Investors eagerly provide loans to the U.S. government through the issuance of various debt securities by the U.S. Department of the Treasury. These securities are crucial for funding government operations, supplementing tax revenues to cover expenditures.
The Treasury’s borrowing capacity, referred to as the public debt, is determined and authorized by Congress. Additionally, Congress approves the annual budget, which outlines the government’s financial needs and sets the amount required to be raised through these securities.
Treasury securities attract a diverse range of investors, including individuals, corporations, state and local governments, Federal Reserve Banks, and international entities. These securities are often viewed as a safe harbor for investment due to their reputation for minimal credit risk and high safety from default.
However, like all debt instruments, U.S. Treasury securities are not immune to market risk. Their market prices and yields fluctuate in response to changes in interest rates and shifts in investor demand.
What are US Treasury securities and how do they work?
Investing in U.S. Treasury securities is a solid strategy for saving and securing your financial future. These securities, backed by the full faith and credit of the U.S. government, offer unparalleled safety, with the government committed to honoring its bondholders even during times of economic downturns, inflation, or geopolitical instability. Depending on the type of security, interest payments may be made either at maturity or semiannually. While Treasury securities are subject to federal taxes, they are exempt from state and local taxes.
Due to their minimal risk, Treasury securities typically offer lower yields compared to other bonds. They can be purchased directly through TreasuryDirect.gov, a government-operated website, or through most banks and brokers.
Treasury securities are categorized into three main types based on their maturity periods:
- Treasury Bills (T-Bills): Short-term securities with maturities ranging from a few days to one year (four weeks, 13 weeks, 26 weeks, or 52 weeks).
- Treasury Notes (T-Notes): Medium-term securities with maturities of two, three, five, seven, or ten years.
- Treasury Bonds: Long-term securities with a fixed principal and a 30-year maturity.
What are the main types of Treasury securities?
The U.S. Treasury provides six varieties of marketable securities, each with distinct features regarding term length, issuance frequency, interest rates, and payment schedules. These securities can be held until maturity or traded in the secondary market.
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The U.S. Treasury offers a diverse array of marketable securities, each with different characteristics:
- Bonds have long-term maturities of 30 years.
- Notes are available in 2-, 3-, 5-, 7-, or 10-year terms.
- Bills come with short-term maturities of 4, 13, 26, or 52 weeks.
Additionally, there are inflation-protected securities called TIPS (Treasury Inflation-Protected Securities), which are issued in 5, 10, or 20-year terms and adjust principal based on changes in the Consumer Price Index (CPI). Interest on TIPS is paid semi-annually on the inflation-adjusted principal.
The newest offering is the Floating Rate Notes (FRNs), introduced in 2014, which have a 2-year term. The interest rate on FRNs adjusts quarterly based on the 13-week T-bill rate, and interest is paid quarterly.
Treasury securities can be purchased in increments of $100, with investment amounts ranging from $100 to $5 million. Bills are bought at a discount and mature at par value, with the difference representing the interest earned. Interest on bonds and notes (except FRNs) is paid semi-annually at a fixed rate. For TIPS, interest is paid semi-annually on the inflation-adjusted principal.
Similar to Treasury bills, Treasury STRIPS are zero-coupon securities sold at a deep discount. Unlike other securities, STRIPS do not pay regular interest installments but instead accrue interest, which is paid in a lump sum at maturity. STRIPS are subject to annual taxes on accrued interest and can experience price volatility, though they are free from credit risk.
What are on-the-run bonds?
On-the-run Treasurys refer to the most recently issued securities within a specific maturity category. For instance, the notes sold in the latest auction of 10-year notes are considered on-the-run 10-year issues. Conversely, any 10-year notes issued before the most recent auction are classified as off-the-run.
The financial media usually focus on on-the-run Treasurys because they are the most sought after and actively traded. As a result, they often command a higher price compared to off-the-run Treasurys, even if the coupon rate and maturity dates are nearly identical. This price disparity can make off-the-run Treasurys an attractive investment opportunity, as they might be available at a better value.
What is a US Treasury bond auction?
The US Treasury conducts public auctions to sell its bonds, notes, and bills, allowing individuals to participate through non-competitive bids. You can purchase these securities directly by enrolling in the TreasuryDirect program or through a broker or bank.
During the auction, the Treasury begins by accepting competitive bids at the lowest rates and gradually includes higher bids until the auction’s quota is met. The rate at which the quota is filled becomes the auction rate. All competitive bidders who bid below this rate receive their securities at the auction rate, as do non-competitive bidders. Institutions bidding at the cutoff rate might not receive their full desired allocation if the quota is reached.
Treasury bills are auctioned weekly, while 2-, 3-, 5-, and 7-year notes, along with floating rate notes (FRNs), are auctioned monthly. Ten-year notes are auctioned eight times a year, and 30-year bonds are auctioned quarterly. The frequency of these auctions can vary based on the government’s cash needs. For up-to-date auction information, visit the TreasuryDirect website.
After issuance, Treasurys can be traded in the secondary market, with prices fluctuating based on demand. The yields on 10-year notes and 30-year bonds often serve as benchmarks for assessing the current state of the securities markets and the broader economy.
Why invest in Treasury securities?
One of the key benefits of Treasury securities is their unconditional backing by the full faith and credit of the US government. While interest from Treasury securities is subject to federal tax, it is exempt from state and local taxes. However, if you purchase these securities at a discount and later sell or redeem them, you may be subject to capital gains taxes on the difference.
Investors often use a laddering strategy with Treasury securities or other fixed-income investments. Laddering aims to:
- Provide a regular return of principal: This allows investors to reinvest or supplement their income periodically.
- Mitigate reinvestment risk: It avoids the challenge of having to reinvest the entire principal of a fixed-income portfolio all at once, particularly if interest rates are low.
In a laddering strategy, you divide your investment into equal portions and invest each portion in securities with different maturity dates. For instance, you might allocate $5,000 to 52-week Treasury bills maturing in June 2016, $5,000 to 2-year US notes maturing in June 2017, and $5,000 to 3-year notes maturing in June 2018. As each investment matures, you reinvest the proceeds into new securities with a longer maturity, maintaining the ladder’s structure.
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