2.1.2 Debt Instruments

Ask who issued it before anything else. Five families of borrower cover this outline: the government itself, an agency or a government-sponsored enterprise, a corporation, a state or local body, and a bank or dealer in the money market. Inside the government branch, four instruments split by term. A bill runs 52 weeks or less and pays no coupon at all, returning the gap between what you paid and face value at maturity. A note runs two to ten years and a bond twenty or thirty, both paying a coupon every six months. TIPS run five, ten or thirty years, paying a coupon on a principal that moves with prices.

What backs it decides where you stand if payments stop. Ginnie Mae is a federal agency, so its paper carries the full faith and credit of the United States; Fannie Mae and Freddie Mac are sponsored enterprises whose securities are guaranteed by those enterprises themselves, which is a much shorter promise. A secured corporate bond has specific property pledged to it, while a debenture has only a general claim on whatever is not already pledged, which is why the same issuer's debenture pays more. A general obligation bond leans on taxing power; a revenue bond leans on one named source and has nothing else behind it. Commercial paper is unsecured outright, a banker's acceptance carries a bank's credit on one commercial deal, and a repo is backed by collateral the lender holds but never owns.

Tax is the third question, and it is two rules rather than one. Treasury interest is taxable federally and exempt from state and local tax. Corporate interest is taxable at every level, with no relief anywhere. Municipal interest is exempt federally and usually exempt in the issuing state only, so where the buyer lives decides the second half. Agencies are left off that grid on purpose, because their treatment varies by issuer.

Then ask what goes wrong first. A Treasury faces interest rate risk, since no credit question is left to ask. A mortgage pass-through faces prepayment, because a homeowner you will never meet holds the option to repay early. A corporate bond faces credit and call together. A revenue bond faces its own project. Commercial paper faces short-dated credit, which is why only the strongest names borrow there, and a Eurodollar deposit faces a bank with no FDIC behind it.