A Comprehensive Guide To U.S. Treasury Securities
Loans are the lifeblood of the American financial system, propelling the nation's economy forward. They provide individuals, businesses, and governments with access to funds that may otherwise be unattainable through mutually advantageous agreements. When a loan is granted, the borrower gains additional financial resources. Simultaneously, the lender profits from the investment, earning a portion of the loan amount over time. This flow of capital promotes economic growth and stability across the United States.
Example: Often, purchasing a house requires more funds than most people have immediately available. To bridge this gap, you can turn to a bank for a loan, covering the remaining cost after your down payment (typically 20% of the property's value). The bank is not providing the loan out of generosity; it expects repayment with interest over an agreed-upon period. This arrangement is mutually beneficial, enabling you to buy the house while the bank earns interest on the loan.
By becoming a lender, you, too, can reap the benefits of the lending process. Loaning money in return for interest income allows you to earn passive income while focusing on other pursuits. The borrower takes on the responsibility of repaying the loan with interest. Reflect on the mortgage scenario – homeowners work to repay the loan and interest while the bank profits effortlessly. Through lending, banks make their money work for them, and by independently lending money, you can achieve the same advantage.
Loans, while offering many advantages, also entail considerable risks, particularly when lending your money. If the borrower fails to repay the loan, you may lose all or part of the funds you provided. Minimizing the risk of loss when lending money is crucial, given the potential consequences of non-repayment.
As a knowledgeable lender, you can adopt strategies similar to banks. Just as banks assess credit scores to determine the risks associated with lending to individuals, you can evaluate the creditworthiness of potential borrowers, such as people, businesses, or governments. When seeking reliable repayment of the principal and interest, few borrowers are as trustworthy as the United States government. According to credit ratings from Finch, one of the "Big Three" credit rating agencies, the United States holds the highest possible credit rating, indicating a consistent record of timely debt liability fulfillment (including loan repayments and interest). With such a strong credit rating, the U.S. government is widely regarded as a low-risk or even zero-risk borrower.
When lending money to the U.S. government, you have various options, which can be broadly classified into two categories: Treasury marketable securities and Treasury non-marketable securities. The primary distinction between these types lies in their tradability. Treasury marketable securities allow for buying and selling between individuals, whereas Treasury non-marketable securities lack this flexibility.
In this context, securities refer to financial instruments issued by the U.S. Treasury, signifying a precise sum of money lent to the American government. As a quick example, buying Treasury securities worth $100 directly from the U.S. Treasury would mean you are lending $100 to the United States government.
Treasury Marketable Securities
Treasury marketable securities encompass a variety of financial instruments, including Treasury Bills, Treasury Notes, Treasury Bonds, Treasury Inflation-Protected Securities (TIPS), and Floating Rate Notes (FRNs).
Understanding par value is crucial when exploring Treasury marketable securities. Par value refers to the security's value upon which the U.S. Treasury bases its interest payments to you. This knowledge is important because if you buy or sell a Treasury security at a price different from the par value, the payment amount remains unchanged, but the interest received will differ.
Example: Imagine you purchase a bond with a par value of $100 from the U.S. Treasury, yielding a 3% annual interest, or $3 per year. If interest rates for new bonds increase, you may sell your bond to invest in one with a higher yield. Your bond has a lower interest rate than the new bonds, so its market value declines. As a result, you may need to sell your bond below its par value of $100, for instance, at $90. The new bondholder will continue to receive the same $3 annual interest payment; however, since they acquired the bond for $90, their effective interest rate rises to approximately 3.33%.
With that said, when you buy a Treasury security at a price below its par value, the interest earned on the security will increase. On the other hand, when you purchase a Treasury security above its par value, the earned interest will decrease.
Treasury Bills:
Treasury bills are short-term loans, with durations ranging from 4 weeks to 52 weeks, depending on the specific Treasury bill you purchase.
Available durations include 4, 8, 13, 17, 26, and 52-week bills.
Treasury bills are sold at a price below their par value. Instead of receiving the full par value plus interest, you are paid the entire par value upon maturity.
Therefore, your profit is determined by the difference between the par value and the purchase price of your Treasury bill.
If, for example, the par value of a Treasury bill is $100 and you buy it at a discount price of $95, you would earn $5 in interest when the loan is repaid at maturity.
Treasury Notes:
Treasury notes are considered medium-term loans with durations of 2, 3, 5, 7, or 10 years.
Interest is calculated based on the par value and is paid semi-annually.
Upon maturity or at the end of the term, the total par value is returned to you, the lender. For example, the par value of a 2-year Treasury note will be paid back to you after two years.
Consider this example: You purchase a 3-year Treasury note with a face value of $100 and an annual interest rate of 4%. You would receive interest payments of $2 every six months, totaling $4 per year for three years. At the end of the three years, you would receive the par value of $100.
Treasury Bonds:
Treasury bonds have longer maturities of 20 or 30 years, distinguishing them from Treasury notes and bills.
Apart from the variation in maturity, Treasury bonds operate similarly to Treasury notes.
Generally, Treasury bonds yield higher interest rates than Treasury notes and bills due to the higher risks involved in longer-term lending.
Treasury Inflation-Protected Securities (TIPS):
Treasury Inflation-Protected Securities (TIPS) aim to protect you from inflationary pressures and come in 5, 10, and 30-year terms.
Like Treasury notes and bonds, TIPS pay interest every six months throughout their term.
What sets them apart is their par value's ability to track the direction of inflation. When inflation rises, the par value increases; when it falls, it decreases.
Upon maturity, the par value you receive will depend on whether it increases or not. If the par value increases, you will receive a higher amount. However, you will receive the original par value if the par value does not change or decrease.
Floating Rate Notes:
Floating Rate Notes (FRNs) are a type of Treasury security that provides protection against increasing interest rates.
FRNs have a maturity period of two years, and their interest rates can change periodically throughout the loan's duration.
Interest payments on FRNs are made every quarter until the end of the loan.
Treasury Non-Marketable Securities
EE bonds and I Bonds are both types of Treasury savings bonds that belong to this category of Treasury-issued loans.
EE Bonds:
EE bonds are considered a low-risk savings option with a 30-year term, earning monthly interest. The U.S. Treasury guarantees that the bond will double in value in 20 years. For the first 20 years, the interest earned is fixed based on the par value, with the interest rate subject to change after that period.
Interest earned on EE bonds is compounded every six months, with interest being added to the principal balance. For example, if the starting par value was $100 and the first six months earned $1 in interest, the next six months would have an interest rate based on the $101 par value.
While EE bonds cannot be sold, they can be cashed in after the first 12 months of holding. However, cashing in before five years results in the loss of the last three months of interest. That said, interest is only earned during the first 33 months if the bond is held for 36 months.
Additionally, as interest earned on EE bonds is added to the principal, the bond's total value (par value plus interest earned) can only be accessed at maturity or redemption.
I Bonds:
I bonds are another Treasury security designed to protect investors from inflation.
While they share most characteristics with EE bonds, I bonds' interest rates fluctuate every six months. The interest rate on I bonds is determined by two factors: a fixed rate and the inflation rate calculated by the U.S. Treasury every six months.
As a result, if the inflation rate rises at one of the six-month marks, the interest rate on your I bond will increase. Conversely, if inflation decreases, the interest rate on your I bond will also decrease.
The U.S. government is a reliable borrower and provides low-risk investment opportunities through its various Treasury securities, including Treasury bills, notes, bonds, inflation-protected securities, floating rate notes, EE bonds, and I bonds. While lending to the U.S. government is not entirely without risks, the primary risks are related to the government's creditworthiness. Despite this, the U.S. remains a highly creditworthy nation, which means it does not need to offer high-interest rates to entice lenders. Instead, the government offers safety to its lenders, assuring them that it will fulfill its required loan payments. Overall, lending to the U.S. government is a low-risk and stable investment option that provides investors with security and peace of mind.
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