U.S. government securities are divided into two categories: those that can be traded and those that cannot. The bonds that can be traded are called marketable. After they are bought, investors can sell them on the secondary market through exchanges, or over the counter. Susceptible to market conditions, the sale of marketable government bonds before they mature can produce capital losses or capital gains. Bond prices will fluctuate with the prevailing interest rates. The secondary market is active and carries a high degree of liquidity.
Only the federal government can redeem non-marketable government securities, which do not trade on secondary markets.
This tutorial will discuss the following topics concerning non-marketable government bonds and marketable bonds:
NON-MARKETABLE TREASURY ISSUES
Series EE and Series HH are the two types of non-marketable U.S. Treasury securities. They are commonly referred to as savings bonds. These securities are called non-marketable because they cannot be transferred to others, but instead must be redeemed by the federal government. Investors purchase these bonds from banks or through payroll deduction plans.
Series EE bonds do not distribute interest periodically. They are purchased at a discount from the face value (par). The discount is calculated using the bond's interest rate and years to maturity. Investors purchase them for less than their face value and let them build up to full face value at maturity. The maximum face value possible is $30,000. One can purchase Series EE bonds at banks or through payroll deduction plans. The investor can allow the accrued interest to be taxed each year, or he can defer it until the bond is redeemed. Tax may even be deferred beyond this date if the investor exchanges his bond for a Series HH bond.
Series HH bonds are savings bonds that do pay interest and are sold at their face values. Interest is paid twice per year. The bond denominations range from $500 to $10,000. Series HH bonds may be redeemed after six months. They normally mature in ten years but can be extended to twenty. Series HH bonds can only be obtained as exchanges of Series E or Series EE bonds. They come with fixed rates of interest.
MARKETABLE ISSUES
As noted earlier, marketable issues are issues that can be sold to other parties on the secondary market. We will discuss five popular ones here:
TREASURY BONDS (T-BONDS)
Treasury bonds (T-bonds) are long-term bonds. Once issued, they mature in 10 to 30 years and pay interest semiannually. Because the full faith and credit of the federal government backs them, they are considered the safest of all investments.
Treasury bonds have fixed coupon rates that specify how much interest will be paid semi-annually. However, Treasury bonds may be sold through the auction process, which affects the actual rates and yields to the bondholder. T-bonds issued today are non-callable, meaning that the government cannot require their redemption earlier than maturity time.
Interest is taxable on the federal level but not on the state and local levels.
TREASURY NOTES (T-NOTES)
Treasury notes (T-notes) have middle-range maturities that mature from one year to ten years. They are essentially the same as Treasury bonds except for the shorter maturities. T-notes are taxed federally but not statewide or locally. They are not callable if issued today, and they are sold through auctions. These securities pay fixed coupon rates of interest every six months.
TREASURY BILLS
Treasury bills are sold in face amounts beginning at $10,000 and increasing in units of $5,000.
The Treasury department sells T-bills at weekly auctions every Monday at New York City's Federal Reserve Bank. The Federal Reserve Board acts as the fiscal agent and conducts the auction, called a yield auction. The bills are sold at discounts from their face values. The investors in attendance bid on how much the bills are worth to them today, using bids based on annualized discount yields. The winning bidders pay on the following Thursday.
Bids over $1 million are called competitive bids; those less than $1 million are non-competitive bids. T-Bills are sold at competitive bids first. The remaining T-Bills are then sold non-competitively for the average price of the winning competitive bids. Both institutional and private investors may bid on Treasury bills. Institutional investors include banks, governments, mutual funds, etc. Broker-dealers also buy T-bills for resale in the secondary market.
MORTGAGE-BACKED SECURITIES
Agencies of the federal government raise money to help certain areas of the economy. One way they raise money is by selling their own securities. The majority of agency bonds are mortgage-backed securities, which represent an investment in a pool of mortgages. These securities are considered very safe from default. Should they ever default, the government most likely would use its creditworthiness to guarantee investors' payments of interest and principal.
These are some well-known issuers of mortgage-backed securities:
- The Federal Intermediate Credit Bank - raises funds for agricultural projects.
- The Federal Land Bank- also raises funds for agricultural projects.
- The Government National Mortgage Association (Ginnie Mae)- finances housing projects.
- The Federal National Mortgage Association (Fannie Mae)- finances mortgages for the Federal Housing Administration and the Veterans Administration.
- The Federal Home Loan Mortgage Corporation (Freddie Mac)- finances federally chartered thrift institutions.
COLLATERALIZED MORTGAGE OBLIGATIONS
There is a recently introduced mortgage-backed security on the market called the collateralized mortgage obligation (CMO). This security was created to relieve investors of prepayment uncertainties that arise when homeowners refinance their mortgages. Mortgage pool payments are divided into sections called tranches (French for "slices") for principal and interest payments. Individuals invest in these tranches based on their desired maturities. This way, CMO's pay interest to all their investors, but principal payments are paid out in the order of maturity.
The collateral on these bonds is a pool of mortgages held by a trustee. Collateralized mortgage obligations are complex investments with varying degrees of risk
This concludes the tutorial on marketable and non-marketable government bonds.
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