ChapterMcGraw-Hill/IrwinCopyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.19Government Bonds19-2Government Bonds• Our goal in this chapter is to examine the securities issued by federal, state, and local governments.• Together, these securities represent more than $6 trillion of outstanding debt.19-3Government Bond Basics, I.• In 2007, the gross public debt of the U.S. government was more than $5 trillion, making it the largest single borrower in the world.• The U.S. Treasury finances government debt by issuing marketable as well as non-marketable securities.• Municipal government debt is also a large debt market. – In the U.S., there are more than 85,000 state and local governments.– Together, they contribute about $2 trillion of outstanding debt.19-4Government Bond Basics, II.• Marketable securities can be traded among investors.• Marketable securities issued by the U.S. Government include T-bills, T-notes, and T-bonds. • Non-marketable securities must be redeemed by the issuer.• Non-marketable securities include U.S. Savings Bonds, Government Account Series, and State and Local Government Series. 19-5U.S. Treasury Bills (T-bills)• T-bills are Short-term obligations with maturities of 13, 26, or 52 weeks (when issued).• T-bills pay only their face value (or redemption value) at maturity.• Face value denominations for T-bills are as small as $1,000.• T-bills are sold on a discount basis (the discount represents the imputed interest on the bill).19-6U.S. Treasury Notes (T-notes)• T-notes are medium-term obligations, usually with maturities of 2, 5, or 10 years (when issued).• T-notes pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity).• T-notes have face value denominations as small as $1,000.19-7U.S. Treasury Bonds (T-bonds)• T-bonds are long-term obligations with maturities of more than 10 years (when issued).• T-bonds pay semiannual coupons (at a fixed coupon rate) in addition to their face value (at maturity).• T-bonds have face value denominations as small as $1,000.19-8U.S. Treasury STRIPS• STRIPS: Separate Trading of Registered Interest and Principal of Securities• STRIPS were originally derived from 10-year T-notes and 30-year T-bonds – A 30-year T-bond can be separated into 61 strips - 60 semiannual coupons + a single face value payment• STRIPS are effectively zero coupon bonds (zeroes).• The YTM of a STRIP is the interest rates the investors will receive if the STRIP is held until maturity.19-9Example: Calculating the Price of a STRIPS• What is the price of a STRIPS maturing in 20 years with a face value of $10,000 and a semiannual YTM of 7.5%?• The STRIPS price is calculated as the present value of a single cash flow. That is, $2,293.38.075/21$10,000PRICE STRIPS4019-10Treasury Bond and Note Prices• When a callable T-bond has a price above par, the reported yield is a yield to call (YTC). Since 1985 however, the Treasury has issued only non-callable bonds.• Because T-bonds and notes pay semiannual coupons, bond yields are stated on a semiannual basis.• The relationship between the price of a note or bond and its YTM was discussed in a previous Chapter (Bond Prices and Yields).19-11Inflation-Indexed Treasury Securities, I.• In recent years, the U.S. Treasury has issued securities that guarantee a fixed rate of return in excess of realized inflation rates.• These inflation-indexed U.S. Treasury securities:– Pay a fixed coupon rate on their current principal, and – Adjust their principal semiannually according to the most recent inflation rate19-12U.S. Treasury, General Auction Pattern• The Federal Reserve Bank conducts regularly scheduled auctions for T-bills, notes, and bonds.• 4-week, 13-week, and 26-week T-bills are auctioned weekly.• 2-year T-notes are auctioned monthly.• 5-year and 10-year T-note auctions occur about four times per year for each maturity.• The U.S. Treasury posts auction FAQs, results, and other details at: www.treasurydirect.gov19-13U.S. Treasury Auctions, Details• At each Treasury auction, the Federal Reserve accepts sealed bids of two types. Competitive bids specify a bid price/yield and a bid quantity. Such bids can only be submitted by Treasury securities dealers. Noncompetitive bids specify only a bid quantity, and may be submitted by individual investors. • The price and yield of the issue is determined by the results of the competitive auction process.19-14U.S. Treasury Auctions, More Details• All noncompetitive bids are accepted automatically and are subtracted from the total issue amount.• Then, a stop-out bid is determined. This is the price at which all competitive bids are sufficient to finance the remaining amount.• Since 1998, all U.S. Treasury auctions have been single-price auctions in which all accepted bids pay the stop-out bid.19-15U.S. Savings Bonds, I.• The U.S. Treasury offers an investment opportunity for individual investors by issuing two types of Savings Bonds:• Series EE Savings Bonds:– Have face value denominations ranging from $50 to $10,000,– Are sold at exactly half the face value.– Treasury guarantees the bond will double in value in no more than twenty years• Fixed interest rate (known at time of purchase)• Earn interest for up to thirty years• Accrue interest semiannually• Must be held at least one year• 3-month interest penalty if held for less than 5 years19-16U.S. Savings Bonds, II.• Series I Savings Bonds:– Have face value denominations ranging from $50 to $10,000.– Are sold at face value.– Earn interest for up to thirty years– Accrue interest semiannually (the interest rate is set at a fixed rate plus the recent inflation rate), and– Can be redeemed after 12 months– At redemption, the investor receives the original price plus interest earned– But, investors redeeming Series I bonds within the first 5 years of purchase incur a three-month earnings penalty19-17Federal Government Agency Securities• Most U.S. government agencies consolidate their borrowing through the Federal Financing Bank, which obtains funds directly from the U.S. Treasury.• However, several federal agencies are authorized to issue securities directly to the public. Examples include:– The Resolution Trust Funding Corporation– The World Bank– The Tennessee Valley Authority19-18Federal Government Agency Securities• Bonds