Treasury bonds: What they are, how they work, and how to invest

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• A Treasury bond is a type of debt security that's distributed and backed by the US government.
• Investors can buy several types of Treasury securities depending on their investment horizon.

If you're looking for a relatively low-risk investment option with high liquidity and flexible time horizons, you're a good candidate for Treasury bonds. But Before buying a Treasury bond, it's important to understand the different types, how they work, and some of their pros and cons.

What are Treasury bonds?

A Treasury bond is a government-backed debt security that's issued by the US Treasury. Several types of securities — including bills, notes, bonds, and more — fall into this category.

"Treasury bonds are all fairly secure, but they don't yield high results," says Jim Pendergast, senior vice president of altLINE. "The key is to find a Treasury bond that keeps your money safe while simultaneously keeping you current with inflation."

Depending on the type of bond you buy, maturities range from four weeks to 30 years, and interest might be paid regularly or at maturity. Investors earn interest while they hold the security, either periodically (such as every six months) or upon redemption.

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Treasury bonds: Pros and cons

Treasury bonds come with some benefits and drawbacks, so consider these points before investing:

Pros

• Credit quality: Treasury securities are backed by the US government, so they're generally considered to be the highest credit quality. Credit quality refers to the likeliness that an individual or entity can repay debts. In this case, credit quality applies to the likeliness that the US government can repay you for holding a Treasury bond.
• Tax advantages: The interest you earn is subject to federal income taxes but not state or local income taxes. However, you may have to pay taxes on capital gains if you sell your bond before your maturity date. The capital gains tax rate ranges from 0% to 20% depending on your annual taxable income. State income tax can range from 0% to 11% depending on the state.
• Liquidity: Investors can buy and sell Treasury securities both at regularly scheduled auctions and in the secondary market. The exact price depends on their coupon rate, compared with prevailing interest rates.
• Choice: Depending on their needs, investors can buy Treasury securities in various structures with maturities that range from four weeks to 30 years.

Cons

• Lower yield: You'll typically earn less interest on Treasuries compared with other, riskier securities.
• Tax considerations: If you buy a bond at a discount and either hold it until maturity or sell it at a profit, that capital gain will be subject to federal and state taxes.
• Interest rate risks: As are all bonds, Treasury bonds are subject to price volatility as a result of changes in market interest rates.
• Inflation risk: The interest earned on Treasury securities may not keep pace with inflation (with the exception of Treasury inflation-protected securities, or TIPS).
• Credit or default risk: All bonds also have a risk of default, so Treasury bond holders should monitor their investments for signs of increasing default risk.

The major drawback to Treasury securities is their low yield.

"Interest rate risk is real," says Alexander Campbell, a registered investment adviser and accredited investment fiduciary with A.G. Campbell Advisory LLC. But it's wise to remember that "fixed income is an important asset class in managing our investment portfolios," Campbell says. "It is often the fixed-income component that keeps us able to invest our other monies for the long term in stocks."

Quick tip: Using a bond ladder could "provide a slightly better yield than short rates and not take all the risk of being invested in long bonds," Campbell says.

How do Treasury bonds work?

When you buy a Treasury security, you're essentially lending money to the government, which promises to repay you at a certain date.

The wide range of maturities available allows you to choose the type of security that aligns with your investing goals. Once you purchase a Treasury security, you'll need to hold it for at least 45 days but can redeem it anytime after that. Of course, investors receive the maximum return by waiting until the maturity date.

The interest you earn on Treasuries is subject to federal income taxes. Increases in principal value may be taxed, too. But you won't pay state or local income taxes.

For 2023, the federal income tax rate ranges from 10% to 37% depending on which income bracket you land in. Taxable bonds — such as corporate bonds, mortgage-backed securities, global bond funds, and diversified bond funds — are subject to federal income tax as well as state and local income taxes.

Some investors stash their emergency funds in Treasury securities because they're safe and liquid. However, you may pay a penalty if you redeem before maturity. Plus, "you might get the same or a similar interest rate from a high-yield savings account that you can access at any time," says John Mendes, a CFP with Creative Financial Group. Therefore, a savings account might be the way to go if you prioritize liquidity without extra steps involved.

Types of treasury bonds

While you might hear the term Treasury bond applied to any government security, there are actually several types. The main differences are when the securities mature and how interest is paid.

"Many argue that keeping up with inflation is the best strategy when choosing your treasury bonds," Pendergast says. "However, occasionally your investment won't correctly reflect inflation. Inflation rates are based on the CPI's findings, which means that they measure averages."

Here are the different types of Treasury bonds:

Treasury bills

Treasury bill mature within four, eight, 13, 26, or 52 weeks. They're sold at a discount, which means you can buy one for a price below its face value. But you receive the full face value (plus interest) at maturity. These are "notorious for having extremely low returns," says Pendergast.

Treasury notes

Treasury notes mature within two to 10 years and pay interest every six months. They're sold at a discount, coupon, or premium, which means the price can be less than, equal to, or greater than the note's face value.

Treasury bonds

Treasury bonds are also sold at discount, coupon, or premium and mature in 20 years or 30 years. Bondholders receive interest every six months.

Treasury Inflation-Protected Securities (TIPS)

TIPS mature within five, 10, or 30 years and pay interest every six months. TIPS can help protect your investment against inflation because the principal increases with inflation. (Though it also decreases with deflation.) At maturity, you receive either the adjusted principal or the original principal, whichever is greater.

Floating-rate notes (FRNs)

FRNs mature in two years and pay interest quarterly. The interest payments increase or decrease based on discount rates for 13-week Treasury bills. These are sold at discounts, coupons, or premiums. "Most FRNs come with the risk of falling," Pendergast says. "Sometimes interest rates plummet, making them an unstable choice for investment(s)."

Separate Trading of Registered Interest and Principal of Securities (STRIPS)

STRIPS are available only through private financial institutions.

The firm starts by taking an eligible Treasury note, bond, or TIPS, and separating the coupons (interest payments) from the principal. It then sells the pieces to investors at steep discount prices. Investors can then redeem the security for full face value at maturity.

TIPS and FRN interest rates are variable and can increase as interest rates rise.

"If you think that rates will go up from where we are, these are two ways to protect your income stream against rising interest rates," Mendes says. "This is for someone who needs an income stream that has the potential to rise over the years."

How to buy Treasury bonds

Treasury securities are available either through the US Treasury or from a private financial services firm. Here's how to buy Treasury bonds.

Buy from the US Treasury

You can buy newly issued Treasury securities straight from the source at TreasuryDirect.gov. After setting up an account, you'll place a bid at one of the regularly held auctions. T-bill auctions are held weekly, T-note auctions are held monthly, and T-bond auctions are held four times a year (on the first Wednesday of February, May, August, and November). The minimum buy-in amount is $100 for each type of security.

At the auction, there are two ways to place a bid:

• Non-competitive bidding: When you make a bid, you agree to accept whatever interest rate is decided at the auction. In exchange, you're guaranteed to have your bid accepted and you'll be paid face value upon maturity.
• Competitive bidding: You can also specify the interest rate you want to receive for the Treasury, but your bid will only be accepted if it is less than or equal to the rate set by the auction.

Buy through a bank or broker

You can also buy Treasury securities through a financial institution, such as a bank or brokerage firm. Each institution sets its own minimum buy-in, so you might need to invest more than you would at TreasuryDirect. You have two main options when purchasing a security through a private firm:

• The firm buys on the government site. The financial institution will monitor the TreasuryDirect auctions and place a bid for you on a newly issued security. This process is simple, but you may pay a fee for the convenience.
• The firm buys on the secondary market. The financial services company will purchase an existing Treasury security for you on the secondary market. You might also have the option of buying a Treasury bond mutual fund or exchange-traded fund (ETF) through the brokerage account. But with all of these options, commission fees may apply.

Read our guide to the best online brokerage accounts>>

How to buy I bonds from the US Treasury

Series I savings bonds are a type of bond that earns monthly interest to protect investors against inflation. I bonds come in both electric and paper versions. You may cash it in after 12 months, but it can earn interest for up to 30 years.

You can only buy I bonds on the US Treasury Department's website as these investments are not available through a brokerage account. With a TreasuryDirect account, go to BuyDirect and select I bond. You are limited to buying $10,000 worth of I bonds per calendar year.

What to consider before buying treasury bonds

1. Liquidity

The maturity date of the Treasuries that you invest in will determine how liquid (easily sellable) your investment will be. Treasury bills, which have maturities of a year or less, are going to be the most liquid option while 30-year bonds will give you the least liquidity.

That said, within the investment universe, Treasuries are pretty liquid animals: There's always a market for US government bonds. So you can always unload them pretty fast, though as mentioned earlier, the exact price they'll fetch depends on their coupon rate, compared to prevailing interest rates.

2. Risk vs. return

While no investment is 100% safe, Treasuries have a negligible level of risk. Since these securities are backed by the United States government, there's virtually no chance that you won't see a return on your investment. Despite ongoing concerns about the budget and deficits, the US has never defaulted on an obligation, in its entire history.

With that in mind, because there is less risk involved, the return you will receive is often not as great as with other income-oriented securities. The 30-year T-bond will generally pay a higher interest rate than shorter T-notes, to compensate for the additional risks inherent in the longer maturity.

3. Taxation

While you will have to pay federal income tax on them, Treasuries' interest is exempt from state and local taxes. This can be a benefit for investors living in high-tax jurisdictions.

You only pay taxes on the interest your T-bonds earn. When your bond matures, you don't owe anything, since it's just repayment of your own money. But if you sell a bond before it matures, it counts as a capital gain or loss, depending on whether you make a profit or not.

What is the Treasury yield?

The Treasury yield refers to the annual return you can expect to get for holding a savings bond to its maturity. Yields generally sway depending on the demand for Treasury bonds.

If the Treasury yield rises, that can be an indicator that the demand for Treasury bonds has declined and the prices will drop. If the Treasury yield falls, this is an indicator that demand for bonds has gone up and the prices will rise. Rising yields also tend to be tied to increased investor confidence.

Long-term Treasuries are generally more vulnerable to market risks over time and often have higher yields. These Treasuries are a better reflection of investors' long-term expectations of the stock market return and the US economy. But while long-term yields may reflect an optimistic economic outlook, it may also be an indicator of rising inflation.

The US Treasury bond yield as of December 27, 2023.

Treasury bonds — Frequently asked questions (FAQs)

Are Treasury bonds a good investment?

Treasury bonds are a good investment with the highest credit quality. They have tax advantages and are generally low risk. They earn interest until their maturity date, so they're good for earning steady cashflow. But Treasury bonds are not risk-free and are still vulnerable to changes in market interest rates and inflation.

How much do 1-year Treasury bonds pay?

The 1 year Treasury bond rate is currently 4.82%. One-year Treasury bonds pay investors in fixed-interest payments every six months.

What are the types of Treasury bonds?

The types of Treasury bonds include Treasury bills, Treasury notes, Treasury Inflation-Protected Securities (TIPS), and Floating-rate notes (FRNs). The different types of Treasury bonds differ in maturity dates, interest payments, and where they are sold.

Should you buy a Treasury bond?

Treasury bonds, T-bills, and T-notes are the closest thing to a risk-free instrument out there. Their reliability makes them ideal for older investors dependent on investment income, or highly conservative ones who never want to risk their principal.

Since they don't offer growth or the sexiest returns, Treasuries usually don't play as big a role with younger investors. Still, they can be a great way to diversify anyone's financial holdings — balancing out that highly speculative stock, for example. By being folded into the asset mix, they can effectively reduce the overall risk of your portfolio.