2. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Chapter 17 Government Securities

3. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Federal Government Securities Non marketable federal government debt –series EE (Patriot) bonds –series HH bonds

4. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Federal Government Securities Marketable federal government debt –Treasury bills –Treasury notes and bonds –Zero coupon bonds (STRIPS)

5. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Federal Debt Amount of federal debt in existence primarily consists of –Treasury bills –Intermediate - term notes –Debt held by U.S. government agencies and trust funds

6. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Federal Debt and Risk Safe from default Risk from price fluctuations Purchasing power risk Measured by standard deviation of returns

7. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Discount Yield Applies to Treasury bills Based on face value and not the discounted price Uses a 360 day year

8. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Discount Yield I d = (Par value - Price) / Par value x 360 / Number of days to maturity ($10,000 - $9,800) / $10,000 x 360 / 90 = 8%

9. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Annualized Yield Based on the discounted price of the Treasury bill Uses a 365 day year

10. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Annualized Yield I d = (Par value - Price) / Price x 365 / Number of days to maturity ($10,000 - $9,800) / $9,800 x 365 / 90 = 8.277%

11. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Inflation-Index Securities Offer investors a “real yield” Interest and principal adjusted for inflation (CPI) Erases purchasing power risk

12. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Federal Government Agency Debt May be supported by “full faith and credit” of the federal government Moral backing

13. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Mortgage Backed Securities Ginnie Mae bonds Fannie Mae bonds

14. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Collateralized Mortgage Obligations (CMOs) Issued in tranches More certainty of timing of payment

15. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. State and Local Government Debt The tax exemption –interest is exempt from federal income taxation The taxable equivalent equation: i c (1 - t) = i m

16. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Interest on Federal Government Securities Is exempt from state and local income taxation The taxable equivalent equation for both exemptions: i c (1 - t f - t s ) = i m

17. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Yield Spread Between triple A and triple B rated municipal bonds

18. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Yield Spread Between triple A and the 30-year federal government bond

19. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Types of Municipal Bonds General obligation bond (GOs) –Supported by "full faith and credit” (Taxing authority of issuing government) Revenue Bond –Supported by revenues generated by project financed by the debt

20. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Risks Associated with Municipal Bonds Changes in interest rates Price volatility Possibility of default Purchasing power risk

21. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Default Revenue bonds are riskier than GOs Importance of credit ratings Insured bonds The lack of marketability

22. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Additional Topics in Municipal Debt Taxable municipal bonds –used to finance private projects Tax-exempt interest –may be subject to the alternative minimum federal income tax

23. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Foreign Government Bonds Higher yields Exchange rate risk Possibility of default High yield foreign government debt Brady bonds

24. Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Government Securities and Investment Companies Mutual funds and closed-end investment companies –may specialize in government securities –offer diversification and convenience