FIN30021 Fixed Income and Debt Markets Topic 7 Suggested Solutions Question 7.1 1. What are the differences among a Treasury bill, Treasury note, and Treasury bond? Fixed-Principal Treasury Securities are fixed-income principal securities that include Treasury bills, Treasury notes, and Treasury bonds. As discussed below the main differences involve maturity and how earnings are received over time. Treasury bills are issued at a discount to par value, have no coupon rate, and mature at par value. The current practice of the Treasury is to issue all securities with a maturity of one year or less as discount securities. As discount securities, Treasury bills do not pay coupon interest. Instead, Treasury bills are issued at a discount from their maturity value; the dollar return to investors is the difference between the maturity value and the purchase price. All securities with initial maturities of two years or more are issued as coupon securities. Coupon securities are issued at approximately par and, in the case of fixed-principal securities, mature at par value. Treasury coupon securities issued with original maturities of more than one year and no more than 10 years are called Treasury notes. Treasury coupon securities with original maturities greater than 10 years are called Treasury bonds. (On quote sheets, an "n" is used to denote a Treasury note. No notation typically follows an issue to identify it as a bond.) 2. The following questions are about Treasury Inflation Protected Securities (TIPS). (a) What is meant by the "real rate"? In terms of TIPS, the real rate is the coupon rate. This is discussed below. The U.S. Department of the Treasury issues Treasury securities that adjust for inflation. These securities are popularly referred to as Treasury inflation protection securities, or TIPS. TIPS work as follows. The coupon rate on an issue is set at a fixed rate. That rate is determined via the auction process. The coupon rate is called the "real rate" since it is the rate that the investor ultimately earns above the inflation rate. The inflation index that the government has decided to use for the inflation adjustment is the non- seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U) Module 7 Solutions Page 1
FIN30021 Fixed Income and Debt Markets (b) What is meant by the "inflation-adjusted principal"? For TIPS, the inflation-adjusted principal is the principal that the Treasury Department will base both the dollar amount of the coupon payment and the maturity value on. It is adjusted semi-annually. Part of the adjustment for inflation comes in the coupon payment since it is based on the inflation-adjusted principal. However, the U.S. government has decided to tax the adjustment each year. This feature reduces the attractiveness of TIPS as investments in accounts of tax-paying entities. Because of the possibility of disinflation (i.e., price declines), the inflation-adjusted principal at maturity may turn out to be less than the initial par value. However, the Treasury has structured TIPS so that they are redeemed at the