Financial Markets and Institutions (2-downloads)

10-Year Bonds

Inflation

2010

2006 2008

F I G U R E   1 2 . 2

Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2010

(January of each year)

Sources:

http://www.federalreserve.gov/releases

and

ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

0

2

4

6

8

10

12

14

16

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

2005

2003

2009

2007

Rate (%)

90-Day

Treasury Bills

20-Year Treasury Bonds

F I G U R E   1 2 . 3

Interest Rate on Treasury Bills and Treasury Bonds, 1974–2010

(January of each year)

Source:

http://www.federalreserve.gov/releases

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284

Part 5 Financial Markets

the periodic interest payments from the final principal repayment. When a Treasury

fixed-principal or inflation-indexed note or bond is “stripped,” each interest payment

and the principal payment becomes a separate zero-coupon security. Each compo-

nent has its own identifying number and can be held or traded separately. For exam-

ple, a Treasury note with five years remaining to maturity consists of a single principal

payment at maturity and 10 interest payments, one every six months for five years.

When this note is stripped, each of the 10 interest payments and the principal pay-

ment becomes a separate security. Thus, the single Treasury note becomes 11 sep-

arate securities that can be traded individually. STRIPS are also called zero-coupon

securities because the only time an investor receives a payment during the life of

a STRIPS is when it matures.

Before the government introduced these securities, the private sector had cre-

ated them indirectly. In the early 1980s, Merrill Lynch created the Treasury

Investment Growth Fund (TIGRs, pronounced “tigers”), in which it purchased

Treasury securities and then stripped them to create principal-only securities and

interest-only securities. Currently, more than $50 billion in stripped Treasury secu-

rities are outstanding.

Agency Bonds

Congress has authorized a number of U.S. agencies to issue bonds (also known as

government-sponsored enterprises (GSEs). The government does not explicitly guar-

antee agency bonds, though most investors feel that the government would not allow

the agencies to default. Issuers of agency bonds include the Student Loan Marketing

Association (Sallie Mae), the Farmers Home Administration, the Federal Housing

Administration, the Veterans Administrations, and the Federal Land Banks. These

agencies issue bonds to raise funds that are used for purposes that Congress has

deemed to be in the national interest. For example, Sallie Mae helps provide stu-

dent loans to increase access to college.

The risk on agency bonds is actually very low. They are usually secured by the

loans that are made with the funds raised by the bond sales. In addition, the fed-

eral agencies may use their lines of credit with the Treasury Department should they

have trouble meeting their obligations. Finally, it is unlikely that the federal gov-

ernment would permit its agencies to default on their obligations. This was evi-

denced by the bailout of the Federal National Mortgage Association (Fannie Mae)

and the Federal Home Loan Mortgage Corporation (Freddie Mac) in 2008. Faced

with portfolios of subprime mortgage loans, they were at risk of defaulting on their

bonds before the government stepped in to guarantee payment. The bailout is dis-

cussed in the following case.

C A S E