Maturities available: 4-week, 8-week, 13-week, 17-week, 26-week, and 52-week.
Real-world example: An investor buys a 26-week T-Bill for $9,800. At maturity, the government pays $10,000. The $200 difference is the investor's earnings. The discount yield is calculated as: ($200 / $10,000) x (360 / 182 days) = approximately 3.96%. Note that T-Bills are quoted on a bank discount yield basis, which uses 360 days and par value (not purchase price) in the denominator — making the quoted yield slightly lower than the actual return earned.
T-Bills are considered the risk-free rate benchmark in finance because they are backed by the full faith and credit of the U.S. government and have virtually zero default risk.
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Treasury Bonds have maturities of 20 or 30 years and also pay semiannual coupon interest. They are otherwise structurally similar to T-Notes. The long duration makes them highly sensitive to interest rate changes — a small rise in rates causes a large drop in price.
Analogy: A 30-year Treasury Bond is like locking in a fixed rent agreement for three decades. If market rents rise, you are stuck at the old rate and your locked-in deal looks less valuable.
Both T-Notes and T-Bonds are exempt from state and local taxes on interest, but federal income tax applies. This makes them attractive to investors in high state-tax states.
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Example: An investor holds a TIPS with a 2% coupon and $10,000 face value. Inflation runs at 3%. The adjusted principal becomes $10,300. The next semiannual coupon is 1% x $10,300 = $103 (paid twice per year). At maturity, the investor receives the greater of adjusted principal or original par value — providing a deflation floor.
TIPS interest income is subject to federal tax, including the phantom inflation adjustment to principal each year (even though no cash is received for that portion until maturity). This makes TIPS less tax-efficient in taxable accounts.
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Example: A 10-year T-Note with semiannual coupons has 20 coupon payments plus 1 principal payment = 21 separate STRIPS. Each is sold at a discount and matures at face value on its specific payment date.
STRIPS trade at steep discounts for distant maturities. Like TIPS, the accreted (phantom) income is taxable each year even though no cash is received — making them most suitable for tax-deferred accounts (IRAs, 401(k)s).
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Fannie Mae (FNMA — Federal National Mortgage Association): A Government-Sponsored Enterprise (GSE) — privately owned, publicly chartered. FNMA guarantees are NOT backed by the U.S. government. FNMA buys conventional mortgages from lenders and issues mortgage-backed securities. It was placed into government conservatorship in 2008 after the financial crisis.
Freddie Mac (FHLMC — Federal Home Loan Mortgage Corporation): Also a GSE, similar in structure to FNMA. Issues participation certificates (PCs) backed by conventional mortgage pools. Like FNMA, it carries implied (not explicit) government backing.
Key exam distinction: GNMA = government guarantee. FNMA and FHLMC = GSEs, no direct government guarantee but carry implied support.
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Prepayment risk is the primary unique risk of MBS: when interest rates fall, homeowners refinance their mortgages at lower rates. This causes investors to receive their principal back faster than expected — right when they would need to reinvest at lower prevailing rates. This is called reinvestment risk and is the mirror of extension risk (when rates rise and prepayments slow, locking investors in longer than expected).
Analogy: Think of MBS prepayment risk like owning a rental property where tenants can break their lease early whenever rent prices drop. You get your deposit back sooner, but now you must rent at the new lower market rate.
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Quiz Questions:
Q1. An investor purchases a 26-week Treasury Bill at a price of $9,750 with a face value of $10,000. What is the investor's dollar return at maturity?
A) $9,750 B) $250 C) $150 D) $10,000
Answer: B — The investor paid $9,750 and receives $10,000 at maturity. The $250 difference ($10,000 minus $9,750) is the return. A is the purchase price, not the return. C is incorrect arithmetic. D is the total maturity value, not the return earned.
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Q2. Which of the following agency issuers provides an explicit, direct U.S. government guarantee on its mortgage-backed securities?
A) Fannie Mae (FNMA) B) Freddie Mac (FHLMC) C) Ginnie Mae (GNMA) D) Federal Home Loan Banks (FHLB)
Answer: C — GNMA is the only agency with an explicit, full-faith-and-credit U.S. government guarantee. FNMA and FHLMC are GSEs with implied but not direct government backing. FHLB also lacks a direct guarantee.
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Q3. A TIPS bond has a 3% coupon and a $10,000 original par value. After one year, CPI has risen 4%. What is the adjusted principal and the annual coupon payment?
A) $10,000 principal; $300 coupon B) $10,400 principal; $312 coupon C) $10,400 principal; $300 coupon D) $10,300 principal; $309 coupon
Answer: B — The principal adjusts by CPI: $10,000 x 1.04 = $10,400. The annual coupon is 3% x $10,400 = $312. Answer A ignores the inflation adjustment. Answer C applies the adjusted principal but uses the old coupon dollar amount. Answer D uses a 3% inflation adjustment instead of 4%.
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Q4. Which of the following best describes prepayment risk for holders of mortgage-backed securities?
A) The risk that homeowners will default on their mortgages B) The risk that interest rates rise, reducing the value of the MBS C) The risk that homeowners refinance when rates fall, returning principal early at lower reinvestment rates D) The risk that the issuing agency will call the bonds before maturity
Answer: C — Prepayment risk specifically refers to homeowners refinancing (or selling homes) when rates drop, causing investors to receive principal back earlier than expected and forcing reinvestment at lower yields. A describes credit/default risk. B describes interest rate risk (extension risk in MBS context). D incorrectly characterizes how MBS work — they do not have issuer call provisions in the traditional sense.
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Q5. STRIPS are best suited for which type of account, and why?
A) Taxable brokerage accounts, because gains are long-term B) Tax-deferred retirement accounts, because phantom income is taxable annually without cash receipt C) Municipal bond funds, because they are state-tax exempt D) Money market accounts, because they mature in under one year
Answer: B — STRIPS generate "phantom income" — the annual accretion toward par is taxable as ordinary income even though no cash is paid until maturity. This tax burden is best handled inside a tax-deferred account (IRA, 401(k)) where no annual tax is owed. A is wrong because the phantom income problem applies regardless of holding period in taxable accounts. C is incorrect — STRIPS are Treasuries, unrelated to municipal funds. D is wrong — STRIPS can have very long maturities.