Treasury and Agency Securities

The SIE will definitely expect you to be familiar with treasury securities (and, to a lesser extent, agency securities). The former is so crucial to understand because treasury securities are often used as a metric for understanding the economy at large. It's also one of the most conservative and liquid assets you can own, making it super popular to trade and hold.

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Episode Three Transcript

Hey everyone! Welcome back to another episode of the FINRA Ninja podcast, where we bring you everything you need to know to ace your FINRA exams. I’m your host, Sean, and today we're diving into two crucial topics for the SIE exam: Treasury Securities and Agency Securities. These topics are essential for anyone looking to understand the backbone of the U.S. financial system, so make sure you stick around until the end.

Let’s get started by talking about Treasury Securities. These securities are some of the safest and most liquid investments available. Why? Because they’re issued by the U.S. Department of the Treasury, which means they’re backed by the full faith and credit of the United States government. In other words, when you invest in Treasury securities, you're lending money directly to the government, and the government guarantees that you'll get your money back with interest. This makes Treasury securities a cornerstone of risk-averse investing.

Now, let’s break down the different types of Treasury securities. Each type serves a different purpose, catering to various investment needs such as capital preservation, predictable income, and protection from inflation. Understanding these distinctions is crucial for anyone in the financial industry.

Treasury Bills (T-Bills)

Let’s start with Treasury Bills, or T-Bills for short. T-Bills are short-term securities that mature in one year or less. What makes T-Bills unique is that they’re sold at a discount to their face value and do not pay periodic interest. Instead, when the T-Bill matures, you receive the full face value. The difference between what you paid for the T-Bill and its face value is essentially the interest you’ve earned.

For example, let’s say you purchase a $10,000 T-Bill for $9,500. When it matures in 26 weeks, you’ll receive the full $10,000. The $500 difference is your earnings. T-Bills are issued with maturities of 4, 8, 13, 26, or 52 weeks, making them an ideal choice for investors looking to park their money for a short period while still earning a return.

One of the reasons T-Bills are so popular is their liquidity. They’re issued weekly, and there’s always a robust secondary market for them, meaning you can sell them before they mature if you need to access your funds. This makes T-Bills a great option for investors who need flexibility and security.

Furthermore, because T-Bills are short-term, they are less sensitive to interest rate changes compared to longer-term securities. This makes them particularly attractive during periods of rising interest rates when the market value of longer-term bonds might decline. However, this also means that the returns on T-Bills are generally lower than those of longer-term securities, but the trade-off is reduced risk and higher liquidity.

Treasury Notes (T-Notes)

Next up are Treasury Notes, or T-Notes. T-Notes have maturities ranging from 2 to 10 years, making them a medium-term investment. Unlike T-Bills, T-Notes pay interest semi-annually, meaning every six months, which can provide a steady income stream for investors. The interest rate, also known as the coupon rate, is fixed when the T-Note is issued.

For example, if you purchase a 5-year T-Note with a 2% coupon rate, you’ll receive interest payments every six months. If the face value of the T-Note is $10,000, you’ll receive $100 every six months until the note matures. At maturity, you’ll get your initial $10,000 back.

T-Notes are popular among investors who are looking for a balance between earning interest and preserving their capital. They offer a higher yield than T-Bills due to their longer maturity, but they’re still considered very safe because they’re backed by the U.S. government.

Another important aspect of T-Notes is their use as a benchmark for other interest rates in the economy. For example, the yield on the 10-year T-Note is often used as a proxy for long-term interest rates in the broader economy, influencing everything from mortgage rates to the cost of corporate borrowing. This makes T-Notes not only a tool for individual investment but also a key indicator for financial markets as a whole.

Treasury Bonds (T-Bonds)

Treasury Bonds, or T-Bonds, are the long-term cousins of T-Notes. T-Bonds have maturities ranging from 10 to 30 years, making them suitable for investors with a long-term horizon. Like T-Notes, T-Bonds pay interest semi-annually and are issued at par.

For instance, if you purchase a 30-year T-Bond with a 3% coupon rate, you’ll receive interest payments every six months for the life of the bond. On a $10,000 T-Bond, that’s $300 per year, or $150 every six months. At the end of the 30 years, you’ll get your $10,000 back.

T-Bonds are often used by investors who want to lock in a steady income stream for an extended period. They’re particularly attractive in a high-interest-rate environment where interest rates are predicted to decline. That's because they can lock in a higher yield for 30 years. However, because of their long maturity, T-Bonds are more sensitive to interest rate changes than shorter-term securities. This means their market price can fluctuate more if interest rates rise or fall.

For example, if interest rates rise after you purchase a T-Bond, the market value of your bond will likely decline because new bonds are being issued with higher yields. Conversely, if interest rates fall, the market value of your T-Bond may increase, as your bond's fixed interest payments become more attractive compared to the lower yields available on new bonds. This interest rate risk is something all long-term bond investors need to consider, especially if they may need to sell the bond before it matures.

Treasury Inflation-Protected Securities (TIPS)

Now, let’s talk about Treasury Inflation-Protected Securities, or TIPS. TIPS are designed to protect investors from inflation, which is the rising cost of goods and services over time. Inflation can erode the purchasing power of your money, so having an investment that keeps pace with inflation can be crucial.

TIPS are issued with a fixed coupon rate, but what sets them apart is that the principal value is adjusted based on changes in the Consumer Price Index (or CPI), which is a measure of inflation. If the CPI goes up, the principal value, not the coupon rate, of your TIPS increases, and so do your interest payments.

For example, let’s say you purchase a 10-year TIPS with an initial principal value of $10,000 and a 1.5% coupon rate. If inflation rises by 2% in the first year, the principal value of your TIPS will increase to $10,200. That's a 2% increase to match inflation. Your interest payment will then be based on this adjusted principal, meaning you’ll receive more interest as inflation rises. At maturity, you’ll receive either the adjusted principal or the original principal, whichever is higher.

TIPS are particularly valuable in an environment where inflation is expected to rise. They offer protection that traditional Treasury securities do not, making them an essential tool for preserving purchasing power over time.

However, it’s important to note that while TIPS protect against inflation, they may offer lower initial yields compared to other Treasury securities. This is because the inflation protection itself is a valuable feature, so the government doesn’t need to offer as high an interest rate to attract buyers. Additionally, TIPS are subject to federal taxes on both the interest income and the inflation adjustments to the principal, which can reduce their overall tax efficiency.

Agencies

In understanding agency securities, we need to be familiar with at least two kinds of agencies. Federal agencies, which you've likely heard of, and Government-Sponsored Enterprises, which are private companies either started by or administered by the government, but aren't actually federal agencies. Let's first talk about federal agencies.

Federal Agencies

First, let’s talk about federal agencies. These agencies are directly tied to the U.S. government and include well-known entities like the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA). Both of these agencies play a crucial role in the housing market by providing loan guarantees to eligible borrowers.

For example, the FHA provides mortgage insurance to lenders, allowing them to offer loans to borrowers with lower credit scores or smaller down payments. This insurance reduces the risk for lenders, encouraging them to provide more loans to homebuyers who might not otherwise qualify. Similarly, the VA offers loan guarantees to veterans and active-duty service members, enabling them to purchase homes with no down payment and lower interest rates. The loans issued by these agencies are backed by the full faith and credit of the U.S. government, making them extremely safe.

Government National Mortgage Association (Ginnie Mae)

The Government National Mortgage Association, commonly known as Ginnie Mae, is a government-owned corporation within the U.S. Department of Housing and Urban Development. Established in 1968, Ginnie Mae plays a crucial role in promoting homeownership by providing liquidity to the mortgage market. It does this by guaranteeing the timely payment of principal and interest on mortgage-backed securities (MBS) that are issued by approved lenders and backed by federally insured or guaranteed loans.

These MBS are typically backed by loans from government programs such as Federal Housing Administration (FHA) loans, Department of Veterans Affairs (VA) loans, and other government-backed mortgage programs. The key advantage of Ginnie Mae’s guarantee is that even if a borrower defaults on their loan, investors holding Ginnie Mae-backed MBS will still receive their scheduled payments on time. This government backing makes Ginnie Mae securities one of the safest investments in the mortgage-backed securities.

Ginnie Mae’s role is particularly vital during periods of economic uncertainty, where credit availability can tighten. By ensuring a continuous flow of funds to mortgage lenders, Ginnie Mae helps maintain stability in the housing market, supporting homeownership and contributing to the overall health of the economy.

Mortgage-Backed Securities (MBS)

So what are mortgage-backed securities? They're a type of asset-backed security that is secured by a collection, or "pool," of mortgage loans. These securities can be issued by Ginnie Mae, Fannie Mae, or Freddie Mac, and they come in two main types: pass-through securities and collateralized mortgage obligations (CMOs).

Pass-Through Securities

Pass-through securities are the simplest form of MBS. In a pass-through security, mortgage payments from the borrowers in the pool are "passed through" to the investors, who receive a share of the principal and interest payments. The payments are distributed monthly, and the amount each investor receives depends on the size of their investment in the pool.

Pass-through securities are popular because they provide a regular income stream, which can be particularly attractive to income-focused investors like retirees. However, the payments can vary depending on the prepayment rates of the underlying mortgages. If borrowers in the pool refinance or pay off their loans early, the amount of principal returned to investors can increase, but the interest payments will decrease.

Collateralized Mortgage Obligations (CMOs)

Collateralized mortgage obligations are more complex than pass-through securities. A CMO is structured into multiple classes, or "tranches," each with different levels of risk, return, and maturity. The cash flow from the underlying mortgage pool is distributed to the tranches in a specific order, which allows CMOs to offer a variety of investment profiles within a single security.

For example, some tranches may receive principal payments first, while others receive interest payments. This structuring allows investors to choose tranches that match their risk tolerance and investment goals. For instance, an investor who prefers lower risk might choose a tranche with a shorter maturity and higher priority in receiving payments, while a more risk-tolerant investor might choose a tranche with a longer maturity and potentially higher yield.

CMOs are often used by institutional investors to match their specific liability structures or investment needs. However, the complexity of CMOs also introduces additional risks, such as prepayment risk and extension risk. Prepayment risk occurs when borrowers pay off their mortgages early, reducing the amount of interest income for investors. Extension risk, on the other hand, occurs when interest rates rise, leading to slower-than-expected payments, which can extend the duration of the investment.

Government-Sponsored Enterprises (GSEs)

Government-Sponsored Enterprises (GSEs) are financial services corporations created by Congress to enhance the flow of credit to specific sectors of the economy, such as housing and agriculture. The most notable GSEs are Fannie Mae, also known as the Federal National Mortgage Association, and Freddie Mac , the Federal Home Loan Mortgage Corporation.

Fannie Mae

Fannie Mae was established in 1938 as part of the New Deal to expand the secondary mortgage market by securitizing mortgages. This means that Fannie Mae buys mortgages from lenders, pools them together, and sells them as mortgage-backed securities to investors. By doing this, Fannie Mae helps ensure that lenders have enough funds to continue offering new mortgages to borrowers.

Fannie Mae primarily deals with conventional loans, which are mortgages that are not insured or guaranteed by the federal government. However, Fannie Mae also purchases loans that are insured by the FHA or guaranteed by the VA, allowing it to provide liquidity to a wide range of mortgage products.

Freddie Mac

Freddie Mac was created in 1970 to provide additional liquidity to the mortgage market and to compete with Fannie Mae. Like Fannie Mae, Freddie Mac buys mortgages, pools them, and sells them as MBS. However, Freddie Mac focuses more on buying conventional loans from smaller lenders and thrifts, which are financial institutions that focus on taking deposits and providing mortgage loans.

Freddie Mac’s role is similar to that of Fannie Mae, but the two organizations operate independently and serve different parts of the mortgage market. Both Fannie Mae and Freddie Mac are publicly traded companies.

Taxation of Mortgage-Backed Securities

Income from mortgage-backed securities is subject to federal, state, and local taxes. Unlike the interest on municipal bonds, which can be tax-exempt, payments from MBS are fully taxable. This includes both the interest income and any capital gains that may result from selling the securities at a profit.

Investors in MBS need to consider the tax implications of their investments, especially if they are in a high tax bracket. The taxable nature of MBS can reduce the overall after-tax return, so it’s important to factor this into your investment decisions. In some cases, holding MBS in a tax-advantaged account, such as an IRA or 401(k), can help mitigate the tax impact.

Other GSEs and Federal Agencies

In addition to Fannie Mae, Freddie Mac, and Ginnie Mae, there are other GSEs and federal agencies that issue securities to support specific sectors of the economy.

Tennessee Valley Authority (TVA)

The Tennessee Valley Authority (TVA) was created during the New Deal to provide regional planning, electricity generation, and economic development in the Tennessee Valley area. TVA bonds are backed by the U.S. government, making them a secure investment option.

TVA bonds are often used to fund infrastructure projects, such as the construction of power plants and dams. These bonds are attractive to investors who want to support public works projects while earning a steady income. Because TVA bonds are backed by the federal government, they carry a lower risk than many other types of bonds.

Small Business Administration (SBA)

The Small Business Administration (SBA) supports small businesses through loans and grants. SBA loans are backed by the federal government, making them less risky for lenders and more accessible for entrepreneurs. The SBA does not directly issue securities, but the loans it guarantees are often securitized and sold to investors.

Investing in SBA-backed securities can be an attractive option for those who want to support small businesses while earning a return. These securities provide a relatively safe investment with the added benefit of contributing to economic growth and job creation in the small business sector.

Federal Farm Credit System (FFCS)

The Federal Farm Credit System (FFCS) was established to provide financial support to farmers, who often face high risks due to factors like weather and market volatility. The FFCS issues bonds to raise funds for these loans, and these bonds are considered very safe because they are backed by the assets of the Farm Credit System.

The bonds are often used to finance loans for purchasing farmland, equipment, and other agricultural needs. Because the agricultural sector is crucial to the economy, FFCS bonds are an important tool for ensuring that farmers have access to the capital they need to succeed.

Sallie Mae

Sallie Mae, originally a government-sponsored enterprise for student loans, was privatized in 2004. It now provides private student loans and is no longer backed by the federal government. Sallie Mae is publicly traded and continues to play a significant role in the student loan market, although it no longer issues securities that are considered government-backed.

Investors interested in the education sector may still find Sallie Mae securities appealing, but they should be aware that these securities carry more risk than those issued by government-backed entities. The privatization of Sallie Mae has shifted the risk profile, and investors need to carefully evaluate the creditworthiness of Sallie Mae before investing.

## Conclusion

That’s a wrap for today’s episode on Treasury and Agency Securities. We’ve covered a lot of ground, from the different types of Treasury securities to the roles of various federal agencies and GSEs. Understanding these concepts is crucial for anyone preparing for the SIE exam, as they form the backbone of the U.S. financial system.

Remember, Treasury securities are your go-to for safe and liquid investments, while agency securities offer slightly higher yields with minimal risk, thanks to their government backing. Whether you're dealing with T-Bills, T-Notes, T-Bonds, or mortgage-backed securities, knowing the ins and outs of these instruments will give you a solid foundation in finance.

If you enjoyed this episode, make sure to check out our previous episodes and visit finraninja.com for more resources, including our blog and training course. Don't forget, you can still get free access to the course with the coupon code THENINJAWAY until August 14th, 2024.

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