Treasury Inflation Protected Securities and Zero Coupon Bonds

1
Treasury Inflation Protected Securities
andZero Coupon Bonds

• Amy Patterson
• Federal Investments Branch
• Bureau of the Public Debt
• April 12, 2007

2
What is a TIPS? (In the Government Account
Series (GAS) Program)

• Treasury Inflation Protected Security (TIPS)
• mirror-image market-based note or bond designed
  to protect investors from inflation
• principal of a TIPS increases with inflation and
  decreases with deflation, as measured by the
  Consumer Price Index (CPI)
• has a stated rate of interest payable
  semiannually that is applied to the
  inflation-adjusted principal
• purchased or redeemed at inflation-adjusted
  premium or discount
• currently auctioned with 5, 10, or 20 year
  maturities
• matures at the higher of the inflation-adjusted
  principal or original principal (not less)

3
What is a ZCB? (In the Government Account Series
(GAS) Program)

• Zero Coupon Bond (ZCB or Zero)
• market-based bond having a maturity date that
  coincides with that of a marketable STRIPS
  security.
• Does not have interest payments
• Purchased or redeemed at a discount
• Matures at Par
• Maturity date over 5 years

Note (STRIPS is for Separate Trading of
Registered Interest and Principal of Securities.
A STRIPS security is a principal or interest
component of an eligible Treasury Note or Bond
that has been stripped off and can be held or
traded separately in the secondary market.
STRIPS are not issued by Treasury)
4
Who may invest in them?

• TIPS securities may be purchased by all of the
  GAS program agencies
• ZCB securities may only be purchased by an agency
  that has entered into a written memorandum of
  understanding (MOU) with Treasury

5
Agencies with MOU for Zeros

• Pension Benefit Guaranty Corporation (PBGC)
• Department of Energy (DOE)
• Federal Deposit Insurance Corporation (FDIC)
• Department of Defense (DOD)
• Railroad Retirement Board (RRB)
• However, only two of these agencies hold ZCB
  securities currently

6
Therefore We are going to cover TIPS first and
when we get to the Zeros please feel free to take
a break if you want!
7
More about TIPS

• Investors buy TIPS Securities at lower yields
  because their return is protected if an era of
  high inflation is encountered that would erode
  the value of traditional note or bonds
• General expectation is that inflation will
  increase over time
• On a daily basis, the Investors principal of the
  TIPS security is adjusted for inflation
• When interest is paid to the Investor it is
  calculated on the inflated principal value
• Therefore, as long as inflation increases, the
  Investors Interest Revenue increases

8
Things to consider

• PROS
• Upon early redemption, after a period of
  inflation, the cash received for the PAR would be
  greater than the original PAR value
• Upon early redemption, after a period of
  inflation, interest received and any
  premium/discount would be calculated on an
  inflated PAR value
• Semi Annual interest payments, after a period of
  inflation, would be computed on a inflated PAR
  value
• If held to maturity, the cash received for PAR
  will never be less than the original PAR even in
  deflation

• CONS
• Upon early redemption, after a period of
  deflation, the cash received for the PAR would be
  less than the original PAR value
• Upon early redemption, after a period of
  deflation, interest received and any
  premium/discount would be calculated on a
  deflated PAR value
• Some or even possibly all semi-annual interest
  payments could be computed on a deflated PAR
  value

9
Consumer Price Index (CPI)

• TIPS securities are adjusted based on changes in
  the Consumer Price Index-Urban, Non-Seasonally
  Adjusted index CPI-U (NSA), with a 3-month lag
• The CPI-U is a measure of the average change in
  prices paid by urban consumers for a fixed market
  basket of goods and services
• The CPI is calculated by the Bureau of Labor
  Statistics (BLS)
• BLS changed the CPI precision to three decimal
  places beginning with the January 2007 CPI

10
CPI-U NSA Statistics

• Over the last 10 years
• There has been inflation from one month to the
  next 80 of the time
• Overall the CPI has increased by 30

Chart from www.bls.gov
11
TIPS Investment/Redemption Rules

• Must invest in a TIPS with at least 6 months
  remaining to maturity
• Must be in 1,000 increments
• Request must be on Face (par) basis
• May redeem FIFO or Specific ID inventory method
• Request must be received by 3p.m. EST

12
Example of TIPS Investment Request in FedInvest

• The Premium, Discount and Accrued Interest are
  calculated the same as any other Market Based
  Note/Bond EXCEPT that each is inflated (or
  deflated) by multiplying by the Index Ratio
• The inflated Par Value at the date of purchase is
  shown as Inflation Compensation

X
13
The Index Ratio

• The Index Ratio is used to calculate the TIPS
  inflated (deflated) value
• The Index Ratio is calculated by dividing the
  Ref CPI for the date you are valuing by the Ref
  CPI on the Securitys Dated Date
• For example, On Oct. 2, 2006 the Index Ratio
  1.14655 (203.5129/177.51.14655)
• The Ref CPI on the Dated Date is also known as
  the Base CPI and it stays the same throughout the
  term of the Security

14
Example Calculation of Purchase Results
Premium Price-100/100PrincipalIndex
Ratio (((124.59375-100)/100)11,500,000,0001.1465
53,242,765,867.19) Accrued Interest
Rate/2/days in semi-annual perioddays since last
interest pay datePrincipalIndex
Ratio ((.03375/2/183/170)11,500,000,0001.146552
06,696,180.72) Inflation Compensation
(PrincipalIndex Ratio)-Principal ((11,500,000,000
1.14655)-11,500,000,0001,685,325,000) Sales
Price Principal-Inflated DiscountInflated
PremiumInflated Accrued InterestInflation
Compensation (11,500,000,0003,242,765,867.19206,
696,180.841,685,325,00016,634,787,048.03)
15
Initial Investment Entry (Budgetary entry
omitted)
AGENCY 1610 Investments in BPD
13,185,325,000 1612 Premium on Investments
3,242,765,867 1340 Interest Receivable
206,696,181 1010 Fund Balance
with Treasury 16,634,787,048
BPD 1010 Fund Balance with Treasury
16,634,787,048 6320 Interest Expense
206,696,181 2532 Premium on Securities
3,242,765,867 2530 Securities Issued
13,185,325,000
Note Inflation Compensation is added to the Par
Value SGLs 1610 2530
16
Daily Inflation Compensation

• Daily, the par value of the TIPS is adjusted to
  its inflated (deflated) value
• The Daily Inflation Compensation is the change in
  the inflation adjusted value from the previous
  day and is calculated using the current day index
  ratio as follows
• Find the current day inflated par value (Original
  Par valueCurrent day Index Ratio)
• Subtract the current day inflated par value from
  the previous day inflated par value
• For our previous example, the Daily Inflation
  Compensation for Oct. 3, 2006 is 805,000
• (11,500,000,0001.1466213,186,130,000)
• (13,186,130,000-13,185,325,000805,000)

17
FedInvest Daily Inflation Compensation Report
X
X
805,000.00
805,000.00
2,005,000.00
18
Daily Inflation Compensation Entry (Budgetary
entry omitted)
AGENCY 1610 Investments in BPD
805,000 5311 Interest Revenue
805,000
BPD 6320 Interest Expense
805,000 2530 Securities Issued
805,000
19
Impact on FMS SF224
(76)/.2 X
The Daily Inflation Compensation is recorded on
the SF 224 as an disbursement to the Subclass 88
Investment principal and a receipt to the
Earnings account (either Subclass 76 or .2
Account), therefore the Section II total is 0
(No IPAC)
20
Weekend/Holiday Inflation Compensation

• The Code of Federal Regulations (CFR) states that
  If any principal or interest payment date is a
  Saturday, Sunday, or other day on which the
  Federal Reserve System is not open for business,
  we will make the payment (without additional
  interest) on the next business day
• Although Inflation Compensation is not a payment
  but rather an adjustment of principal, it is not
  reported until the next business day for cash
  basis reporting
• For month-end accrual basis reporting when
  month-end falls on a non business day, the
  Inflation Compensation Adjustment needs to be
  accrued and therefore recognized as earnings by
  the Agencies and as Interest Expense by BPD

21
Cash vs Accrual Basis
The month-end for September (and FY06) ended on a
non business day

• Agencies BPD reported Inflation Compensation
  Adjustments for Saturday 9/30/06 on cash basis
  reports in October 2006 (SF 224, MTS, DTS)
• BPD did not accrue 9/30/06 inflation adjustments
  in IRAS or on the Schedule of Federal Debt (BPD
  system limitation requires the accrual of
  inflation adjustments as par to be reported to
  the DTS in September)
• Agencies had trouble accruing the 9/30/06
  inflation adjustment as par using SGL 1610
  because it would not pass the FACTS II and 2108
  edit checks unless they also reported it on the
  SF 224 in September
• Some agencies reported the 9/30/06 inflation
  adjustment as interest receivable SGL 1340
  instead of par SGL 1610

22
Elimination Issues

• These reporting issues and system limitations
  caused elimination differences in IFCS IRAS for
  the 16 million Inflation Adjustment for 9/30/06

• BPD reported it as Par in IFCS but not at all in
  IRAS
• Some Agencies reported it as Par in IFCS IRAS
• Some Agencies reported it as Interest Receivable
  in IFCS IRAS

23
Solution Beginning with March 2007

• When the last day of the month falls on a
  non-workday, report the inflation compensation
  for the last day(s) of the month as accrued
  interest.

AGENCY 1340 Interest Receivable
805,000 5311 Interest Revenue
805,000
BPD 6320 Interest Expense
805,000 2140 Interest Payable
805,000
24
March 2007 EOM Reporting

• posted as accrued interest for accrual reporting
  (Schedule of Federal Debt)
• reported in IRAS IFCS as accrued interest
• Not included on 3/30/07 DTS or March MTS
• Not reported on the March SF 224 GWA Account
  Statements

25
Entry for the Next Business Day

• On the next business day (4/2/07), record the
  Inflation Adjustment (for 3/31/07) as Principal

AGENCY 1610 Investments in BPD
805,000 1340 Interest Receivable
805,000
BPD 2140 Interest Payable
805,000 2530 Securities Issued
805,000
26
April 2007 EOM Reporting

• The inflation adjustment for 3/31/07 was
• Included on 4/02/07 DTS April MTS
• Reported on the April SF 224 GWA Account
  Statements

27
Any Questions so far?
28

• So.
• OUT with the TIPS and

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IN with the STRIPS!
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Lets review, What are Zeros again?

• market-based bond w/maturity date to marketable
  STRIPS security.
• No interest payments
• Purchased/Redeemed at a Discount
• Mature at Par Value
• Maturity date gt 5 years
• MOU required

31
Why is a MOU required?

• Generally it is done to ensure an
  understanding by the Agency of the potential
  risks involved with investing in ZCBs. Longer
  maturity and lower coupon instruments are more
  price sensitive to interest rate movements.
  There is a potential for large losses when they
  are early redeemed.

32
Effort to Standardize MOUs

• Different MOUs Different rules
• FedInvest need for similar rules
• Operating Circular provides a basis of defining
  standard rules

33
ZCB Investment Rules

• At least 5 years remaining to maturity and same
  maturity date as a marketable STRIPS
• STRIPS component at least 1 Billion outstanding1
• Specify principal or interest STRIPS2
• Initial investment must result in at least 50
  million par
• Must be in increments of 1 million par3
• Limited to 5 requests per business day
• May purchase on Available or Face (par) basis
• Request must be received by 1100 am (EST)
• Requests are binding once received by BPD

1Currently, this is being reconsidered by
Treasury 2 If not specified, one with the lower
yield will be used 3 Investment Fund Operating
Circular states 5 million (needs revised)
34
ZCB Redemption Rules

• Must not reduce remaining holding less than 50
  million par, if so the entire holding will be
  redeemed
• Must be in increments of 5 million par
• Limited to 5 requests per business day
• Must redeem on Face (par) basis
• May redeem FIFO or Specific ID inventory method
• Request must be received by 1100 am (EST)
• Requests are binding once received by BPD

35
Example of Requests in FedInvest
X Zero Acct
X Zero Acct
36
Request initiates email notification to BPD
Zero customer
X Zero Acct
Email is sent by BPD to the Office of Debt
Management (ODM) for pricing
37
ODM prices ZCB requestat 1200 noon
Discount rate calculated via a survey of dealer
quotes Note BPD also calculates ZCB pricing in
case of contingency
38
ODM Pricing results sent to BPD by approximately
100 p.m.

• BPD applies price to transaction
• BPD notifies agency of memo
• Agency obtains confirmation from FedInvest

39
Confirmation from FedInvest
X Zero Acct
40
Agency Accounting Guidance

• Intent is Held to Maturity follow FASAB
  Standard 1 - Accounting for Selected Assets and
  Liabilities
• Carry at acquisition cost less discount
• Adjust for amortization using the interest method
  
• Disclose market value
• Intent is Available for Sale follow FASB
  Statement 115 - Accounting for Certain
  Investments in Debt and Equity Securities
• Carry at market value
• Unrealized Gains or Losses

41
OMB Business Rules for Intragovernmental
Fiduciary Transactions

• For Zero Coupon Bonds
• BPD Agencies amortize interest method
• BPD carry ZCBs at amortized cost with market
  adjustments
• Agency with ZCBs available for sale may recognize
  market adjustments

42
Impact on Debt Subject to Limit

• Treasury policy is to score the ZCBs against the
  debt subject to limit on the Market Value Basis
• The market adjustment and discount amortization
  are included in the unamortized Discount line of
  the Daily Treasury Statement (DTS)

43
Market value adjustment vs Amortization

• BPD only has SGL 2533 (Amortization of Discount
  and Premium) to record both the amortization of
  discount and the market value adjustments of the
  ZCBs
• Therefore, prior to FY 06, BPD did not amortize
  the discount of the ZCBs but instead calculated
  the market value adjustment on the cost value
  instead of amortized cost value
• Beginning with FY 06, BPD separated the
  amortization and market value adjustment
  calculations

44
Example of BPD change for FY 06
45
BPD provides Market Value Amounts(Old Method)

• BPD provided their Market Value Adjustment to the
  agencies
• However, the Agencies have separate SGL Accounts
  for Amortization Market Value Adjustments
• Therefore, the Agency would need to back out
  their amortization from the BPD provided amount

46
Old method caused problems with Held to
Maturity Agency

• Agency holding ZCBs to maturity carry at
  Amortized Cost Disclose Market Value
• They have SGL 1639 as a Contra Account for this
  purpose
• However, They did not back out their
  amortization from the BPD provided amount
  instead recorded entire amount to SGL 1638 1639
• Resulted in overstating the Market Value
  Adjustments

47
SGL/TFM Guidance needs revised

• It seems that the SGL TFM Guidance for
  reporting Zero Coupon Bond Investments was based
  on the Held to Maturity Agency reporting only the
  BPD provided market adjustment on the SF 224 and
  as .931 activity (unamortized discount) on the
  FMS 2108
• However, the BPD market adjustment calculated
  using the old method should be the same as the
  total of the agencys amortization and market
  value adjustment
• Therefore, both the amortization and the market
  value adjustment amounts should be reported on
  the SF224 as Subclass (72) and on the FMS 2108 as
  .931 activity
• This problem was discovered when BPD began
  calculating the market adjustment using the new
  method
• FMS is currently working on revising the
  guidance

48
Entry for initial purchase

• AGENCY
• 1630 Investments in ZCBs
  340,000,000
• 1631 Discount on ZCBs
  249,142,048
• 1010 Fund Balance with Treasury
  90,857,952

BPD 1010 Fund Balance with Treasury
90,857,952 2531 Discount on Securities Issued
249,142,048 2530 Securities Issued
340,000,000
49
Entry for Amortization(Budgetary entry omitted)

• AGENCY
• 1633 Amortization of Discount on ZCBs
  365,246
• 5311 Interest Revenue - Investments
  365,246

BPD 6320 Interest Expense on Securities
368,116 2533 Amortization of Discount on
Securities 368,116
Note Immaterial Difference of 2,870 due to use
of Different Effective Interest Methods of
Amortization (BPD uses Scientific Level Yield -
Effective Interest Method)
50
End of Month Market Valuation

• BPD provides the Agencies with the EOM Market
  Value of each of their ZCB tax lots in an excel
  spreadsheet format
• The Market Value is calculated by BPD using the
  ZCB pricing formula discussed in previous slide
  with the Discount Rate equal to the prior day bid
  close from Bloomberg Generic pricing source
• The BPD calculation is compared against ODM
  spreadsheets for accuracy

51
Example of BPD Spreadsheet provided to Agency
BPD does not provide the amount the agency is
required to record as the Market Value
Adjustment, however this spreadsheet may be used
to calculate it
52
Agency calculation of EOM market adjustment
balance
Step 1 Column I - Add the Amortized Cost Balance
(Net amount of SGL 1630, 1631, 1633)
Step 2 Column J - Add formula to subtract
Amortized Cost balance from Tax Lot Market
Value. This is the balance that needs to be in
the Market Adjustment account (SGL 1638).
53
Agency calculation of market adjustment entry
for current period
Step 3 Column K - Add the prior EOM Market
Adjustment balance (SGL 1638 Beginning Balance)
Step 4 Column L - Add formula to subtract
Beginning Balance from the Ending Balance. This
is the amount required for the current period
market adjustment entry.
54
Entry for Market AdjustmentAvailable for Sale
Agency(Budgetary entry omitted)

• AGENCY
• 7280 Unrealized Loss-Investments
  4,731,425
• 1638 Market Adjustment-Investments in ZCBs
  4,731,425

BPD 2533 Amortization of Discount
4,734,295 6320 Interest Expense
4,734,295

• Entries would be reversed and 7180 Unrealized
  Gain used instead of 7280 if the market
  adjustment is a positive amount
• Note Same Immaterial Difference of 2,870 between
  Agency BPD due to difference in Amortized Cost
  Value

55
Entry for Market AdjustmentHeld to Maturity
Agency(Budgetary entry omitted)

• AGENCY
• 1639 Contra Market Adjustment-ZCBs
  4,731,425
• 1638 Market Adjustment-ZCBs 4,731,425

BPD 2533 Amortization of Discount
4,734,295 6320 Interest Expense
4,734,295

• Entries would be reversed if the market
  adjustment is a positive amount
• Note Same Immaterial Difference of 2,870
  between Agency BPD due to difference in
  Amortized Cost Value

56
ZCB Elimination Issues

• Large differences exist in the Intragovernmental
  Fiduciary Confirmation System (IFCS) because the
  Agency SGLs that include the market adjustment
  amounts are not included, however the SGLs that
  BPD uses for market adjustments and amortization
  are included
• Large differences exist in the Intragovernmental
  Reporting and Analysis System (IRAS) between BPD
  and Held to Maturity Agencies because BPD carries
  ZCBs at Market Value and the Agency carries them
  at Amortized Cost Value
• No overall difference exists in IRAS between BPD
  and Available for Sale agencies
• BPD has proposed changes to SGL guidance for ZCB
  market adjustment entries to help alleviate
  elimination issues

57
BPD SGL Proposal

• New Liability SGL Account for BPD market
  adjustments (instead of using 2533 Amortization
  of Discount)
• New Expense SGL Account for BPD market
  adjustments (instead of using 6320 Interest
  Expense)
• New Contra-Unrealized Gain/Loss Account for Held
  to Maturity Agency market adjustments

58
BPD Proposed Entry for Market AdjustmentAvailable
for Sale Agency(Budgetary entry omitted)

• AGENCY
• 7280 Unrealized Loss-Investments
  4,731,425
• 1638 Market Adjustment-Investments in ZCBs
  4,731,425

BPD 2XXX Market Adjustment-ZCBs
4,734,295 632X Market Adjustment
Expense-ZCBs 4,734,295
59
BPD Proposed Entry for Market AdjustmentHeld to
Maturity Agency(Budgetary entry omitted)

• AGENCY
• 1639 Contra Market Adjustment-ZCBs
  4,731,425
• 1638 Market Adjustment-ZCBs 4,731,425

7280 Unrealized Loss Investments
4,731,425 7XXX Contra Unrealized Gain/Loss
4,731,425
BPD 2XXX Market Adjustment-ZCBs
4,734,295 632X Market Adjustment
Expense-ZCBs 4,734,295
60
IRAS ReportingAvailable for Sale Agency
NO OVERALL DIFFERENCES PROPOSED - INDIVIDUAL SGL
DIFFERENCES DUE TO AMORTIZATION METHODS
61
IRAS ReportingHeld to Maturity Agency
PROPOSED - DIFFERENCES DUE TO AMORTIZATION
METHODS ARE APPARENT AND OVERALL DIFFERENCES
AMOUNTS IN AGENCY CONTRA ACCOUNTS
62
Now that the fun is finally over.
Are there any Questions?
63
For more information.

• Contact the Federal Investments Branch at
• 304-480-5151
• Fedinvestor_at_bpd.treas.gov
• www.treasurydirect.gov/govt/govt.htm