Understanding The Different Types Of U.S. Treasury Securities – How It Works


What are U.S. Treasury Securities?

You’ve probably heard about U.S. Treasury securities before but have no idea up to today what they are and how they can benefit you.  U.S. Treasury securities are instruments of debt – more specifically, debts of the U.S. Federal Government.  So, the simple truth is, if you buy any Treasury security, you are in essence lending money to the government for a specific period of time.  T

They come in different forms.  You have Treasury Bills, Treasury Notes, Treasury Bonds, Floating Rate Notes (FRNs), and Treasury Inflation Protected Securities (TIPS).  Collectively, investors and finance experts call these securities as “Treasuries.”

Here’s the thing:  federal debt obligations enjoy the “full faith and credit” backing of the government.  And because of the government’s ability to print money and generate tax revenues, investors consider Treasury securities as the safest of all investment.  Bankers view them as having zero “credit risk”– meaning it’s highly likely that you will get your full interest and principal on time.  After all, the government would probably be the last entity in the country to become bankrupt – if that is at all possible.

In general, Treasuries offer lower interest rates compared to other widely-traded but riskier debt securities such as corporate bonds.  Perhaps unsurprisingly, safer investments offer lower returns.  Needless to say, investments with higher risks dangle a higher potential return but also exposes investors to a greater possibility of losses.

As of April 2018, the total amount of marketable U.S. Treasury securities run to almost $16 trillion.  This massive amount is made up of outstanding bills, notes, bonds FRNs and TIPS.  At this point, you may realize that we are talking about a massive amount of money. Amazingly, the Treasury market is one of the world’s most liquid markets.  Despite the volume of transactions and amounts involved, pricing, executing, and settling a trade remains highly efficient.

Understanding Bond Characteristics

Now hang on – before you buy US Treasury Bonds, it is important to recognize that several factors directly affect the market value of a bond.  Consider these bond characteristics before you decide whether buying US Treasury Bonds is a well-founded financial decision:

Face/Par Value

This refers to the amount of money a bondholder will expect to receive on the bond’s maturity date.  In case of newly-issued bonds, they are available at face value. By default, US Treasury bonds have a $1,000 par value.

Let’s get this straight:  face value is not synonymous with bond price. Face value remains constant but the bond price goes up and down due to a host of reasons.  Therefore, there will be occasions when bonds will sell at discount (below face value) and times when they will sell at a premium (above face value).

Interest

You may hear the term ‘coupon’ in bond investment lingo; this also means ‘interest’.  This is the fixed percentage of the bond’s face value and the government pays it to the bondholders semi-annually.

Maturity

This is the future date when the issuer will repay the investor’s capital. US Treasury Bonds normally have a maturity date of more than 10 years; therefore, they pay higher interest rate than other instruments such as T-Notes.  This is because long-term bonds are more susceptible to price fluctuations than short-term bonds.

Yield

This is the amount of return that an investor is supposed to get from a bond.  If you were able to buy US Treasury Bonds at their face value, the yield will be equal to the interest.  Here’s the kicker:  if the bond’s price fluctuates, so will the yield.  For example, if you were able to buy a US Treasury bond with a 10% interest rate ($100 coupon for $1,000 bond) at face/par value, the yield is exactly 10%.

Assuming that after a year, the bond trades at $1,200 because perhaps the newer bonds have lower interest rates, the yield goes down to 8.33% [$100 (coupon price)/$1,200 (bond price)].  Conversely, when the bond trades at a discount, the yield goes up.

So it all adds up to this:  bond price and percent yield are inversely proportional to each other.

Understanding The Different Types Of U.S. Treasury Securities - How It Works

The Main Types of U.S. Treasury Securities and How They Work

Treasury Bills (“T-Bills”)

Treasury bills (commonly called T-bills) are short-term bonds that mature within one year or less from their date of issuance.  Authorized sellers sell T-bills with maturities of 4, 13, 26 and 52 weeks.  Bankers call them as the one, three, six, and twelve-month T-bills, respectively.

The first three kinds become available through auction once a week.  They auction the 52-week bills every four weeks.  Now, listen to this:  since the maturities on Treasury bills are shorter, they offer lower yields than Treasury notes or bonds.

Treasury Notes (“T-Notes”)

Treasury notes are also known as T-Notes, for short.  They are intermediate-term bonds from the U.S. Treasury.  They commonly mature in two, three, five or ten years.  Holders of T-Notes can expect to receive semi-annual interest payments at fixed coupon rates.

Before 1984, the U.S. Treasury was issuing callable T-Notes which means that the Treasury can repurchase the notes under certain circumstances.  T-Notes usually have a $1,000 face value but those with two or three-year maturities have $5,000 face values.

Treasury Bonds (“T-Bonds”)

Treasury bonds are the long-term bonds from the U.S. Treasury.  Traders commonly refer to them as T-Bonds.  They normally have a face value of $1,000 and interest payment comes semi-annually.  The government issues them to help fund shortfalls in the federal budget, regulate the nation’s money supply, and carry out U.S. monetary policy.

As a typical bond issuer, the U.S. Treasury looks at market risks and return requirements to prudently and effectively raise capital.  This is the reason why over the years, the Treasury been coming out with several types of Treasury securities such as T-bills, T-notes, T-bonds, STRIPS, and TIPS, to name some of them.

U.S. Savings Bonds

Savings bonds come in the traditional paper or the modern electronic form. However, beginning in 2012, financial institutions stopped selling the paper form.  Investors may purchase them from most financial institutions or through www.treasurydirect.gov. U.S. citizens, U.S. residents, and U.S. government employees (regardless of citizenship) may be able to buy and own savings bonds.  The good thing here is, even minors can own savings bonds.

Let’s dig a little deeper.  Authorized sellers offer the paper EE bonds at 50% of face value which means that a purchaser will only pay $50 to get a $100 bond.  The bond only becomes worth its face value of $100 when it matures.  On the other hand, sellers sell electronic EE bonds at face value.  So, if you want to buy a $50 bond, you have to pay $50 for it.  You can purchase electronic EE bonds in any amount as long its over $25.

Now, let’s go to I bonds.  If you want to purchase I bonds, you need to understand that you have to pay its face value so, if you want a $100 bond, you have to pay $100.  Similar to the EE bonds, the minimum you can invest is $25 and you can buy any amount over $25.

When it comes to paper savings bonds, investors can only purchase in $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000 increments.  They may buy up to $30,000 worth of savings bond per year.

This is how it works:  when a bond matures, the holder will receive the face value of the bond plus the accrued interest.  Holders cannot redeem them for the first 12 months they are outstanding.  If a holder redeems it within the first five years, they will forfeit the last three months of interest as a penalty.

Treasury Inflation-Protected Securities (TIPS)

In 1997, the U.S. Treasury came out with notes and bonds in a new form that would protect the holders from the effects of inflation.  They called these inflation-indexed securities as Treasury Inflation-Protected Securities or TIPS.

Basically, the Treasury Department uses the Consumer Price Index (CPI) as a guide to adjust the value of the principal to reflect the effects of inflation.  This instrument gets a fixed rate of interest payment two times a year based on the adjusted principal.  The final adjustment comes at maturity.

If inflation has increased the value of the principal, the investor would receive the higher, adjusted amount back.  However, in a case when inflation has decreased the value, the investor will receive the original face amount of the security.

Let’s look at an example of how inflation-indexed securities work.  Please note that this simplified example is for illustration only and does not necessarily reflect current market conditions.

  • At the beginning of January, you invest $2,000 in a new 10-year inflation-indexed note. The note states a 3% annualized interest and it is payable semi-annually.
  • In the middle of the year, the CPI indicates an inflation rate of 2% for the first six months. What happens then is that they will adjust your principal upward to $2,040 ($2,000 x 102%) and your resulting interest payment would be $30.60 ($2,040 x 3.0% x 6/12) for the interest earned for the first 6 months.
  • At year-end, the index indicates that inflation has risen to 3%. This will bring the value of your principal to $2,060.  Under this amount, your second interest payment would be $30.90 ($2,060 x 3.0% x 6/12).

Since these instruments already help cushion inflationary impacts, they offer lower interest rates compared to other U.S. Securities of similar maturities but without the inflation protection.

Separate Trading of Registered Interest And Principal Securities (STRIPS)

I know the feeling: any product with that long a name would have to be a complicated one.  Well, STRIPS are fairly simple as an instrument.  They are basically the same traditional bonds but banks just sell the bond principal and bond coupon separately.  The U.S. Government does not issue the STRIPS directly to investors the way they sell treasury securities or savings bonds.  Instead, it is the financial institutions such as investment banks who create the STRIPS.

They purchase conventional treasury securities then strip the interest payments away from the principal.  They then sell the principal and interest to investors as separate securities with separate CUSIP numbers.

Nevertheless, the U.S. Government still backs the STRIPS with its full faith and credit notwithstanding they have disassembled the original security. Banks sell the principal part at a discount so the investor can earn the face value when the bond matures later.  Many other countries also sell, issue and back STRIPS.

Floating Rate Notes (FRNS)

The U.S. Treasury started issuing Floating Rate Note (FRNs) in January 2014.  They are basically debt securities that pay interest rates quarterly until they mature.  They normally have a term of two years.  The reason for the name is that interest payment of FRNs change or “float” depending on discount rates in auctions of 13-week T-bills.

The U.S. Treasury holds an auction for FRN so the results of the auction will determine the price of the instrument.  It could be greater than, less than or the same as its face value.

However, when the notes mature, the holder gets paid the face value of the FRN.  Its interest rate varies, however, because it depends on the highest accepted discount rate of the most recent 13-week Treasury bill so it changes each week.  On the other hand, the spread is the highest accepted discount margin in the auction where they first offered it.  It will remain the same for the entire life of the note.

Should an investor want to bid for an FRN, he could do it in two categories: non-competitive and competitive.  Non-competitive investors have to bid online through an account on the website TreasuryDirect.  Investors can also use an intermediary such as a bank or a broker.

The U.S. Treasury holds the FRN auction every month but they issue original FRNS in January, April, July, and October.  There are also reopenings – when additional amounts of a previously-issued security become available.  This happens in the other months.

How Can You Buy U.S. Treasury Securities?

You can buy U.S. Treasury securities in any of the three ways.  The first one is through a non-competitive bid auction.  This is for an investor who really wants the note and is agreeable to accept any yield.  This is the most common method for individuals.  All they need to do is go online to complete their purchase.  An individual may only buy up to $5 million worth of Treasuries through this method.

The second one is through a competitive bidding auction.  Some investors will buy a Treasury only if they will be able to get their desired yield.  This method is for them.  The catch is, they must go through a bank or a broker.  An investor can buy as much as 35% of the Treasury Department’s initial offering amount with this method provided they have the funds to do it.

The third method is buying them in the secondary market.  A secondary market is the trading system where Treasury owners sell their securities before they mature.  The banks or brokers act as middlemen to facilitate the transactions.

If an investor does not want to directly invest in individual Treasuries, he may instead invest in a mutual fund or exchange-traded fund (ETF) specializing in Treasuries.  Some funds hold other fixed-income securities or derivatives aside from Treasuries – so investors must make sure they understand the investment mixes as well as any fees or other charges.

And about the savings bonds we’ve discussed earlier?  Unlike other marketable U.S. Treasury securities discussed in this guide, banks and traders do not trade them.  An owner of a savings bond cannot resell them or give them away to another person.  When you intend to purchase a U.S. savings bond as a gift, you have to register the recipient who will be the sole owner of the bond.  Therefore, it will not count towards the purchaser’s annual purchase limit.