In 2008, thousands of municipal bonds lost their AAA ratings within months, though their issuers kept paying. Every bond here raises one question: whose promise actually pays your client?
Treasury securities are direct debt of the U.S. government, backed by its full faith and credit: its pledge to use its taxing and borrowing power to pay. They come in three maturity families:
- Treasury bills: Bills of a year or less sold at a discount, in terms of 4, 6, 8, 13, 17, 26 and 52 weeks. A bill pays no coupon.
- Treasury notes: Notes of 2, 3, 5, 7 and 10 years, paying fixed interest every six months.
- Treasury bonds: Bonds of 20 and 30 years, paying fixed interest every six months.
All are sold in $100 increments and traded in the most liquid bond market in the world, so clients can sell quickly.
Treasuries carry no practical default risk, but they carry price risk: when market rates rise, existing bonds fall in price, and longer maturities fall more.
Common mistakes
- Dividing by the rate: A 3% muni for a 37% client is 3% ÷ 0.63 = 4.76%, not 3% ÷ 0.37 = 8.11%. Use the marginal rate, never the average rate.
- Fannie and Freddie guaranteed: Only Ginnie Mae carries the full faith and credit of the United States; Fannie Mae and Freddie Mac guarantee their own securities.
- Swapped MBS risks: Falling rates bring prepayment risk; rising rates bring extension risk. A CMO tranche shifts these risks but never erases them.
Bottom line
- Treasuries carry full faith and credit and no practical default risk, but price risk rises with maturity, and interest is taxed federally only (31 U.S.C. 3124).
- TIPS (5, 10, 30 years) index principal to CPI-U, pay a fixed real rate on adjusted principal, repay the greater of adjusted or original principal, and create yearly phantom income best held in tax-deferred accounts.
- ABS and MBS pay monthly from a borrower pool; Ginnie Mae is U.S.-guaranteed, Fannie Mae and Freddie Mac are not; falling rates bring prepayment risk, rising rates bring extension risk.
- Corporate bonds have $1,000 par, are secured (mortgage, equipment trust, collateral trust) or unsecured (debentures, subordinated debentures), are issued publicly under a Trust Indenture Act indenture with a trustee, and are taxed federally and by states.
Exam shortcut
When a stem names a bond, ask whose promise pays: the U.S. government (Treasuries, TIPS, Ginnie Mae), a company (Fannie Mae, Freddie Mac, corporates, industrial development bonds), a borrower pool, a tax base (GO), a project (revenue) or an insurer. For yield math, subtract the bracket from 1 first. If your tax-equivalent yield comes out lower than the muni yield, you multiplied when you should have divided.
The full lesson (about 3,394 words, 23 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- B6
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