Bonds
U.S. government bonds are considered the safest of all investments. There are two primary types of backing: direct government backing or guarantee, as in the case of Treasury issues, and moral guarantee, as in the case of federal agencies. Most government issues trade in the capital market, which is the market for long-term securities such as stocks and bonds, but some issues trade in the money market, where short-term instruments that mature in one year or less are traded. The widely recognized bellwether of the money market is the U.S. Treasury bill.
Treasury bills (T-bills) are short-term, direct debt obligations of the U.S. government issued weekly through a competitive bidding process. Maturities include 4 weeks, 13 weeks, and 26 weeks, with 52-week bills issued every four weeks. T-bills pay no interest; they are issued at a discount from par value. For example, an investor might buy a $10,000, 26-week T-bill for $9,800, and at maturity, receive $10,000. The $200 difference is considered interest income. T-bills are always issued and traded at a discount, are the only Treasury security issued without a stated interest rate, are highly liquid, and the 13-week bill is commonly used as the standard “risk-free” investment in market analysis.
U.S. Treasury notes are direct debt obligations of the U.S. Treasury with intermediate maturities of 2, 3, 5, 7, or 10 years. They pay semiannual interest based on the stated par value, mature at par, and are noncallable. U.S. Treasury bonds are also direct obligations, but have long-term maturities of 10 to 30 years, pay semiannual interest, are noncallable, and mature at par. For calculation purposes on the exam, the par or face value of bonds is always assumed to be $1,000, although these securities can be issued in denominations as low as $100. All government securities are book-entry, meaning no physical certificates are issued—ownership is recorded electronically.
Treasury Inflation-Protected Securities (TIPS) are Treasury notes or bonds designed to protect against inflation risk. They pay a fixed interest rate, but the principal is adjusted semiannually based on changes in the Consumer Price Index (CPI). Maturities are 5, 10, and 30 years, and denominations start at $100. Interest payments increase with inflation and decrease with deflation. TIPS generally have lower interest rates than comparable fixed-rate Treasuries. Interest income is subject to federal tax but exempt from state and local taxes. In years when the principal is adjusted upward for inflation, the increase is considered taxable income even though it is not received until maturity.
The Government National Mortgage Association (GNMA or Ginnie Mae) is a wholly owned government corporation whose securities are guaranteed by the full faith and credit of the U.S. government. Ginnie Maes are modified pass-through certificates representing interests in pools of FHA-insured or VA-guaranteed mortgages. Payments are passed through monthly to investors, consisting partly of interest and partly of principal. The interest portion is subject to federal, state, and local taxes. Ginnie Maes have a $1,000 minimum denomination.
Other U.S. government agency securities are issued by government-sponsored enterprises (GSEs), which do not have full government backing but are considered moral obligations of the U.S. government. The Federal National Mortgage Association (FNMA or Fannie Mae) buys and sells FHA-insured and VA-guaranteed mortgages, issuing bonds backed by those mortgages. These bonds pay semiannual interest taxable at all levels and are issued in book-entry form. Both Ginnie Mae and Fannie Mae securities carry prepayment risk, as homeowners may refinance when interest rates fall, forcing investors to reinvest at lower rates. This is a form of reinvestment risk. Mortgage-backed securities generally offer higher returns than other debt securities with similar ratings, but they carry several risks: complexity, prepayment risk, default risk (especially in subprime mortgages), reinvestment risk, and liquidity risk.
Bonds can serve as a means of preserving capital while generating a predictable return, typically through a steady stream of interest payments made prior to maturity. For investors, this reliability can be particularly attractive, especially when compared to more volatile investments. Municipal bonds offer an additional benefit, as their interest income is generally exempt from federal income tax and may also be exempt from state and local taxes for residents of the issuing state, potentially increasing their after-tax yield.
Like any investment, bonds involve certain risks. Credit risk refers to the possibility that the issuer will fail to make scheduled interest or principal payments, resulting in a default. Interest rate risk arises from the inverse relationship between market interest rates and bond values: while holding a bond to maturity ensures the return of face value plus interest, selling it beforehand may result in a gain or loss depending on prevailing rates. When interest rates rise, newly issued bonds become more attractive because they offer higher yields, which can force holders of older, lower-rate bonds to sell at a discount. Inflation risk—the general rise in prices over time—can erode the purchasing power of fixed interest payments. Liquidity risk occurs when there is insufficient market activity to allow an investor to buy or sell a bond at will, potentially limiting flexibility. Call risk refers to the possibility that an issuer will redeem a bond before its maturity date, often when interest rates fall, in much the same way a homeowner might refinance a mortgage to secure a lower rate.