Treasury and agency debt, mortgage- and asset-backed securities

Treasury publishes the terms exactly, and the exam uses them to name the security. Treasury notes are sold for terms of 2, 3, 5, 7 or 10 years; Treasury bonds are sold for terms of 20 or 30 years. Both pay a fixed rate of interest every six months until they mature, and either can be held to maturity or sold before it. So a seven-year Treasury paying interest twice a year is a note, and a thirty-year one is a bond. A Treasury bill is the one that pays no coupon.

One tax fact about Treasuries is worth carrying because it separates them from every corporate bond. Interest on a Treasury security is subject to federal income tax each year, and there are no state or local taxes on it. A municipal bond runs the other way — generally free of federal tax, and generally free of state and local tax only for a resident of the issuing state.

Treasuries reach the market through an auction, and how a bid is entered decides what the bidder gets. A noncompetitive bidder does not name a rate at all: they agree to accept whatever rate, yield or discount margin the auction determines, and in exchange the bid is awarded in full, up to $10 million per auction: Treasury first accepts all noncompetitive bids that comply with the auction rules. A competitive bidder does name the rate they will accept and may be awarded nothing if they ask for too much, with a ceiling of 35 percent of the offering amount. The settlement is what surprises people: every successful bidder, competitive or not, receives the same rate, yield or discount margin as the highest accepted bid. Naming a lower rate wins an allocation, not a better price.

One more Treasury instrument completes the family. STRIPS — Separate Trading of Registered Interest and Principal of Securities — let investors hold and trade the individual interest and principal components of eligible Treasury notes, bonds and TIPS as separate securities. They are zero-coupon securities, because the only time a holder receives a payment from STRIPS is at maturity, which is what makes them the purest case of the price sensitivity discussed elsewhere: with no coupons arriving along the way, the whole value sits at the far end.

Agency and mortgage-backed paper is the part of this objective candidates most often arrive without. A mortgage-backed security is a debt obligation representing a claim on the cash flows from a pool of mortgage loans; the loans are bought from originators, assembled into a pool and turned into securities, which is what securitization means. Who issued it decides the credit question. Ginnie Mae is a US government agency and its guarantee of timely payment is backed by the full faith and credit of the United States. Fannie Mae and Freddie Mac are government-sponsored enterprises: they give certain guarantees and have special authority to borrow from the Treasury, but they are not backed by the full faith and credit of the government. Anything securitized by a private institution such as a bank is private-label and carries neither.

The structures divide into two. A pass-through participation certificate entitles the holder to a pro-rata share of every principal and interest payment the pool makes. A collateralized mortgage obligation, also called a real estate mortgage investment conduit, slices the same cash flows into classes called tranches and pays them in a stated priority, so each tranche can carry its own principal balance, coupon, prepayment risk and maturity. Read that last point carefully, because it is where the structure is oversold: giving each tranche a different prepayment risk spreads the risk across the classes, and spreading is not removing. The cash flows are still whatever the borrowers in the pool decide to pay, and no priority of payments can make a homeowner keep a mortgage he wants to refinance. The risk that defines the whole family is prepayment: homeowners refinance when interest rates fall, which returns principal to the investor at exactly the moment there is nothing good to reinvest it in. When rates rise the reverse happens: borrowers keep their mortgages, prepayments slow and the holder waits longer for principal that could now be reinvested at higher rates. Market and liquidity risk sit on top of that.

Mortgage-backed securities belong to a larger family. Under the SEC’s Regulation AB, an asset-backed security is a security primarily serviced by the cash flows of a discrete pool of receivables or other financial assets that convert into cash within a finite time period. A mortgage pool is one such pool; other loans and receivables can be pooled and securitized the same way. The buyer is relying on the payments that come out of the pool. Whether any government stands behind those payments is a separate question, answered as for mortgage pools: only a guarantee that carries the full faith and credit of the United States, as Ginnie Mae’s does, puts the government’s credit behind it.