What Are Treasury Bonds And How Do They Work?

One of the most important questions we’ll ask ourselves is where should we invest our money?

If you’re a beginner, you may think that stocks are the only option, but they can be uncertain and extremely volatile. Luckily, if you’re an investor who has a low tolerance for risk, know that there are safer options provided by the U.S. Treasury. Compared to stocks, U.S. Treasury bonds are predictable and offer a steady income.

Read on to learn about Treasury bonds, so you can make an informed decision when expanding your investing portfolio.

What Is A Treasury Bond?

Treasury bonds, also known as T-bonds, are issued by the federal government as longstanding debt securities, that need a minimum investment of $100. T-bonds fall into the category of U.S. Treasury securities, which consist of Treasury bills and Treasury notes. Unlike treasury notes, T-bonds have a fixed maturity date that can last up to 30 years and earn periodic interest payments, which make them attractive to an investor looking for long-term, tax-free interest rates. Other types of bonds do exist, such as corporate bonds, which have a higher yield. This stems from the unforeseen circumstances that can occur within a company’s business structure.

Due to the increased risk, corporate bonds offer a higher return to counterweigh the unpredictability. Put side by side, Treasury bonds raise fewer red flags because the U.S. government is an established institution that continues to operate no matter what the economy is doing.

Types Of US Treasury Securities

As previously mentioned, the federal government offers multiple debt securities based on their maturity date.

• Treasury bill: Short-term securities that mature between 4 – 52 weeks. Interest isn't paid before the maturity date.
• Treasury notes: Long-term securities that mature in 2 – 10 years
• Treasury bonds: Long-term securities that mature in 30 years. Interest is paid every 6 months.
• Treasury Inflation Protection Securities: Includes both bonds and notes that have a principal based on the Consumer Price Index. Interest is paid every 6 months and the maturity date can last between 5 – 30 years.

How Do Treasury Bonds Work?

Whether is getting a loan for tuition or a mortgage on a house, most people will have to borrow money at some point. Borrowing money has become so universal that even the U.S. government does it. When the federal government needs money to fund its ventures, they issue bonds to receive capital, pay off debts and continue to operate.

How To Purchase Treasury Bonds

There are several ways to purchase T-bonds: you can acquire them in a competitive or non-competitive bid, through a bank, broker, or dealer. TreasuryDirect.gov offers online, non-competitive bidding for investors. According to TeasuryDirect.gov, the first thing you would need to do is open an account if you would like to bid on bonds directly from them. Take into account, you’ll need a legal Social Security number, checking or savings account and a U.S. address to complete your application.

When participating in non-competitive bidding, you’re promised the security you want to purchase but you must agree to the yield or rate determined at auction. The maximum purchase for a non-competitive bond is $5 million. On the other hand, competitive bidding requires to specify the rate or yield they’re willing to accept. When submitting a bid online, you must log on to the site and click the BuyDirect® section. Then, you simply follow instructions to ensure you purchase the Treasury bond you prefer.

Banks, brokers, and dealers offer both competitive and non-competitive bidding.

Treasury Bond Yield

The amount of fixed-rate security will depend on the yield to maturity date (YTM). Treasury bond yields help create a yield curve, which is a graphical representation that displays a full range of investments offered by the government. The diagram is typically displayed upward, which means short-term securities are lower than long-term securities. When the yield curve is inverted, the diagram indicates that the government is in a recession. The U.S. Treasury updates the yield curve for every auction; be sure to review the graph so you can identify the best time to bid on a T-bond.

Typical Interest Rate For A Treasury Bond

As of August 31, 2021, TreasuryDirect.gov reported that the average interest rate for marketable T-bonds is 3.154%. Keep in mind, the federal government agrees to pay interest semiannually to the buyer until the bond has reached its maturity date.

When You Might Want To Sell

Typically, investors will hold onto a bond until maturity to receive the face value. However, there are occasions where it’s appropriate to sell a bond before its maturity date. For instance, you might want to sell a treasury bond if interest rates are expected to rise. This means you, the buyer, will lose value, since your bond is not going to reflect national rates. Another reason why you may want to liquidate your bond is if the issuer becomes unreliable, which could result from a huge loss such as a bankruptcy or a lawsuit. This is especially true for corporate bonds.

Lastly, during times of negative interest rates, the investor could lose money, especially at maturity when the buyer receives less than the initial face value.

What Are The Benefits Of A Treasury Bond?

Treasury bonds have quite a few advantages that make them an attractive option for investors. Consider the following:

• Steady income: The stability of a treasury bond overshadows other bonds and investments. Besides the repayment of the principal, the federal government pays interest semi-annually.
• Nontaxable: At the state and local levels the investor will not be responsible for paying taxes on T-bonds.
• Guaranteed repayment by the government: Stock isn't guaranteed because businesses are not contractually obligated to pay a return, unlike bond issuers who are required to pay interest.
• Great for retirement: Since Treasury bonds are a long-term investment, it would be most beneficial to utilize them for various life stages, such as retirement.

What Are The Drawbacks Of A Treasury Bond?

Even though treasury bonds are recognized as safe investments, they are paired with a few drawbacks. Read on to discover why investors may be hesitant in purchasing this type of U.S. Treasury security.

• Long-term investments: For younger investors not nearing retirement, T-bonds may be considered less beneficial, since they do not offer quick returns due to extensive maturity dates up to 30 years.
• Low-interest rates: Due to low-risk Treasury bonds rates are low, unlike corporate bonds, which typically have a higher interest rate. In some cases, corporate bonds may be a better option if you're seeking a greater return.
• Tax implications: Taxes on the interest are not paid at the state or local level, however, the investor may be obligated to pay federal income tax.

The Bottom Line: T-Bonds Are A Great Long-Term Investment Option

Treasury bonds are suitable for people who want to be on the safe side of investing, but don’t expect fast returns since this type of treasury security can take up to 30 years to mature. Even for those who like to take high risks by investing in stocks, T-bonds can diversity an investor’s portfolio. Please be advised to go over the pitfalls and benefits of T-bonds with a bank, broker, or dealer to assure this long-term investment aligns with your financial goals.

Now that you know the advantages and disadvantages of T-bonds, read on to learn how bonds can impact mortgage rates.