Treasury Bills, Notes, and Bonds With Examples of How They Work
How They Work and How to Buy Them.
Treasury bills, notes, and bonds are fixed-income investments issued by the U.S. Treasury Department. They are the safest investments in the world since the U.S. government guarantees them. This low risk means they have the lowest interest rates of any fixed-income security. Treasury bills, notes, and bonds are also called "Treasurys" or "Treasury bonds" for short.
How They Work
The Treasury Department sells all bills, notes, and bonds at auction with a fixed interest rate. When demand is high, bidders will pay more than the face value to receive the fixed rate. When demand is low, they pay less.
The Treasury Department pays the interest rate every six months. If you hold onto Treasurys until term, you will get back the face value plus the interest that was paid over the life of the bond. You get the face value no matter what you paid for the Treasury at auction. The minimum investment amount is $100. That places them well within reach for many individual investors.
Don't confuse the interest rate with the Treasury yield. The yield is the total return over the life of the bond. Since Treasurys are sold at auction, their yields change every week. If demand is low, notes are sold below face value. The discount is like getting them on sale. As a result, the yield is high. Buyers pay less for the fixed interest rate, so they get more for their money. When demand is high, they are sold at auction above face value. As a result, the yield is low. The buyers had to pay more for the same interest rate, so they get less return for their money.
Since Treasurys are safe, demand increases when risk rises. The uncertainty following the 2008 financial crisis heightened their popularity. In fact, Treasurys reached record-high demand levels on June 1, 2012. The 10-year Treasury note yield dropped to 1.442 percent, the lowest level in more than 200 years. This was because investors fled to ultra-safe Treasurys in response to the eurozone debt crisis. On July 25, 2012, the yield hit 1.43, a new record low. On July 1, 2016, the yield fell to an intra-day low of 1.385.
These lows had a flattening effect on the Treasury yield curve.
The Difference Between Treasury Bills, Notes, and Bonds
The difference between bills, notes, and bonds are the lengths until maturity:
- Treasury bills are issued for terms less than a year.
- Treasury notes are issued for terms of 2, 3, 5, and 10 years.
- Treasury bonds are issued for terms of 30 years. They were reintroduced in February 2006.
How to Buy Treasurys
There are three ways to purchase Treasurys. The first is called a non-competitive bid auction. That's for investors who know they want the note and are willing to accept any yield. That's the method most individual investors use. They can just go online to to complete their purchase. An individual can only buy $5 million in Treasurys with this method.
The second is a competitive bidding auction. That's for those who are only willing to buy a Treasury if they get the desired yield. They must go through a bank or broker. The investor can buy as much as 35 percent of the Treasury Department's initial offering amount with this method.
The third is through the secondary market. That's where Treasury owners sell the securities before maturity. The bank or broker acts as a middleman.
You can profit from the safety of Treasurys without actually owning any. Most fixed-income mutual funds own Treasurys. You can also purchase a mutual fund that only owns Treasurys. There are also exchange-traded funds that track Treasurys without owning them. If you have a diversified portfolio, you probably already own Treasurys.
How They Affect the Economy
Treasurys affect the economy in two important ways. First, they fund the U.S. debt. The Treasury Department issues enough securities to pay ongoing expenses that aren't covered by incoming tax revenue. If the United States defaulted on its debt, then these expenses would not be paid. As a result, military and wouldn't receive their salaries. Recipients of Social Security, Medicare, and Medicaid would go without their benefits. It almost happened in the summer of 2011 during the U.S. debt ceiling crisis.
Second, Treasury notes affect mortgage interest rates. Since Treasury notes are the safest investment, they offer the lowest rate of return or yield. Most investors are willing to take on a little more risk to receive a little more return. If that investor is a bank, they will issue loans to businesses or homeowners. If it's an individual investor, they will buy securities backed by the business loans or mortgage. If Treasury yields increase, then the interest paid on these riskier investments must increase in lock-step.
Otherwise, everyone would switch to Treasurys if added risk no longer offered a higher return.