Government Debt Practice Questions for the SIE

Answer: By buying the bill at a price below its face value and receiving the full face amount at maturity

Treasury bills (issued in tenors of up to 52 weeks) carry no coupon. They are sold at a discount to face value, and the investor's entire return is the difference between the discounted purchase price and the face amount received at maturity — that discount accretion is what the tax code treats as interest income. Choice A describes Treasury notes and bonds, which do pay semiannual coupons. Choice C describes mortgage-backed pass-through certificates such as GNMAs, not bills. Choice D reverses the tax treatment: interest on Treasury securities is subject to federal income tax but exempt from state and local income tax — the mirror image of municipal bonds. Source: U.S. Treasury marketable securities program (TreasuryDirect) and IRS treatment of original issue discount.

The Trap: t-bill-interest-equals-coupons

• By earning interest that is exempt from federal income tax: Misconception: the tax-treatment flip. Treasury interest is federally TAXABLE; it is state and local tax that Treasuries are exempt from (the municipal-bond mirror image).
• By receiving monthly payments that include both interest and principal: Misconception: confusing Treasury bills with mortgage-backed pass-through certificates, which pay monthly P&I.
• By receiving fixed semiannual coupon payments until maturity: Misconception: confusing T-bills with Treasury notes/bonds — the 'T-bill interest = coupons' trap. Bills pay no coupon at all.

Verified against: taxation)

Answer: A Treasury note

The Treasury's maturity buckets are the foundation fact here: bills are issued with maturities of one year or less and are sold at a discount; notes are issued with maturities of 2 to 10 years (2, 3, 5, 7, and 10 years) and pay semiannual coupons; bonds are issued with 20- and 30-year maturities (note that the 20-year bond returned in 2020, so 'Treasury bonds are 30-year only' is outdated). A 7-year, coupon-paying issue is therefore a Treasury note. Series EE savings bonds are nonmarketable — they cannot be bought or sold in the secondary market and do not make semiannual cash interest payments — so they fail the 'marketable' requirement of the question. Source: U.S. Treasury marketable securities offerings (TreasuryDirect).

The Trap: maturity-bucket-confusion

• A Series EE savings bond: Misconception: forgetting that savings bonds are NONMARKETABLE and non-transferable, and they do not pay semiannual cash coupons.
• A Treasury bond: Misconception: calling any coupon-paying Treasury a 'bond.' Treasury bonds are issued with 20- and 30-year maturities, not 7.
• A Treasury bill: Misconception: maturity-bucket confusion. Bills are issued with maturities of one year or less and pay no coupon.

Verified against: EE/I nonmarketable; 20-year bond current-fact warning)

Answer: $1,022.50

Government securities are quoted in 32nds of a point, so the digits after the decimal point are 32nds, not hundredths. A quote of 102.08 means 102 and 8/32 percent of par. Since 8/32 = 0.25%, the price is 102.25% of $1,000 = $1,022.50. Choice A applies the corporate-bond reading instead: for corporate bonds, the number after the point is an ordinary fraction of a point (e.g., 98 1/2 = 98.5% of par = $985), so treating 102.08 the same way gives 102.08% of par = $1,020.80 — the classic error of mixing up the two quoting systems. Choice C converts the fraction correctly (8/32 = .25) but then shrinks it to 25 cents instead of a quarter of a point; each full point equals $10 per $1,000 bond, so a quarter point is $2.50, not $0.25. Choice D correctly finds 102.25% of par but applies that percentage to a $100 face amount instead of scaling up to the $1,000 bond asked about in the question. Quoting-convention map: corporate bonds trade in points and fractions of a point, government securities trade in 32nds, and municipal bonds are typically quoted on a yield basis rather than a dollar price.

The Trap: 32nds-read-as-decimal

• $1,020.25: Misconception: converting 8/32 to .25 correctly but applying it as 25 cents rather than as a quarter of a point ($2.50 per $1,000).
• $1,020.80: Misconception: reading the quote as a decimal (102.08% of par) instead of recognizing that Treasury quotes use 32nds — the most common 32nds error.
• $102.25: Misconception: computing the price per $100 of face value and forgetting to scale to the $1,000 par convention.

Verified against: corporate point = $10)

Answer: It will be filled in full, and the investor accepts the yield determined at the auction

Treasury auctions accept two kinds of tenders. Competitive bidders (mostly dealers and institutions) specify the yield they demand and risk receiving no securities if their bid is too aggressive. Noncompetitive bidders specify only a quantity, agree to accept the yield the auction produces, and in return are filled in full (up to the noncompetitive award limit). That trade-off — certainty of execution in exchange for accepting the market-determined yield — is exactly what suits individual investors, who commonly bid noncompetitively through TreasuryDirect. Choice B describes competitive bidding; choice C invents an institutions-only barrier that doesn't exist; choice D combines the guaranteed fill of a noncompetitive bid with the yield-naming of a competitive bid, which no tender type offers. Source: U.S. Treasury auction rules (Uniform Offering Circular / TreasuryDirect).

The Trap: competitive-vs-noncompetitive-flip

• It will be filled in full at whatever yield the investor specifies: Misconception: mixing the two bid types — a noncompetitive bidder does not specify a yield at all, and no bidder can dictate their own yield and be guaranteed a fill.
• It will be rejected, because individual investors may only buy Treasury securities in the secondary market: Misconception: believing auctions are institutions-only. Individuals routinely participate, typically through noncompetitive tenders (e.g., via TreasuryDirect).
• It will be filled only if the yield the investor specifies is at or below the yield where the auction stops: Misconception: this describes a COMPETITIVE bid, which names a yield and risks being shut out — the competitive/noncompetitive flip.

Verified against: noncompetitive always filled)

Answer: On the actual number of calendar days elapsed since the last coupon payment, accruing up to but not including the settlement date

When a coupon-paying bond changes hands between interest dates, the buyer pays the seller the interest earned so far. The day-count convention depends on the security: Treasury notes and bonds use actual calendar days elapsed over the actual days in the coupon period (the actual/actual convention), while corporate and municipal bonds use the simplified 30-day-month/360-day-year convention. In both cases, interest accrues up to but not including the settlement date (regular way for Treasuries is T+1). Choice B applies the corporate/muni convention to a government security. Choice C miscounts by including settlement day. Choice D confuses coupon Treasuries with instruments that trade flat (without accrued interest) — zero-coupon securities such as STRIPS, income bonds, and defaulted bonds. Source: standard industry accrued-interest conventions for government vs. corporate/municipal securities.

The Trap: 30-360-vs-actual-flip

• On the actual number of calendar days elapsed, up to and including the settlement date: Misconception: including the settlement day. Interest accrues up to but NOT including the day the trade settles.
• On the basis of 30-day months and a 360-day year: Misconception: applying the corporate/municipal 30/360 day-count convention to Treasuries — the flagship day-count flip.
• No accrued interest is owed, because Treasury securities trade flat: Misconception: confusing coupon-paying Treasuries with securities that trade flat — zero-coupon bonds, income (adjustment) bonds, and bonds in default.

Verified against: flat trading)

Answer: The principal is adjusted upward, and because the fixed coupon rate is applied to the adjusted principal, the dollar amount of each interest payment increases

TIPS separate the two components students tend to merge: the coupon RATE is fixed for the life of the security, but the PRINCIPAL is adjusted with the Consumer Price Index. Each semiannual payment equals the fixed rate times the inflation-adjusted principal, so when the CPI rises, both the principal and the dollar amount of each coupon grow — that is how TIPS preserve purchasing power. At maturity the investor receives the greater of the adjusted principal or the original par (the par floor). Choice B reverses the mechanics. Choice C wrongly defers the adjustment to maturity. Choice D overstates the protection: TIPS guard against inflation, not against interest-rate risk — their market prices still fall when yields rise. Source: U.S. Treasury TIPS program (TreasuryDirect).

The Trap: tips-rate-vs-principal-flip

• The security's market price cannot decline, because TIPS are protected against all investment risk: Misconception: 'inflation-protected' read as 'risk-free in price.' TIPS still carry interest-rate risk — if real yields rise, TIPS prices fall.
• Nothing changes until maturity, when the investor receives a single lump-sum inflation adjustment: Misconception: treating the inflation adjustment as deferred to maturity (blending TIPS with the accrual pattern of savings bonds/zeros). Adjustments occur on an ongoing basis and raise every subsequent coupon.
• The coupon rate is adjusted upward while the principal remains fixed at $1,000: Misconception: the rate-vs-principal flip — students reverse which component adjusts. The rate never changes; the principal does.

Verified against: U.S. Treasury TIPS program (TreasuryDirect) — principal indexed to CPI with a fixed coupon rate applied to the adjusted principal

Answer: Upward principal adjustments are subject to federal income tax in the year they occur, even though the investor does not receive that money until the security matures or is sold

TIPS create 'phantom income': each year's upward inflation adjustment to principal is federally taxable in the year it occurs, even though the investor receives no corresponding cash until maturity or sale. Combined with the semiannual coupons (also federally taxable), this is why TIPS are frequently suggested for tax-deferred accounts such as IRAs, where the annual phantom income has no current tax cost. Like all Treasury interest, TIPS income is exempt from state and local income tax but NOT from federal tax — choice C reverses that. Choice B wrongly defers the tax to maturity, and choice D mislabels the accretion as capital gain when it is taxed as ordinary interest income. Source: IRS treatment of inflation-indexed debt (original issue discount rules) and U.S. Treasury TIPS disclosures.

The Trap: phantom-income-deferral

• Upward principal adjustments are taxed as long-term capital gains when the security is sold: Misconception: character confusion — the inflation accretion is treated as ordinary interest-type income, not capital gain.
• Upward principal adjustments are not taxed until the security matures: Misconception: assuming the accretion is tax-deferred to maturity. It is taxed each year as it accrues.
• The interest and principal adjustments are exempt from federal income tax because TIPS are Treasury securities: Misconception: the tax-treatment flip — Treasuries are exempt from STATE and local tax, not federal tax (the reverse of municipal bonds).

Verified against: best in tax-deferred accounts; federal-taxable/state-exempt)

Answer: $15.90

TIPS coupon math is a two-step calculation: (1) halve the fixed annual rate, because Treasury notes and bonds pay interest semiannually — 3% ÷ 2 = 1.5%; (2) apply that rate to the inflation-adjusted principal, not the original par — 1.5% × $1,060 = $15.90. This is how TIPS deliver inflation protection: the fixed coupon rate never changes, but the principal it is paid on is adjusted with the CPI and can move up or down — a period of deflation lowers the adjusted principal (and the resulting coupon payment), though holders are guaranteed to receive at least the original par amount if the security is held to maturity. Choice A uses the stale $1,000 principal; choice D uses the right principal but the full annual rate instead of the semiannual rate; choice C makes both mistakes. On the exam, always ask two questions of any TIPS payment problem: 'What is the semiannual rate?' and 'What is the CURRENT adjusted principal?' Source: TreasuryDirect — TIPS payment mechanics, treasurydirect.gov/marketable-securities/tips/.

The Trap: coupon-on-unadjusted-principal

• $15.00: Misconception: applying the semiannual rate to the ORIGINAL $1,000 principal, missing that the fixed rate is paid on the inflation-ADJUSTED principal.
• $31.80: Misconception: applies the rate to the adjusted principal correctly but forgets to halve the annual rate for a semiannual payment.
• $30.00: Misconception: double error — uses the full annual rate (forgetting Treasury coupons are semiannual) AND the unadjusted $1,000 principal.

Verified against: TreasuryDirect, "TIPS" (marketable-securities/tips) — fixed coupon rate applied to inflation-adjusted principal each semiannual period

Answer: STRIPS eliminate reinvestment risk because they pay no coupons, but they are the most price-volatile Treasury securities, so a sale before maturity could produce a significant loss

Treasury STRIPS are zero-coupon securities created by separating the interest and principal payments of Treasury notes and bonds. Because there are no coupons, there is nothing to reinvest — an investor who holds to maturity locks in the return, which is exactly what suits a fixed future goal. The catch is the other edge of the zero-coupon sword: with no coupon cushion and a long maturity, STRIPS have the greatest price volatility of any Treasury security, so a forced sale before maturity when rates have risen could mean a substantial loss. The representative should present both sides, since this customer may sell early. A further consideration in a taxable account: the annual accretion of the discount is taxable phantom income even though no cash is received. Choices B and D confuse credit backing with price behavior in opposite directions, and choice C misdescribes zeros as coupon payers. Source: U.S. Treasury STRIPS program and standard risk taxonomy (interest-rate vs. reinvestment risk).

The Trap: strips-volatility-paradox

• STRIPS eliminate both reinvestment risk and price volatility because they are backed by the U.S. government: Misconception: equating government CREDIT backing with PRICE stability. The Treasury guarantee addresses default risk only; zeros swing hardest when rates move.
• STRIPS pay semiannual interest that the customer would still need to reinvest, so they do not address the customer's concern: Misconception: forgetting STRIPS are zero-coupon securities created from separated Treasury payments — there are no semiannual coupons.
• STRIPS are unsuitable for this goal because they carry significant default risk: Misconception: assigning credit risk to a Treasury-backed instrument. STRIPS are backed by the U.S. government; their signature risk is price volatility, not default.

Verified against: U.S. Treasury STRIPS program (TreasuryDirect) — zero-coupon Treasury mechanics and standard interest-rate/reinvestment-risk taxonomy

Answer: Government National Mortgage Association (GNMA) pass-through certificates

This is one of the most frequently tested distinctions in the agency-securities family. GNMA (Ginnie Mae) is an actual arm of the federal government, and its guarantee of timely payment of principal and interest on its pass-through certificates is backed by the full faith and credit of the United States — it is the only agency mortgage security with that direct backing. FNMA (Fannie Mae), FHLMC (Freddie Mac), and the Federal Home Loan Banks are government-SPONSORED enterprises (GSEs): shareholder-owned or member-owned entities whose securities carry only an implied — not explicit — government backing, which is why their debt typically yields slightly more than comparable Treasuries. Remember the shorthand: Ginnie is GOVERNMENT; Fannie and Freddie are SPONSORED. Source: GNMA guarantee disclosures (Government National Mortgage Association / HUD).

The Trap: gnma-vs-gse-backing

• Federal Home Loan Mortgage Corporation (FHLMC) securities: Misconception: same trap — FHLMC (Freddie Mac) is a GSE; its obligations are not direct obligations of the U.S. government.
• Federal Home Loan Bank (FHLB) debentures: Misconception: assuming all 'federal' issuers are government-guaranteed — FHLB is a GSE that issues debentures without full-faith-and-credit backing.
• Federal National Mortgage Association (FNMA) securities: Misconception: the top GNMA-vs-GSE trap — FNMA (Fannie Mae) is a shareholder-owned, government-SPONSORED enterprise with only implied backing.

Verified against: FNMA/FHLMC = GSEs, implied backing)