What are treasury bonds?

There are five main types of bonds:

  • Treasury bonds
  • Corporate bonds
  • Municipal bonds
  • Agency bonds
  • Saving bonds

All with their own risks and rewards.

Treasury bonds

Treasury bonds are issued by the treasury department of the U.S. Government. Meaning you are lending the government money if you buy a treasury bond. Treasury bonds come in different forms:

  • Treasury bonds
  • Treasury bills
  • Treasury notes
  • TIPS (Treasury inflation protected securities)
  • FRNs (Floating rate notes)
  • STRIPS (Separate Trading of Registered Interest and Principal of Securities)
  • Saving bonds

While they effectively are all “bonds”, the difference lies in the maturity date, interest and principal  payment. An overview:
 

Type Years until Maturity Interest rate Interest and principal payments
Treasury bonds 20,30 Fixed Interest paid every six months and principal at maturity
Treasury bills <1  None* Principal  paid at maturity
Treasury notes 2,3,5,7,10 Fixed Interest paid every six months and principal at maturity
TIPS 5,10,30 Variable Interest paid every six months and principal  at maturity
FRNs 2 Variable Interest paid quarterly and principal  at maturity
STRIPS Variable None* Interest and principal  paid at maturity
Saving bonds Variable depending on the issue date. New saving bonds (from 2021) are always 30 years Fixed and variable Interest paid monthly and compounded. Principal  paid at maturity

* An important note about interest payments is that zero coupon bonds do not pay interest. These bonds typically trade below par value or at discount. In this case, the difference between the par value and price paid at the end of maturity is also considered interest. For example, when buying a bill with a par value of $1000 for $950, after one year you get paid $1000 and received $50 in interest.

Treasury bonds

Treasury bonds are held for at least 20 or 30 years. Interest is paid every six months and principal is paid at the end of 20 or 30 years. 

Treasury bills

Treasury bills are sold at discount (below par value). You get no interest payment but interest and principal at once at maturity.

Treasury notes

Same as treasury bonds, only they have a lower maturity date (<10 years).

TIPS

Treasury inflation protected securities (TIPS) protect your bonds against inflation. The par value will grow with inflation until maturity. But it will also shrink when there is deflation. As interest payments are based on par value, the percentage will change each year based on inflation or deflation.

You can buy TIPS at Treasurydirect.gov or through a bank or broker. There are two kinds of bids:

  • Non Competitive bid
  • Competitive bid

With a non competitive bid you agree with the yield that is determined at the auction. While with a competitive bid you specify the yield you are willing to accept. Your bid may be:

  1. Accepted in the full amount you want if your bid is less than the yield determined at auction.
  2. Accepted in less than the full amount you want if your bid is equal to the high yield.
  3. Rejected if the yield you specify is higher than the yield set at auction.

You can only place competitive bids at a bank or broker.

FRNs

Floating rate notes mature in two years. They pay interest each quarter. The interest paid is determined by the discount rates for 13 week treasury bills. FRNs are also callable, meaning the issuer has the right to refund the principal and stop paying interest.

STRIPS

STRIPS are only available at private institutions and are also known as zero coupon bonds. Because there is no coupon rate, you’ll receive the interest and principal  at maturity. STRIPS are sold at a discount price. Basically the coupons are stripped from the bonds and are sold separately. Hence the name STRIPS. All bonds with a maturity date at 10 years or more are eligible for stripping. 

Saving bonds

Saving bonds have fixed interest that is paid at maturity. The interest is applied every month and then compounds. They can be bought below (50%) par value and can be held for 20 years. Newly issued saving bonds (from 2021) have a maturity date of 30 years. There are two types of U.S. saving bonds:

  • Series EE
  • Series I

Both are sold for par value when they reach maturity. They can be bought at a discount. The only difference is that Series I is adjusted for inflation. Meaning the interest rate will rise when inflation rises. Saving bonds can’t be bought and sold between private parties. Saving bonds do not have to be held until maturity. If the investor wants to cash the bonds, they can do so after 12 months of purchase. But they will get a penalty of three months worth of interest. The bond is then sold for whatever the market is asking at that time.

Treasury Bonds and taxes

All treasury bonds are exempt from income taxation at the local and state level. However, they are fully taxable on your federal income tax return. Bonds that don't pay interest will be taxable at the maturity date. Keep in mind that the above examples are for U.S. citizens. You can also buy U.S. bonds if you live in Europe or other regions. But other tax rules may apply. Also, the above type of bonds may be different for the country you live in. But all bonds work with the same principles.

Pro and cons of treasury bonds

Pro’s Cons
High credit rating(backed by U.S. Government) Inflation risk. With low yield, inflation can ruin your profits
Tax advantages (no state or local taxes) Low yields
Populair and much choice (many bond variants and extreme high liquidity) Yields depending on market interest (interest rate risk)


Chapters: The Ultimate Investing Guide

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