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Making Sense of Treasury Securities: Treasury Bills, Notes, and Bonds
Quite often, I read about using treasury securities as the “baseline” for what your money can return with no risk. Yet to the beginning investor, these items are a bit unclear: what are they? How are the returns? How can an individual investor get them? The Simple Dollar did a bit of research and found some answers.
The United States Treasury Department regularly issues securities that exist for the sole purpose of financing the debt of the United States government. These securities are sold at auction to the highest bidder, maximizing their immediate value for the government; they are also actively traded on the secondary market, which means you can usually find a buyer if you need to. They are considered highly stable investments (often described as “zero risk”) because they are based on the stability of the government of the United States, simply because the likelihood of government default or overthrow is basically nonexistent.
There are four main types of securities issued by the Treasury Department:
Treasury bills (or T-bills) are investments that mature in one year or less and they are considered to be the baseline “risk free” investment. They are offered with maturity dates of 28 days, 91 days, or 182 days. Treasury bills do not pay any interest directly; instead, they are sold at a discount of their face value and thus “earn” by selling at face value upon maturity. The rate of return is thus the annualized return that a given T-bill will have when comparing the amount paid for a T-bill, what it will be worth upon maturity, and how long it takes to mature.
Treasury notes (or T-notes) are investments that mature in between two and ten years. They are also purchased from the government at an amount lower than, equal to, or sometimes greater than their face value. Why? Every six months, treasury notes pay out an amount equal to half of their “coupon rate.” Here’s an example: say you have a $10,000 ten year treasury note with a coupon rate of 4.25%. Every six months, you’ll receive a payment of $217.50 from the goverment, then when the note matures, you can redeem it for $10,000. Thus, depending on the market, such bonds can sometimes sell below their face value and at other times above their face value. Currently, this coupon rate is fluctuating just below 5%, and the bonds themselves are selling at auction just a fraction of a percent below face value. For example, in one recent auction of five year notes, you could buy a note with a face value of $10,000 and a coupon rate of 4.625% for $9,965.13. Every six months, you would receive a payment of $231.25, then upon maturity, your note could be redeemed for $10,000, giving a total return of $2,347.17, or an annual investment return of 4.71%.
The ten year treasury note is usually the basis for long term interest rates, and in a time of high interest (usually coupled with a weak stock market), such bonds are a very good investment. This is why the federal reserve lowers interest rates when the economy goes south; people move their investments out of these bonds and back into other investments, which push the economy along.
Treasury bonds (or T-bonds) are basically identical to treasury notes, but exist over periods of ten years or more, up to thirty years in the United States. They also have a coupon payment every six months and they also are valued at their face value upon maturity. These are wonderful things to purchase and transfer to others if you want them to have steady income over a very long period with a bonus at the end. Many long-term trusts hold a lot of treasury bonds, as do people who want to have steady income from the coupon payments over a very long period. I know of at least one person with several million dollars sitting in treasury notes; he lives rather well off of the coupon payments and still has enough left over to occasionally buy more bonds, which enables him to keep up with inflation. He plays a lot of golf, incidentally.
One special type of bond issued by the government are called TIPS, which are treasury bonds that have a coupon rate that is adjusted by the Consumer Price Index. These bonds will make coupon payments that are initially at a lower amount, but over the life of the security, that amount will grow with the rate of inflation. These are great investments if you’re concerned primarily about beating inflation.
Savings bonds are the government security that most people are familiar with. Once you buy a savings bond, it begins to accrue interest that is not paid out until redemption. One year after purchase, savings bonds can be redeemed by the federal government (usually via your local bank). They earn a fairly low interest rate, but this interest compounds, meaning that the value of a savings bond accelerates over time, unlike other treasury securities. Many people buy savings bonds as small gifts because they must be held for at least a year and they accrue value over time.
Treasury securities in a portfolio These investments are considered a part of any stable investment portfolio because of their stability. While they are often outperformed by stocks, these securities keep earning even when the stock market is down. For example, if your stock market investment earns 17% one year and then goes down 8% the next year, your initial investment of $10,000 in the market is now worth $10,764, but your same $10,000 investment in a treasury note with a 4.625% coupon rate is now worth $10,925.
But I can earn 5% in my high-yield savings account! First of all, any interest you make in a high yield savings account is taxable by federal, state, and local authorities, while income from treasury notes is exempt from state and local taxes. Second, savings accounts are subject to rate changes. Third, the rate mentioned with regards to a savings account is often quoted as APY, while the coupon rate on a treasury security is a straight percentage of the value of the security. Combining these three factors, a treasury security is a better long-term investment than a savings account.
Great! Where can I get started? The United States government has made it very easy to invest in treasury securities via the Internet. The site TreasuryDirect.gov enables you to purchase these treasuries directly from the government either as an auction participant or at a set price, and also manage these investments by indicating what you wish to happen to the coupon payments and what happens upon a rollover.