When many people think about how the U.S. government raises the revenue it needs to pay for the programs and services it provides, their thoughts go to taxes. However, most of us know that the revenue raised through our taxes is not sufficient to cover the full cost of government spending. Our national debt is in the trillions and rising.
Of course, this debt has to be paid for in some way, and one way the United States pays for our national debt, similar to a corporation, is by issuing fixed-income securities, one of which is a treasury bond.
Treasury bonds and other fixed-interest securities from the U.S. Treasury Department can be a predictor of the health of the overall economy and are a key driver of mortgage rates for homebuyers.
This article will review what a treasury bond is, the different kinds of treasury bonds, how treasury bonds are purchased, what the risks may be for investors and the impact that treasury bonds can have on consumers and the broader economy.
What is a treasury bond?
A treasury bond is a government bond issued by the United States Treasury Department. Treasury bonds are one fixed-rate security that the United States issues to fund its national debt. In this way, treasury bonds, and other related Treasury securities are a crucial way the United States finances government spending and a way to help regulate the nation’s money supply.
A treasury bond is one of four kinds of debt issued by the Treasury Department. The other options are treasury bills, treasury notes, and Treasury Inflation-Protected Securities (TIPS). These securities are available in different maturities (dates until the bondholder is guaranteed their full principal) and coupon payments (the interest payments paid to the bondholder as a percentage of the bond’s face value). Treasury bonds have the longest maturity dates of all the treasury securities.
Treasury bonds pay the bondholder interest, semiannually, at a rate that is determined at the time the bond is purchased. This is known as the coupon payment.
Are there different kinds of treasury bonds?
Treasury bonds differ both in terms of maturity dates, face value (also called “par value” or “principal value”) and in their yield.
- Maturity dates– treasury bonds are called long bonds because they have maturities of 20 or 30 years.
- Face value– the minimum treasury bond purchase is $1,000.
- Bond yield– the bond yield is determined by the market at the time the bond is purchased. In September 2018, the interest rate (or yield) of 20- and 30-year treasury bonds moved above 3%, which is more of a psychological barrier than anything else since yields and bond values move in opposite directions.
What are ways to buy treasury bonds?
Treasury bonds can be purchased either directly from the U.S. Treasury or through a broker. For many individual investors, a discount broker, such as e-trade is sufficient for purchasing treasury bonds. Treasury bonds can be purchased at any time. However, the U.S. Treasury issues new bonds four times a year at bond auctions in February, May, August, and November. These are for bonds with 30-year maturities. Each auction has two phases. The first phase features competitive bidding. This is typically done by institutional investors who specify the par value (face value) of the bonds they desire and the yield they require. Because it is an auction, these investors are not guaranteed to be awarded every bond they bid on. Instead, they will receive their bonds according to how well their bid compared to other bidders. Competitive bids are restricted to the maximum purchase value of 35% of the overall offering.
After the competitive stage, the average bond yields of all the competitive bids are averaged and noncompetitive bids are awarded. The biggest difference between a non-competitive bid and a competitive bid is that non-competitive bidders are agreeing to the yield defined by the U.S. Treasury while the competitive bidders are bidding on the yield they will require. Non-competitive bids have a maximum purchase value of $5 million. Both competitive and non-competitive bidders specify the par value of the bond they will purchase.
Although many bidders wait until the auction date, investors can put in bids in advance of the auction date. Once the bonds are sold at an auction, they can be sold on the stock market. Treasury bonds are considered highly liquid investments and their prices can fluctuate.
What are the benefits of buying treasury bonds?
Although treasury bonds are most often purchased by large institutional investors, they can and are purchased by individual investors as a way of building diversification into their portfolio. Treasury bonds offer two important benefits.
First, for investors with a low-risk tolerance, treasury bonds, and other U.S. treasury-backed securities are considered the most risk-free of all investments. This is because they are backed by the U.S. Government. As investors know, if a bond issuer were to default on their promise to pay the market value of the bond at the time of maturity, it would affect their credit rating. For a national government to do this, not to mention a country with an economy as large as the United States, the result would be devastating. For this reason, treasury bondholders have confidence that they will receive their principal should they hold the bond to maturity.
The second benefit for investors is that the income generated from treasury bonds is only taxed at the federal level. For investors who live in states with high state tax rates, this can make treasury bonds a more profitable alternative to other fixed-income securities that may have a higher yield, but would also be taxed by their state.
What are the risks of holding treasury bonds?
As stated above, treasury bonds are considered one of the least risky of all investment types. There are, however, some risks to owning treasury bonds. We’ll look at each one individually.
Inflation– Inflation can hurt bond yields in two ways. First, if the economy is experiencing a period of inflation, the Federal Reserve may raise short-term interest rates. However, interest rates don’t rise in a vacuum. When short-term rates rise, the interest rates (or yields) on long-term investments like treasury bonds also rise. Bond yields and bond prices move in opposite directions so when yields rice the principal value of the bond will decline.
The second effect of inflation is less obvious. By purchasing a treasury bond, investors are guaranteed a yield of 1.5%. However, during the period of time, the bond was held inflation averaged 3%. In this case, the nominal value of the treasury bond did not keep pace with the inflation-adjusted return.
In a real-world example, the cost of $150 worth of groceries adjusted for 3% annual inflation will cost you $109.50 next year (3% of $150 = $4.50). If you had a bond fund that matured at a rate of 1.5%, you would think that same $150 netted you a profit of $1.50. However, in inflation-adjusted terms, you would have actually lost $3.00. That’s the effect of inflation on treasury bonds.
Interest Rates– bond yields and interest rates have an inverse relationship. This means that if you purchase a $1,000 bond that had a 4% yield at the time of purchase. However, if you try to sell your bond and the same bond has a yield of 10% you will be hard-pressed to find interested buyers. The only way investors would choose to buy your bond over one that paid a higher yield would be if you discounted your bond. Your 4% interest becomes locked once you purchase your bond. So, although interest rates have climbed, you would have to discount your bond so that it was now offering a yield of 10%. In this example, you would have to discount your bond to $300, meaning you would take a $700 loss.
This can be a particular issue for treasury bond holders because the minimum maturity for treasury bonds is 10 years. The longer timeframe a bond has to maturity, the more sensitive it is to interest rate fluctuations.
Opportunity Cost– because investors are holding bonds for long periods of time, they are losing the ability to use that capital for other purposes. This can make treasury bonds less appealing for some investors.
What do treasury bonds say about the economy?
Yields for fixed-income securities establish what is called the yield curve. Typically yields on short-term securities (1-year, 2-year, 5-year) will have lower yields than treasury bonds that have maturities of 20 or 30 years. This reflects a “normal” yield curve that gently slopes upward from left to right. Although treasury bonds are considered low-risk vehicles, the value of long-term bonds is subject to potential volatility; therefore bondholders will expect a higher yield. However, a fairly accurate predictor of recessions for the U.S. economy is when the yield curve flattens; meaning the spread between short-term and long-term yield rates narrows, and an even more accurate predictor is when the yield curve inverts. This is when the yield on short-term rates is higher than that of long-term interest rates. This is caused when market interest rates are forecast to be lower due to the market's perception of weak or uncertain economic activity. In this scenario, however, businesses and governments have access to affordable investment capital which can help lead the economy out of a recession.
The bottom line on treasury bills
Treasury bonds are one of four types of debt instruments issued by the U.S. Treasury. Of all four types which also include treasury bills, treasury notes and Treasury Inflation-Protected Securities (TIPS), treasury bonds have the longest maturity dates. Treasury bonds are issued for 20 or 30 years.
Treasury bonds can be purchased through a broker or directly from the U.S. Treasury. New bonds are issued at four bond auctions held throughout the year. Although many treasury bonds are purchased by institutional investors, many individual investors will purchase treasury bonds for diversification in their portfolio. Because treasury bonds are backed by the U.S. government, they are also considered to have a very low risk of default, making them ideal for investors with a low-risk tolerance.
In addition to their low risk, investors who live in states with high tax rates may find that treasury bonds (which are only taxed at the federal level) may be a better alternative to higher yielding securities that would trigger a tax event.
The three primary risks that owners of treasury bonds face are rising inflation which can affect the face value of the bond as well as make the nominal value less than the inflation-adjusted value; rising interest rates which react inversely to bond yields, and the potential of lost opportunity costs for tying up capital that could be used for other purposes.
Treasury bond yields have tended to be an accurate predictor of the state of the overall economy. Typically long-term bonds, like treasury bonds, will command a higher yield in accordance with the potential for a decline in premium. This creates what is known as a yield curve that has an upward left-to-right slope. However, if interest rates begin to shrink, yields on short-term bonds may rise above that of long-term debt causing the yield curve to invert. This has been an accurate predictor of recessions.