is still called a note. Even though its name remains the same throughout its life, it will now act almost exactly as if it were a 1-year Treasury bill (T-bill) . In other words, it will have the volatility of and be priced to yield the same as a 1-year.
Treasury bills or T-bills are different from other Treasuries in that they are traded using their yield, not their price. The T-bill's yield as calculated by the U. S. Treasury is the discount rate. This is the difference between the price you paid at issuance and the face value. Even though the T-bill is outstanding for 52 weeks or 364 days, the Treasury calculates the discount yield on a 360-day basis. (See Table 1.1) Simple interest is the rate you earn if you buy the T-bill at some time other than at issue. It is the difference between what you pay and the face value. Since coupon bonds are outstanding for longer and pay coupons that you can reinvest to compound your earnings, you need to convert the T-bill's simple interest rate to a bond equivalent yield (BEY) in order to make a fair comparison. If you don't use the BEY, also known as the investment rate or equivalent coupon yield, you'll be comparing apples and oranges. The simple or discount yield would appear inaccurately more attractive than it should because you are not recognizing the added return a coupon bond earns by compounding reinvested coupon interest.
Treasury Notes and Bonds
U. S. Treasury notes and bonds are coupon bonds that pay interest semiannually. For example, if the bond's coupon rate is 10%, a $1000 investment will pay the investor $50 two times a year (i.e., 5% each coupon payment). The $100 the investor gets a year is a 10% return on their investment. (See Figure 1.3.) U.S. Treasury notes are federal securities issued with maturities ranging from 2 to 10 years. Currently, T-notes are issued with 2-year, 3-year, 5-year, and 10-year maturities. U.S. Treasury bonds are "govies" issued with maturities beyond 10 years. Currently, the only Treasury bond issued matures in 30 years. The last Treasury issued with a 20-year maturity was the 9 3/8% Feb 2006 issued in January 1986 at 100; in July 1998 it was trading at 123 3/4 . Treasuries that are currently being issued are non-callable. However, there are still some callable Treasury bonds outstanding that were issued when the government was issuing callable bonds. Notice in Table 1.2 the bond 7 7/8% November 2002-07. This means the Treasury bond is first callable in 2002; its final maturity is in 2007. We will discuss callable bonds when we talk about municipal bonds. Here are two more U.S. government debt securities: U.S. Treasury zero coupon bonds and T.I.P.S. They are currently issued on a sporadic basis and do not have regularly scheduled auction dates.
There are two types of zero coupon Treasury securities. They differ only in how they are created; the investor perceives no difference between them. Zeros that are issued directly from the U. S. Treasury are known as STRIPS. The other type of Treasury zero is created by investment firms that buy Treasury coupon bonds and then separate the coupon and principal payments. The firms then sell each payment separately as individual zero coupon bonds. These securities have been bestowed with many imaginative acronyms, including CATS and TIGRS (pronounced tigers).
Recently, the U. S. Treasury has begun auctioning securities that are indexed to the inflation rate. This is to protect your returns from being eroded away by inflation. These securities are known as T.I.P.S., which stands for Treasury Inflation Protection Securities. The interest will rise with inflation. This will also protect the value from falling as interest rates rise. Since they offer below-market rates and inflation is not currently a threat, interest in them has been lackluster. Even so, by the summer of 1998 more than $58 billion in 5-, 10-, and 30-year inflation-indexed bonds had been issued. At that time a 10-year inflation-indexed bond yielded about 3.8%, while traditional 10-year Treasurys yielded roughly 5.6%. So, if inflation averaged more than 1.8% a year over the next 10 years, the inflation-indexed bonds would outperform their traditional counterparts.
The principal is adjusted semiannually for inflation. If inflation rises 2% a year, the bond's face value rises 2%. Therefore, the amount of interest will also increase because there is more face value earning interest. For example, you own $10,000 face value with a 5% coupon, so you earn $500 a year. If inflation rises by 3% the next year, the face value rises to $10,300, and you'll earn $515 a year. If there is deflation, the face value will adjust downward by the amount of the deflation. You have to pay taxes on the interest paid every year and on the inflation adjustment. Paying taxes on the inflation adjustment each year may not make sense since you don't pay taxes on capital gains until realized or the bond matures, but that's the way the IRS bounces. Many finance professionals do not recommend this investment because of this ludicrous tax treatment.
Inflation-indexed savings bonds became available for sale in September 1998. Like traditional savings bonds, they are sold at a discount and the interest, which is compounded semiannually, is not paid out until maturity.
Even though current investor interest may be moribund, should inflation again become a problem these securities will become very popular. Other inflation hedges, such as gold, do not pay interest.
THE TREASURY AUCTION
Okay, now that we know all about what kinds of Treasuries there are, how do you buy the things? You can buy them either from the government when they first come out (the primary market) or from a previous owner after they've been issued (the secondary market).
As with all bond issuers, when the government wants to borrow money from investors, it offers bonds in the primary market through regularly scheduled auctions. The Treasury announces the size of the offering in a press release about a week before the auction. (See Table 1.3.)
If the normal auction day is a holiday, the auction is generally held the next business day.
Most individual investors enter a noncompetitive bid in Treasury auctions. This is a nonspecified bid meaning we don't say what yield we want to receive. We say how many bonds we would like and agree to accept the yield that's determined by the competitive bids that are accepted by the Fed. Competitive bids are entered by large investment firms and size bond buyers with one of the Federal Reserve Banks. These bids are submitted stating how many bonds they'd like and what specific yield they want to receive.
Two-year and five-year notes are sold via a single-price auction. In this case, all competitive (BIG buyers) and noncompetitive (you and me) bidders receive the same rate-the highest accepted rate. The Treasury starts at the lowest yield and keeps moving higher until it has sold all the bonds it has to sell (the size of the auction). It is this highest yield that everyone receives. (See Table 1.4.)
All other Treasuries are sold at a multiple-price auction. In this type of auction, each competitive bidder whose order is accepted gets the yield asked for. Non-competitive investors (you & me) get the weighted average yield of all the accepted competitive bids. (See Table 1.5.)
This weighted average yield is the yield that determines the issue's coupon. If the coupon is lower than the yield you are slated to get, you will pay slightly less than the face value to adjust the yield to its proper level. If the coupon is higher than the yield awarded, you will pay slightly more than the face value, but this rarely happens.
Here's an example of how an average and a weighted average can differ:
5 apples @ $.35 each
1 grapefruit @ $1.20 each
10 candy bars @ $.50 each
20 hot balls @ $.02 each
2 watermelons @ $2.00 each
The average cost per item is $.81
(.35 + 1.20 + .50 + .02 + 2.00) ÷ 5 = $.81
The weighted average cost per item is $.33
[(5 3 .35) + (1 3 1.20) + (10 3 .50) + (20 3 .02) + (2 3 2.00)] ÷ (5 + 1 + 10 + 20 + 2)
In your portfolio, computing the average yield weighted by the size of the each bond's face value, tells you more about what you actually own than just computing the average yield. For example, if you own:
$200,000 @ 7%
$20,000 @ 4%
Your average yield is: 5.5%
Your weighted average yield is: 6.73%
The weighted average yield will be closer to your actual return.
If awarded yield > coupon, then you pay > par (i.e., more than 100).
If awarded yield = coupon, then you pay = par (i.e., 100).
If awarded yield < coupon, then you pay < par (i.e., less than 100).
For example, you can submit an electronic bid through your investment adviser, or you can buy directly from one of the 12 Federal Reserve Banks by standing in line or by mail. (See Figure 1.4.) Most investment firms do not charge a commission on bonds bought at Treasury auctions, but they may charge a nominal fee to cover the expense of processing the transaction. Many investors choose this route for its convenience.
If you decide to deal with the Fed yourself, the Fed offers a service where interest and principal can be paid directly into your bank account, and, if you choose, the principal can be automatically reinvested. However, you can't sell bonds in the secondary market through the Fed. To sell Treasuries, you need to employ the services of a broker.