A Crash Course in Treasury Securities Carmichael Hill

Ever wondered what treasury securities are? What about the difference between a treasury note, a treasury bond, and a treasury bill? Let’s uncover what these securities are so that you can have a sense of how they function and why there’s been so much talk lately about treasury yields.

What Are Treasury Securities Used For?

Treasury securities, or treasuries for short, are loans you make to the US government. The government borrows money to pay for things the country needs, such as infrastructure projects, healthcare, and national defense. Some of these loans are short term that go for 4-52 weeks (treasury bills), others are medium term and go for 2-10 years (treasury notes), while others are long term and range from 10-30 years (treasury bonds). These securities pay back their investors with either an accretion in value after being purchased a discount, or through interest payments made at regular intervals.[1]

Just like with any other bond, treasuries are only as good as the institution that backs them. Their payments are guaranteed by the full faith and credit of the US government. For comparison, a corporate bond is only as good as its corporate issuer’s ability to repay it. This is why many bonds are rated based on their backer’s perceived credit worthiness. Treasuries are highly rated, but bond’s issued by corporations with strained balance sheets may not be able to say the same.

Let’s dig into how treasury securities really work.

The Inner Workings of a Treasury Security

These securities have a par value, which is sometimes also called face value. These are just two terms for the same thing. Par value is just the size of the treasury bond, which is usually $1,000. Buying a single treasury security with a par value of $1,000 means you have loaned the government $1,000. You’ll get your $1,000 back when the loan comes due, which is known as the maturity date in bond land. The maturity will be anywhere from 4 weeks to 30 years depending on the security.

US Treasuries tend to be safe, but that doesn’t mean they are risk free. The price of the bond will fluctuate over its lifetime, which means that you could make or lose money if you sell your treasury early. This is because bond prices are inversely correlated to interest rates (i.e. they move in opposite directions).

Let’s say that you buy a treasury paying 4%. Interest rates then move up to 5% a few weeks later. All new bonds issued at $1,000 par value will pay 5% now. Why is an investor going to pay you $1,000 for your bond at 4% when they can buy it directly from the treasury at 5%? The simple answer is they won’t. Not unless you’re willing to drop the price of your bond, which is exactly what happens when rates go up. Bond prices move downward.

The same is true when interest rates go down. You won’t want to sell your 4% bond for its $1,000 par value when interest rates are at 3%. Like any wise investor, you’d only part with it if someone was willing to pay you a premium price for your premium rate bond. Your treasury bond price goes up when interest rates go down.

None of this matters if you hold your treasury for its full lifecycle. You loan the government money, and they will give you the full value back at the treasury’s maturity date. The risk of loss only comes into play when you sell a bond early or the issuer defaults. For the sake of this article, we’re not going to open the can of worms that is a US Government default.

Treasuries as an Investment

So, given that these kinds of investments carry relatively little risk, why doesn’t everyone just invest in these kinds of securities? The answer is that these kinds of investments often yield lower returns than higher-risk options.[2] Treasuries are among the safest investments in the world. In fact, nearly all modern financial theory is predicated on the idea of a risk-free rate of return. Most economists and financiers use the 3-month treasury bill for this rate. All other investments must pay more than this rate, otherwise why would you take the risk to invest?

Your portfolio will likely need to earn more than the risk-free rate of return. Treasuries can be a powerful safety net in your portfolio, but they may not be appropriate (or prudent) for the entirety of your portfolio. You’ll have to consider that if you are interested in investing in these kinds of securities, they don’t fit every portfolio or financial situation.

When it comes to portfolio design, there are many, many options to consider, both high-risk and low-risk and long-term and short-term. And all of these options come with different considerations and are impacted by different financial factors. If you are looking for someone to help guide you through the myriad of options available to you for investment, then give us a call. We’ll set up a complimentary consultation and will walk you through your options.

 

 

This article is intended for educational purposes only and is not intended to serve as the basis for any purchasing decision.
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