# Presentation: 695340

## Treasury Inflation Protected Securities  andZero Coupon Bonds 

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

## 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)

## 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)

## 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

## 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

## 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!

## 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 Investor’s 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 Investor’s Interest Revenue increases

## 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***

## 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

## 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

## 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

## 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#####

## 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 Security’s Dated Date
- For example, On Oct. 2, 2006 the Index Ratio = 1.14655 (203.5129/177.5=1.14655)
-  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

## Example Calculation of Purchase Results

- _Premium_ = Price-100/100*Principal**Index Ratio*
- (((124.59375-100)/100)*11,500,000,000*1.14655=3,242,765,867.19)
- _Accrued Interest_ = Rate/2/days in semi-annual period*days since last interest pay date*Principal**Index Ratio*
- ((.03375/2/183/170)*11,500,000,000*1.14655=206,696,180.72)
- _Inflation Compensation_ = (Principal**Index Ratio*)-Principal
- ((11,500,000,000*1.14655)-11,500,000,000=1,685,325,000)
- _Sales Price_ = Principal-*Inflated* Discount+*Inflated* Premium+*Inflated* Accrued Interest+Inflation Compensation
- (11,500,000,000+3,242,765,867.19+206,696,180.84+1,685,325,000=16,634,787,048.03)

## 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

## 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 value*Current 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
- (11,500,000,000*1.14662=13,186,130,000)
- (13,186,130,000-13,185,325,000=805,000)

## FedInvest Daily Inflation Compensation Report

-  $805,000.00

- ##X####

- ##X#####

-                          $805,000.00

-                       $2,005,000.00

## 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

## Impact on FMS SF224

- 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)

**(76)/.2 ##X####**

## 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

## 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

## 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

## 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

## 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

## 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

## 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

## Any Questions so far?

## 
So.... 

OUT with the TIPS and...

- So....
- OUT with the TIPS and...

## IN with the STRIPS!

## Let’s 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 > 5 years
- MOU required

## 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.

## Effort to Standardize MOUs

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

## 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 11:00 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)

## 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 11:00 am (EST)
- Requests are binding once received by BPD

## Example of Requests in FedInvest

- ##X##### Zero Acct

- ##X##### Zero Acct

## Request initiates email notification to BPD

- ##X##### Zero Acct

- Zero customer

- Email is sent by BPD to the Office of Debt Management (ODM) for pricing

## ODM prices ZCB requestat 12:00 noon

- Discount rate calculated via a survey of dealer quotes
- Note:  BPD also calculates ZCB pricing in case of contingency

## ODM Pricing results sent to BPD by approximately 1:00 p.m.

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

## Confirmation from FedInvest

- ##X##### Zero Acct

## 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

## 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

## 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)

## “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

## Example of BPD change for FY 06 

## 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

## 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

## 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 agency’s **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

## 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

## 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)

## 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

## 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

## 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).

## 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.

## Entry for Market AdjustmentAvailable 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

## Entry for Market AdjustmentHeld 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

## 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

## 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

## BPD Proposed Entry for Market AdjustmentAvailable 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

## BPD Proposed Entry for Market AdjustmentHeld to Maturity Agency(Budgetary entry omitted)

- _AGENCY_
- 1639 	Contra Market Adjustment-ZCBs 	      4,731,425
- 		1638 	Market Adjustment-ZCBs			  4,731,425

- _BPD_
- 2XXX  Market Adjustment-ZCBs   		     4,734,295
- 	    632X        Market Adjustment Expense-ZCBs    	 4,734,295

- 7280	Unrealized Loss – Investments	      4,731,425
- 	7XXX	Contra Unrealized Gain/Loss		  4,731,425

## IRAS ReportingAvailable for Sale Agency

- NO OVERALL DIFFERENCES
- PROPOSED - INDIVIDUAL SGL DIFFERENCES DUE TO AMORTIZATION METHODS

## IRAS ReportingHeld to Maturity Agency

- PROPOSED - DIFFERENCES DUE TO AMORTIZATION METHODS ARE APPARENT AND OVERALL DIFFERENCES = AMOUNTS IN AGENCY CONTRA ACCOUNTS

## Now that the fun is finally over....

- Are there any Questions?

## For more information....

- Contact the Federal Investments Branch at:
- 304-480-5151
- _[Fedinvestor@bpd.treas.](mailto:Fedinvestor@bpd.treas.gov)__[gov](mailto:Fedinvestor@bpd.treas.gov)_
- www.treasurydirect.gov/govt/govt.htm