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Question: Where do most banks and investors turn to when they want a safe and lucrative investment option?
Over the years, investors who wanted to preserve and grow their capital investments have found that investing in Treasury securities is one of the best financial strategies in this area. In fact, U.S. Treasury securities are one of the safest and highly profitable options an investor can have. In this article, we will give you the relevant information about them to help you understand this investment choice.
Technically, U.S. Treasury securities are certificates of indebtedness emanating from the U.S. federal government. This actually means that each time you buy a Treasury security, you are in effect, lending money to the government for a pre-determined period of time.
They are available in different forms namely: Treasury Bills, Treasury Notes, Treasury Bonds, Floating Rate Notes (FRNs), and Treasury Inflation Protected Securities (TIPS). The generic term for all these is “Treasuries”.
Were we to name the one differentiator between bills, notes, and bonds, we would have to say it’s the length until their maturity date. See for yourself:
- Treasury bills have less than one year to mature
- Treasury notes have terms of 2, 3, 5, and 10 years
- Treasury bonds take 30 years to mature
- Treasury Inflation-Protected Securities (TIPS) have 5, 10, and 30-year maturities
- U.S. Savings Bonds have varied maturity dates but they generally stop earning after 30 years
- Separate Trading of Registered Interest and Principal Securities (STRIPS) ride on the original instrument’s maturity date
- Floating Rate Notes usually carry a 2-year maturity
Here’s a summary of the main pros & cons (click to see explanation or scroll down):
|High Credit Quality||Low Yield|
|Tax Advantages||Call Risk|
|Liquidity||Interest Rate Risk|
|Choices||Credit or Default Risk|
|Friend Until Retirement||Inflation Risk|
|Restrictions and Penalties|
Treasury Bonds Advantages
Any investment has its own pros and cons and no single instrument is absolutely perfect. The same thing applies to Treasuries. Therefore, you should understand its advantages (and disadvantages) before you say that it is the right option to achieve your financial goals.
Treasury securities do not burden investors in paying maintenance fees – that’s just one advantage. Here are some more of them:
High Credit Quality
Obviously, no private debt instrument issuer would ever beat the U.S. government in the area of creditworthiness. Needless to say, Treasury securities have the highest credit quality among the instruments in the U.S. market if not in the world.
Just imagine the taxing power of the most powerful government in the globe and size of the U.S. economy that secure these instruments. But do take note that in August 2011, Standard & Poor downgraded the long-term sovereign credit rating of the USA to AA+ from AAA.
This was amidst concerns about the U.S. budget deficit and the direction of the U.S. economy. The credit-rating agencies have since upgraded this rating.
Here’s something that’s really interesting for investors: you won’t have to pay state and local income taxes on interest income from Treasury bonds. However, you still have to pay federal income taxes as you would from your income in a majority of investment options.
And you have to remember that when you sell your bond or redeem it at maturity, some components may then become taxable. Purchasing a bond at a market discount on the secondary market is different than buying a bond at Original Issue Discount (OID) from the point of view of taxation.
For example, if you buy the bond at a discount (the purchase price is less than the face value) and you hold it until maturity or sell it at a profit, that gain will be taxable. You have to pay federal and state capital gains taxes on them. However, if you buy it at OID and you hold it until maturity or sell it at a profit, your gains will fall into a different type of income.
If you were to dig deep into the volume of Treasuries that investors buy and sell throughout each trading day, you will likely become awestruck by the amount involved. Not only do individual investors chug them up but more so do big financial institutions, corporate investors, and even foreign governments in many cases. You don’t have to be a financial wizard to conclude that liquidity is probably the last thing to worry about.
If you want to buy Treasury securities such as bonds, there are two venues where you can go. The most common is through the secondary market which enjoys the distinction of being the most actively-traded market. Or, you can participate in regularly scheduled auctions for them; just check out the Auction Schedule.
In the secondary market, you can find postings for Treasury bills, notes, and bonds with active bids and offers. Another important thing to remember is that in this arena, you’ll find that the spreads (the difference between bids and offers) are the narrowest in the bond market. Watch out for the few times when Treasury securities reach their highest volatility.
For example, when the government releases significant economic data to the public, it normally affects Treasury securities.
As we’ve said, Treasuries come in various maturities – from 2 to 30 years. Here’s the thing about securities: the longer maturities would always offer higher coupons. One more thing you should note is that Treasuries come in different structures. There are Treasuries with coupons, zero-coupons, and TIPS, whose principal and returns move up and down to reflect changes in the consumer price index.
So, as an investor, you would not find yourself contained in a box but rather one who can rummage through a box to find the best product for your needs.
Your Friend Until Retirement
If the purpose of investing is to build a retirement nest egg, Treasuries are great. They’re obviously safer than stocks so that eliminates some tensions and fear for the future. Not only that, the interest payments that you will receive can help you create an alternate income stream when you retire.
Disadvantages Of Treasury Bonds
Treasuries do make a safe investment but like any other instrument, they have some handicaps. For investors who are looking for a quick return, this falls way below that expectation.
Here are some more disadvantages:
Yes, they give you peace of mind but don’t expect it to be like winning the lottery. The rates of returns are different for each type of instrument but they’re basically similar when it comes to overall returns.
Even if you hold them until maturity to cash out, the proceeds will typically be low. Other investments that carry bigger risks than Treasury bonds offer greater returns – that’s how things work in the financial investment world.
So, if you’re adventurous when it comes to your money or very keen on getting higher returns on your investments, Treasury securities would sit at the bottom of your priority list, and you’d probably need to consider corporate bonds instead. And if you’re in a hurry to cash out, Treasury bonds will take you at least 10 years before you can redeem them.
Interest Rate Risk
Treasuries are not immune to interest rate risk – the fluctuations in interest rates affect them. What’s more, the degree of volatility increases as the instrument nears its maturity. When interest rates go up, the prices normally go down.
Some treasury securities have call provisions that allow the government to retire them before the originally-stated maturity date. The government does this during times when rates fall.
Inflation risk is what happens when the value of your investment declines because of the increase in the inflation rate. Although this risk is real for practically all investment instruments, it’s a much bigger reality for Treasury instruments since they generally have lower rates.
For example, if your Treasury bond has an interest of 2.84% and the inflation rate reaches 3.5% or rises by just 1%, your investment is losing. Technically, the real value or purchasing power of your investment and earnings has declined.
There’s no question though that come maturity date, you’ll get the principal back. However, it will be worth a lot less in terms of monetary value.
Of course, there’s a way to lessen this problem and that is through TIPS or Treasury Inflation-protected Securities which adapts to the current inflation rate. Or you may invest in mutual funds that also invest heavily in TIPS.
Credit or Default Risk
All investors need to know that all bonds carry the risk of default (where the issuer cannot pay the interest or principal on time). The U.S. Government remains to be the strongest government in the world but there were times that it shut down for a period of days.
If you are a serious investor, you should monitor current financial and political events and pay attention to national debt issues, GNP, Treasury yields, falling of the U.S. dollar and other signs that may indicate a default risk is imminent.
Restrictions and Penalties
If you redeem Treasury securities before their maturity date, you might incur some penalties. At best, some restrictions may limit what you can or can’t do at certain times.