Section 3Function 3: Investment Products, Recommendations & Records
U.S. Treasury securities
46 min read
· Lesson 4 of 19
About This Lesson
Treasuries are the zero point of the risk scale, the credit everything else is priced against, and the exam tests them as a precision exercise: exact maturities, exact quote conventions, exact tax treatment. Three details generate most of the questions: T-bills are quoted in yield with the bid above the ask, notes and bonds trade in 32nds, and two products (TIPS and STRIPS) generate phantom income for entirely different reasons.
What you'll cover
the product lineup: bills, notes, and bonds, with maturities, denominations, and the 32nds quote convention
auction mechanics (competitive versus non-competitive bids, the Dutch auction) and the inverted T-bill quote
TIPS inflation mechanics, STRIPS versus Treasury Receipts, phantom income in its three forms, and the yield curve
This is the fourth chapter of the products module.
The U.S. Treasury issues debt across a range of maturities to finance government
operations. All Treasury securities share three key characteristics: they are backed
by the full faith and credit of the U.S. government (highest possible credit quality),
exempt from state and local income taxes, and issued and traded in book-entry form
(no physical certificates).
Treasury bills (T-bills)
Short-term, zero-coupon discount securities. Maturities: 4, 8, 13, 26, and 52 weeks. Purchased at a discount; redeemed at par. The difference is the investor's return — there is no stated coupon.
Most liquid Treasury — the global benchmark for risk-free rate
Treasury notes (T-notes)
Intermediate-term coupon-paying securities. Maturities: 2, 3, 5, 7, and 10 years. Pay semi-annual coupon interest. The 10-year T-note is the most widely referenced benchmark for long-term rates.
10-year yield = benchmark for mortgages and corporate bonds
Treasury bonds (T-bonds)
Long-term coupon-paying securities. Maturities: 20 and 30 years. Pay semi-annual coupon interest. Highest interest rate risk of the non-inflation-linked Treasuries due to long duration.
Longest duration = most sensitive to rate changes
TIPS (Treasury Inflation-Protected Securities)
Available in 5-, 10-, and 30-year maturities. The principal adjusts with the CPI — rising with inflation, falling with deflation. The coupon rate is fixed, but coupon payments vary because they are applied to the adjusted principal. At maturity, investors receive the greater of the inflation-adjusted or original principal.
Phantom income tax on accrued inflation adjustment each year
STRIPS
Separate Trading of Registered Interest and Principal Securities. Individual coupon payments and principal of T-notes and T-bonds are separated and sold as zero-coupon bonds. Not directly issued by the Treasury — broker-dealers create them. Sold at a deep discount; taxed annually on OID (phantom income).
Highest duration — only one cash flow at maturity
Treasury receipts
Predecessor to STRIPS — zero-coupon instruments backed by Treasuries held in trust by a custodian bank. Sold under brand names like TIGRS and CATS. No longer commonly issued; STRIPS have replaced them, but they still appear on exams.
Legacy product — broker-dealer created, not direct Treasury issuance
Treasury Denominations and Maturity Bands
Bills, notes, and bonds split the maturity curve among them, each with its own pricing convention and payment schedule. The exam asks for these characteristics cold, so the grid below is memorization, not concept:
Feature
T-Bill
T-Note
T-Bond
Maturity
4, 8, 13, 17, 26, or 52 weeks
2 to 10 years
10 to 30 years
Interest Payment
None (issued at discount)
Semiannual coupon
Semiannual coupon
Minimum Denomination
$100
$100
$100
Quoted In
Yield (discount basis)
32nds of a point
32nds of a point
Day-Count
Actual/Actual
Actual/Actual
Actual/Actual
Maximum T-bill maturity is 52
weeks. Anything longer is a T-note or T-bond, not a T-bill. The
Treasury auctions 4-, 8-, 13-, 17-, and 26-week bills weekly; the 52-week
bill auctions every four weeks.
Treasury Quote Mechanics: 32nds vs Eighths
Treasury notes and bonds trade in 32nds of a point, not the eighths you learned for corporates. A quote of 99-16 is 99 and 16/32, which is 99.500% of par, or $995.00 per $1,000 face. 101-08 is 101 and 8/32 = 101.250% = $1,012.50. Some screens use a colon (99:16) instead of a hyphen; the meaning is identical.
Concept Check
What is the longest original maturity available for a U.S. Treasury bill?
T-bills are issued in original maturities of 4, 8, 13, 17, 26, and 52 weeks, with 52 weeks being the longest. Any government debt with a longer original maturity is classified as a Treasury note (2 to 10 years) or a Treasury bond (10 to 30 years), not a T-bill. The 4-, 8-, 13-, 17-, and 26-week bills are auctioned weekly while the 52-week bill is auctioned every four weeks. The 24-month distractor maps to T-notes, not T-bills. The exam frequently tests the boundary between T-bills and T-notes because the products have different pricing conventions — discount yield for bills versus 32nds-of-a-point quotation for notes.
Concept Check
Interest income from which of the following debt securities is exempt from state and local income taxation?
Treasury notes and bonds, like all direct obligations of the U.S. government, are exempt from state and local income taxes on interest income. The federal government does tax that interest at ordinary income rates. Corporate debentures and bank-issued CDs produce interest income that is fully taxable at all three levels (federal, state, and local). GNMAs are a notable trap: despite being directly backed by the U.S. government for credit purposes, the income they generate is fully taxable at all three levels because the underlying mortgages are private obligations.
Section 2 of 5~7 min · 2 concept checks
Auctions and Quoting
Treasury Auctions and the Primary Market
New Treasuries are born at auction, run by the Federal Reserve on a published calendar, and the exam cares about one thing: who gets filled and at what price. Two ways to bid:
Competitive bids name both a quantity and the yield the bidder will accept. Fills run from the lowest yield (highest price) upward until the offering is gone, so a bidder who demands too much yield can walk away with nothing.
Non-competitive bids name only a quantity and take whatever yield the auction sets. In exchange for giving up the price vote, non-competitive bidders are guaranteed a full allocation, which is why retail investors bid this way through TreasuryDirect.
The Dutch auction twist: every successful bidder, competitive and non-competitive alike, ends up at the same single stop-out yield: the highest yield (lowest price) that clears the full offering. One price for everyone, a uniform price format.
Regular auction schedule:
T-bills are auctioned weekly. T-notes and T-bonds follow a monthly schedule
by maturity. TIPS are auctioned quarterly. The auction calendar is published
by the Treasury in advance.
Treasury Bill Quote Convention: Bid Higher Than Ask
T-bills break the pattern: they are quoted in discount yield, not price, and that one convention flips the bid-ask relationship on the screen. A T-bill's bid is numerically higher than its ask.
Example T-bill quote: A 26-week T-bill quoted at 4.85 bid /
4.80 ask.
• The 4.85 bid is the yield the dealer offers when buying the bill from
the customer. Higher yield means lower price — the dealer pays less.
• The 4.80 ask is the yield the dealer charges when selling the bill to
the customer. Lower yield means higher price — the customer pays more.
• Net result: the dealer buys low and sells high, just as in any
bid-ask transaction. The yield-quoting convention simply inverts how the
price relationship looks on the screen.
What the exam expects: recognize the format on sight. A quote where the bid is numerically higher than the ask is a T-bill quote, full stop. No question asks you to compute the dollar prices, only to identify what you are looking at.
Why T-Bills Use Discount Yield
The convention exists because T-bills pay no coupon. They are issued at a discount and mature at par, the discount being the entire return, so with no coupon to anchor a price quote, the market quotes the return itself: a discount yield annualized on a 360-day basis.
Concept Check
The U.S. Treasury uses a Dutch auction process to sell new Treasury securities. Which of the following correctly describes how the Dutch auction determines the price paid by all successful bidders?
In a Dutch auction, the Treasury ranks all competitive bids from lowest yield (highest price) to highest yield (lowest price). It accepts bids starting from the lowest yield until the full offering amount is sold. The "stop-out" rate — the highest yield accepted — becomes the uniform price paid by ALL successful competitive bidders, even those who bid lower yields. Non-competitive bidders (retail investors) automatically receive this same stop-out rate, guaranteeing their purchase at the market-clearing price.
Concept Check
A registered representative looking at a screen sees a U.S. Treasury bill quoted at 4.85 bid / 4.80 ask. The bid is higher than the ask because
T-bills are quoted in discount yield rather than in price, which inverts the apparent bid-ask relationship on the screen. The 4.85 bid is the yield the dealer offers when buying — a higher yield translates to a lower dollar price, so the dealer is paying less. The 4.80 ask is the yield the dealer charges when selling — a lower yield translates to a higher dollar price, so the customer is paying more. Net result is the normal "buy low, sell high" dealer spread, simply expressed in yield rather than price. The exam expects candidates to recognize this format on sight without performing the price computation.
Section 3 of 5~12 min · 4 concept checks
TIPS
TIPS: How the Inflation Adjustment Works
TIPS are the most calculation-intensive Treasury product on the exam, and the entire calculation turns on one fact: the principal adjusts for inflation, never the coupon rate. Run the arithmetic once and the pattern locks in:
Given: $1,000 par TIPS with a 2% coupon rate. Annual inflation = 4%. Step 1 — Adjust principal: $1,000 × 1.04 = $1,040 adjusted principal Step 2 — Calculate coupon payment: $1,040 × 2% = $20.80 (paid semi-annually: $10.40 each) Step 3 — Phantom income: The $40 principal increase is taxed as ordinary income in the current year, even though the investor does not receive this cash until maturity.
At maturity the investor collects the greater of the adjusted principal or the original $1,000 par. If deflation has pushed the adjusted principal below par, the floor catches it. That asymmetry, full inflation upside with no deflation downside, is the product's quiet selling point.
Tax trap: each year's principal increase is treated as OID and taxed as ordinary income immediately, even though the cash does not arrive until maturity. That phantom income is the main reason TIPS belong in tax-deferred accounts (IRAs, 401(k)s) rather than taxable ones.
TIPS: Inflation Adjustment Mechanics in Detail
Here is the machinery behind the adjustment. TIPS pair a fixed coupon rate with a principal that resets semiannually to the Consumer Price Index, which delivers inflation protection without the Treasury ever touching the rate:
How the Adjustment Works
Worked example: An investor buys a $1,000 par TIPS with a
fixed 2% coupon. Inflation runs at 3% over the next year (1.5% in each
semiannual period).
After first 6 months: Principal adjusts to $1,000 ×
1.015 = $1,015. Interest payment = $1,015 × 0.02 / 2 = $10.15. After 12 months: Principal adjusts to $1,015 × 1.015 =
$1,030.23. Interest payment = $1,030.23 × 0.02 / 2 = $10.30.
Total first-year interest = $20.45 (vs. $20.00 on a non-adjusting bond). At
maturity, the investor receives the inflation-adjusted principal —
approximately $1,030.23 in this example.
Phantom Income on the Principal Adjustment
The principal increase is reportable income in the year it happens, cash or no cash: the same phantom income you met with zero-coupon OID. The standard move is to hold TIPS in tax-deferred accounts (IRAs, 401(k)s) so the tax bill and the cash arrival stop diverging.
Tax Treatment
Like every Treasury security, TIPS interest and principal accretion are exempt from state and local income taxes. The federal government taxes both the coupon and the inflation adjustment as ordinary income.
Suitability: TIPS fit the risk-averse investor worried about purchasing power. Government backing, a principal that grows with inflation, and the state/local exemption come bundled nowhere else. The phantom income is the one caveat, which points sizable TIPS positions toward tax-deferred accounts.
Concept Check
An investor purchases a TIPS with a 1.5% coupon rate and a $1,000 par value. Over the following year, inflation as measured by the CPI increases by 3%. What is the investor's annual coupon payment for that year?
With TIPS, the principal adjusts with inflation: $1,000 x 1.03 = $1,030 adjusted principal. The coupon rate (1.5%) is applied to the adjusted principal: $1,030 x 1.5% = $15.45. The coupon rate stays fixed, but because the principal it is applied to increases with inflation, the actual dollar coupon payment rises. Additionally, the $30 principal increase is taxable as phantom income in the current year.
Concept Check
An investor buys TIPS (Treasury Inflation-Protected Securities) with a face value of $10,000. Inflation runs at 3% during the first year. What happens to the investor's principal?
With TIPS, the principal adjusts with the CPI-U inflation index. At 3% inflation, the $10,000 principal becomes $10,300. The coupon rate is fixed, but since it is applied to the adjusted principal, the actual interest payment also rises with inflation. At maturity, investors receive the greater of the adjusted or original principal. The inflation adjustment accrues to the principal — it is not paid as a separate cash flow. This is why TIPS have "phantom income" that is taxable in the year of accrual.
Concept Check
A risk-averse customer wants a debt instrument backed by the U.S. government that provides income growing with inflation. The most suitable recommendation is
TIPS uniquely combine three customer requirements: U.S. government credit backing, fixed-income payment structure, and principal that adjusts semiannually with the Consumer Price Index. The fixed coupon rate is applied to the inflation-adjusted principal, so dollar interest payments rise during inflation. GNMAs carry full government backing but pass-through cash flows do not adjust for inflation. T-bills are also government-backed but their short maturities and discount-only return offer no inflation hedge over longer horizons. ADRs are equity instruments and not debt securities, failing the customer’s underlying request.
Concept Check
A customer holds $10,000 par of TIPS in a taxable brokerage account. The Consumer Price Index increases 4% during the year. Which statement about the customer’s tax situation is most accurate?
The annual increase in TIPS principal is reportable as ordinary income in the year of adjustment, even though no cash is received until the bond matures. This phantom income parallels the OID accretion treatment of zero-coupon bonds. The customer must include the $400 principal increase in current-year federal taxable income despite having received only the fixed coupon payments in cash. Capital gain treatment does not apply because the adjustment is OID accretion, not a sale or exchange. The federal exemption argument is incorrect — only state and local taxes are waived for Treasury securities; federal taxation applies in full.
Section 4 of 5~12 min · 4 concept checks
STRIPS, Receipts, and Phantom Income
STRIPS vs. Treasury Receipts: The Credit Backing Distinction
STRIPS and Treasury Receipts look like twins: both are zero-coupon products carved out of Treasuries, both quoted in yield to maturity. The exam tests the one difference that matters: who issued the thing, and whose credit you are actually holding.
STRIPS
Treasury-issued, fully U.S.-backed
Issuer: U.S. Treasury, through registered broker-dealers participating in the STRIPS program.
Credit backing: Full faith and credit of the U.S. government — no issuer credit risk.
Mechanism: Each coupon payment and the principal of an underlying Treasury are stripped into separate zero-coupon securities, each tradeable independently.
Acronym: Separate Trading of Registered Interest and Principal of Securities.
Treasury Receipts
Broker-dealer issued, NOT U.S.-backed
Issuer: A broker-dealer that holds Treasuries in a custodial account and issues receipts against them.
Credit backing: The broker-dealer’s own credit — these are NOT direct obligations of the U.S. government.
Examples: CATS (Certificates of Accrual on Treasury Securities), TIGRS (Treasury Income Growth Receipts), and similar trade-named products.
Status: No longer actively issued, but the exam still tests the concept.
The trap to avoid: in marketing materials both read like government zeros. Only STRIPS carry direct U.S. government backing. Treasury Receipts (CATS, TIGRS) trade on the broker-dealer's credit; the underlying Treasuries are collateral, not the obligor.
STRIPS vs. TIPS vs. Zero-Coupon Bonds: Three Different Phantom Income Situations
The exam tests phantom income across three instruments that all have it, each for its own reason:
Zero-coupon corporate bonds: OID accretes annually as ordinary income, no cash attached.
STRIPS: the same OID treatment, because each STRIP is itself a zero-coupon piece of a Treasury, a stripped coupon or the stripped principal.
TIPS: the inflation adjustment to principal is taxed as ordinary income the year it accrues, paid only at maturity. The coupons are taxed as received, like any bond.
The common thread, and the answer the exam is fishing for: all three belong in tax-deferred accounts, because all three tax you today on money that arrives later.
Concept Check
Which of the following best describes how STRIPS are created?
STRIPS (Separate Trading of Registered Interest and Principal of Securities) are not directly issued by the Treasury. They are created by broker-dealers who take a coupon-bearing T-note or T-bond and separate (strip) each coupon payment and the final principal payment, then sell each piece as an individual zero-coupon security. Each STRIP is backed by the underlying Treasury security held in custody.
Concept Check
A Treasury STRIP with a face value of $1,000 matures in 10 years and is currently trading at $614. Which of the following most accurately describes how the investor is taxed on this investment?
STRIPS are zero-coupon bonds that generate original issue discount (OID). The IRS requires the OID to be accreted and recognized as ordinary income annually — even though the investor receives no cash until maturity. This "phantom income" is taxable in the year it accrues. STRIPS are exempt from state and local tax (as Treasury securities) but fully subject to federal income tax. This phantom income treatment makes STRIPS especially appropriate in tax-deferred accounts like IRAs.
Concept Check
A new parent receives a $20,000 gift to set aside for the child’s higher education in 18 years. The parent insists the principal must grow with certainty regardless of market conditions. The most appropriate recommendation is
Treasury STRIPS match this profile precisely. The parent wants principal certainty at a known future date, U.S. government backing, and no reinvestment risk on intervening coupon payments. STRIPS deliver all three: full faith and credit backing, a fixed nominal payout at maturity, and no coupons to reinvest. Municipal bonds carry credit risk and rely on reinvestment of semiannual coupons that may not match the original yield. Blue-chip stocks and equity mutual funds carry market risk that contradicts the customer’s requirement that principal grow regardless of market conditions.
Concept Check
Which of the following statements correctly distinguishes Treasury STRIPS from Treasury Receipts such as CATS and TIGRS?
STRIPS are issued through a Treasury Department program and carry the full faith and credit of the U.S. government. Treasury Receipts (including CATS, TIGRS, and similar trade-named products) are broker-dealer-created instruments collateralized by Treasuries held in custody, but the obligor is the broker-dealer, not the U.S. government. If the broker-dealer fails, holders of receipts become creditors in bankruptcy rather than holders of a direct government obligation. Both products are zero-coupon and both are quoted in yield to maturity, so the differentiating fact is the credit backing.
Section 5 of 5~6 min · 1 concept check
Yield Curve
The Yield Curve
The yield curve plots the yields of Treasury securities against their maturities
at a single point in time. Its shape reflects market expectations about future
interest rates, economic growth, and monetary policy — and it is one of the
most important economic indicators watched by investors, economists, and the Federal Reserve.
Normal (upward sloping)
Long-term yields higher than short-term. Reflects expectations of future growth and inflation. Investors demand more compensation for locking up capital longer. Most common shape in healthy economies.
Inverted (downward sloping)
Short-term yields higher than long-term. Signals market expects rate cuts ahead (slowing economy). Historically a reliable recession predictor. Occurs when the Fed has raised short-term rates aggressively.
Flat
Short and long-term yields are approximately equal. Typically a transition state between normal and inverted, or between inverted and normal. Signals uncertainty about future direction.
Humped
Mid-term yields are highest, with both short and long-term yields lower. Uncommon; may indicate short-term tightening followed by expected long-term easing. Also called a bell-shaped curve.
Tool Card: Yield Curve Visualizer
See all four yield curve shapes interactively — normal, inverted, flat, and humped.
Adjust individual maturity yields with sliders and watch the curve update in real time.
Also covers the relationship between monetary policy and curve shape.
An inverted yield curve — where short-term Treasury yields are higher than long-term yields — most commonly signals:
An inverted yield curve occurs when short-term rates exceed long-term rates, typically because the Fed has raised short-term rates to fight inflation, and the market expects rates to fall in the future as the economy slows. Investors accept lower long-term yields in anticipation of declining rates. The inverted curve has historically been a reliable leading indicator of recession. All Treasuries carry the same credit quality — credit risk does not differ by maturity.
SummaryExam-day review · 2 essentials blocks
Chapter Summary — Exam Essentials
Ch 11 Exam Essentials — U.S. Treasury Securities
Treasury product maturity grid: T-bills (up to 52 weeks, discount), T-notes (2–10 years, semi-annual coupon), T-bonds (20–30 years, semi-annual coupon), TIPS (5/10/30 years, inflation-adjusted principal).
TIPS mechanics: Principal adjusts with CPI-U. Coupon rate is fixed but applied to adjusted principal, so actual interest payment varies. At maturity, investor receives greater of adjusted or original principal. Phantom income (OID accrual) is taxable annually.
STRIPS: Zero-coupon instruments created by separating coupon and principal cash flows from T-notes and T-bonds. Purchased at deep discount; OID accretes as ordinary income annually even though no cash is received. Best held in tax-deferred accounts.
Dutch auction (Treasury auctions): All successful competitive bidders pay the same price — the stop-out rate (highest yield accepted to fill the offering). Non-competitive bidders automatically receive this rate.
Treasury tax treatment: Interest is subject to federal income tax but exempt from state and local income taxes. This is the key distinction from agency securities, which are fully taxable at all levels.
Treasury Securities Exam Traps — Consolidated
Twelve Treasury traps the exam recycles. One pass the night before; each line is the deciding fact in a real question pattern:
1. T-bill maximum maturity is 52 weeks. Anything longer is a
T-note or T-bond. T-bills come in 4, 8, 13, 17, 26, and 52-week maturities.
2. T-bills are quoted in yield, with bid HIGHER than ask.
Reverse of normal price-quoted bonds because higher yield = lower price. The
exam does not require computing the dollar prices, only recognizing the
format.
3. T-notes (2-10 years) and T-bonds (10-30 years) pay semiannual
coupons. Quoted in 32nds. A quote of 99-16 means 99 and 16/32 =
99.500% = $995.00 per $1,000 bond.
4. Treasury day-count is actual/actual. Different from the
30/360 convention used for corporates, agencies, and munis. Same basic
formula; different calendar treatment.
5. STRIPS are U.S. government-backed; Treasury Receipts are NOT.
Both are zero-coupon and quoted in YTM, but STRIPS are issued by the Treasury
program. Treasury Receipts (CATS, TIGRS) are broker-dealer products backed by
the dealer’s own credit.
6. STRIPS suit known-future-amount goals. Education funding
in 18 years, a planned major purchase, retirement target dates — anywhere
the investor wants principal certainty in nominal dollars at a specified date,
with no reinvestment risk.
7. TIPS protect against inflation; STRIPS do not. A
risk-averse investor concerned about purchasing power needs TIPS. A
risk-averse investor wanting a known nominal amount at a specific date needs
STRIPS. Different objectives, different products.
8. TIPS principal adjusts semiannually based on CPI. The fixed
coupon rate is applied to the adjusted principal, so the dollar interest
payment changes over time even though the rate does not.
9. TIPS principal adjustments are taxable as ordinary income in the
year of adjustment. Phantom income, just like zero-coupon OID.
Typically held in tax-deferred accounts to avoid the cash-flow mismatch.
10. All Treasury securities are exempt from state and local income
taxes. Federal taxation applies to coupon interest, OID accretion on
STRIPS, and the principal adjustment on TIPS.
11. T-bills issued at a discount, redeemed at par. No coupon
payments; the entire return is the discount earned over the holding period.
Minimum denomination is $100.
12. Treasury minimum denomination is $100 across all three types.
T-bills, T-notes, and T-bonds all carry the same retail-friendly $100 minimum
through TreasuryDirect or broker access.