4 Types of U.S. Treasury Securities and How They Work
Treasury bonds are issued by the government of the United States in order to pay for government projects. The money paid out for a Treasury bond is essentially a loan to the government. As with any loan, repayment of principal is accompanied by a fixed interest rate. These bonds are guaranteed by the 'full faith and credit' of the U.S. government, meaning that they are extremely low risk (since the government can simply print money to pay back the loan). Additionally, interest earned on Treasury bonds is exempt from state and local taxes. Federal taxes, however, are still due on the earned interest.
The government sells Treasury bonds by auction in the primary market, but they can also be purchased through a broker in the secondary market.
A broker will charge a fee for such a transaction, but the government charges no fee to participate in auctions. Treasury bonds are marketable securities, meaning that they can be traded after the initial purchase. Additionally, they are highly liquid because there is an active secondary market for them. Prices on the secondary market and at auction are determined by interest rates. Treasury bonds issued today are not callable, so they will continue to accrue interest until the maturity date. One possible downside to Treasury bonds is that if interest rates increase during the term of the bond, the money invested will be earning less interest than it could earn elsewhere. Accordingly, the resale value of the bond will decrease as well. Rising inflation can also eat into the interest earned on Treasury bonds. Because there is almost no risk of default by the government, the return on Treasury bonds is relatively low, and a high inflation rate can erase most of the gains by reducing the value of the principal and interest payments.
Investors who wish to participate in auctions and purchase Treasury securities directly from the Federal Reserve Bank can open a Treasury Direct Account. There are no fees associated with the account unless it contains over $100,000, at which point a very small maintenance fee is incurred.
There are three types of securities issued by the U.S. Treasury. These are distinguished by the amount of time from the initial sale of the bond to maturity.
These securities have the longest maturity of any bond issued by the U.S. Treasury, from 10 to 30 years. The 30-year bond is also called the "long bond." Denominations
range from $1000 to $1 million. T-bonds pay interest every 6 months at a fixed coupon rate
. As mentioned above, these bonds are not callable, but some older T-bonds available on the secondary market are callable within five years of the maturity date.
T-notes have maturities between 1 and 10 years. Denominations range from $1000 to $5000 and are determined by the amount of time to maturity. Like T-bonds, these securities pay interest semi-annually at a fixed coupon rate.
CPI-indexed Treasury Notes
TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection of government securities available to investors. The notes have a 10 year maturity and pay interest at a fixed rate. The principal increases with the inflation rate, which in turn increases future interest payments. One danger associated with investing in TIPS is that taxes are due on the increased principal before maturity when the investor gains access to the principal. In times of high inflation, tax payments could even exceed the interest income earned by the note.
T-bills are available with maturities of 13 weeks, 26 weeks and 52 weeks. They are purchased at a discount to their $10,000 face value, and the full amount is received at maturity (making them zero-coupon). The bills are sold at auction where the price of sale is determined by how much the bill is worth on the date of issue, which depends mainly on interest rates.
By InvestorGuide Staff