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Course 108
Introduction to Government Bonds

Introduction

The United States government issues or backs a number of debt securities referred to as "government bonds." Because they have the backing of the government, government bonds are considered among the most secure investments. However, there is a vast difference among the types of government bonds, and the educated investor picks and chooses from them to select those best suited to his or her investment objectives.

The Basics of Government Securities

To fund government programs and to meet its payrolls, the U.S. government issues its own bonds from the Treasury and from several government agencies. Institutional investors trading very large blocks of bonds do most of the trading in these securities. Most individual investors invest in government bonds through mutual funds. Overall, U.S. government bonds are very popular with investors worldwide.

Many people consider U.S. government bonds the safest of all because of the creditworthiness of the U.S. government.

Government bonds offer fixed interest rates. Most government bonds do not have specific collateral backing them. Instead, they are backed by the full faith and credit of the U.S. government.

Government bonds have maturities ranging from one to 50 years. Although some government securities mature in less than one year, those securities are really not bonds but are part of the money market.

Treasury Bonds

Treasury bonds (T-bonds) are very long-term US government bonds. Once issued, they mature in from 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 investments. Treasury bonds are issued in denominations of $1,000.

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. T-bonds issued today are non-callable. This means 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

Treasury notes (T-notes) have middle-range maturities lasting from one year to 10 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 no longer callable if issued today, although many T-notes issued before 1984 are. Treasury notes are sold through auctions using the bidding process. These securities pay fixed coupon rates of interest every six months.

Treasury notes with two-year or three-year maturities are sold in $5,000 denominations. All others are sold in $1,000 units.

Collateralized Mortgage Obligations

On the market is a recently introduced mortgage-backed security 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") of principal and interest payments. Individuals invest in these tranches based on their desired maturities. This way, CMOs 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 that a trustee holds. Collateralized mortgage obligations are complex investments with varying degrees of risk.

Agency Bonds and Mortgage-Backed Securities

Agency Bonds and Mortgage-Backed Securities

Agencies of the federal government raise money to help certain areas of the economy. Various government-sponsored organizations also do. Together, their securities are called agency bonds. These groups sell their own securities as one way to raise money. The U.S. Treasury does not issue any agency bonds.

Agency securities are considered very safe from default. Should they ever default, the government would probably use its creditworthiness to guarantee investors' payments of interest and principal. This is generous protection, since the U.S. government does not fully guarantee most agency securities.

Most agency bonds are in the form of mortgage-backed securities. These securities represent investments in pools of mortgages.

Agency bonds provide yields that are higher than those of Treasury securities. This is because they lack explicit guarantees of safety. Their maturities range from one year to fifty years. Denominations vary from $1,000 to $50,000.

Some well-known agencies that issue securities include the following:

  • The U.S. Postal Service, which raises funds to help its mail-delivery operations
  • The Federal Land Banks, which raise funds for agricultural projects
  • The Government National Mortgage Association (Ginnie Mae), which finances housing projects
  • The Federal National Mortgage Association (Fannie Mae), which finances mortgages for the Federal Housing Administration and the Veterans Administration
  • The Federal Home Loan Mortgage Corporation (Freddie Mac), which finances federally chartered thrift institutions

The last three on the list--Ginnie Mae, Fannie Mae, and Freddie Mac--issue mortgage-backed securities. They issue the vast majority of them.

U.S. Savings Bonds

U.S. Government securities can be divided into 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. The secondary market is very active, and bond prices fluctuate with the prevailing interest rates. There are also non-marketable government securities. Only the federal government can redeem these. They do not trade on secondary markets. These are the U.S. savings bonds.

Only the federal government can redeem U.S. savings bonds.

The three types of non-marketable bonds are called Series EE, Series HH, and Series I bonds.

Series EE Bonds
Series EE bonds are the savings bonds that have been popular for decades. They do not distribute interest periodically, as many other bonds do. They are purchased at a discount from the face value, also called "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 minimum face value of a Series EE bond is $50. 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 or she can defer it until the bond is redeemed. Tax may even be deferred beyond this date if the investor exchanges his or her bond for a Series HH bond.

Series HH Bonds
Series HH bonds are savings bonds that do pay interest and are sold at their face values. Interest is paid twice per year. The 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. These are no longer available as of August 2004.

Series I Bonds
Series I bonds also are sold at their full face value, beginning with a minimum denomination of $50. Other denominations are $75, $100, $200, $500, $1,000, $5,000, and $10,000. Like Series EE bonds, you receive the interest earned when you cash the bonds; however, you must hold EE and I bonds at least six months (12 months if purchased in February 2003 or after). I bonds earn interest for 30 years.

You Can Invest in Your Government through Government Securities

U.S. government securities are considered the safest investments because of their backing by the United States government. Yet they are not without their own risks. For this reason, it is important to know the distinctions among different issues of government bonds.

Investing in government bonds that are not suited to your investment needs and goals can be risky business. You should know the many characteristics of government bonds so you can pick those that are right for your portfolio.

Quiz 108
There is only one correct answer to each question.

1 Why does the U.S. Government sell bonds?
a. To fund its programs and meet its expenses.
b. To profit from the market.
c. To keep abreast of the private sector.
2 Many investors consider government bonds the safest of all bonds because:
a. They are not part of the private sector.
b. Many of them have long maturities.
c. They are backed by the credit of the U.S. Government.
3 Why were collateralized mortgage obligations introduced to the market?
a. To keep mortgage bond yields above the rate of inflation
b. To create collateral for government bonds
c. To reduce the prepayment risks that arise from refinanced mortgages
4 Which of the following agencies does not issue mortgage-backed securities?
a. Fannie Mae
b. The U.S. Post Office
c. Freddie Mac
5 On which type of bonds can the owner defer taxes on interest until the bond is redeemed?
a. Series EE
b. Agency
c. Treasury
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