Treasury bond: Meaning, Criticisms & Real-World Uses

What Is Treasury bond?

A Treasury bond is a marketable fixed-income security issued by the U.S. Department of the Treasury to finance the government's borrowing needs. As part of the broader category of fixed-income securities, Treasury bonds are generally considered one of the safest investments globally because they are backed by the "full faith and credit" of the U.S. government, implying a minimal risk of default. These long-term debt instruments typically have maturity periods ranging from 20 to 30 years. Investors who purchase a Treasury bond receive regular interest payments, known as coupon payments, until the bond matures, at which point they receive the original principal amount.

History and Origin

The issuance of government debt in the United States dates back to the nation's founding, but the modern concept of the Treasury bond evolved significantly over time. Early forms of U.S. government debt included war bonds issued to finance conflicts such as World War I. For instance, Liberty Bonds were sold to the public to raise funds during that period. The formal introduction of competitive bidding for Treasury bonds by syndicates of securities dealers and banks began in 1963⁸.

Over the decades, the specific maturities offered for Treasury bonds have changed based on government financing needs and market conditions. While 25-year bond issues became a regular feature of Treasury's mid-quarter coupon refunding in 1974, they were replaced by 30-year bond issues by 1977⁷. The 30-year Treasury bond was temporarily discontinued in 2001 amidst budget surpluses but was reintroduced in 2006⁶. In recent years, 20-year and 30-year Treasury bonds are typically auctioned at original issue in specific months, with reopenings in other months⁵.

Key Takeaways

Treasury bonds are long-term debt instruments issued by the U.S. government with maturities of 20 to 30 years.
They pay fixed interest payments, known as coupons, semi-annually until maturity.
Treasury bonds are backed by the full faith and credit of the U.S. government, making them highly secure investments.
They play a crucial role in investor portfolio diversification and serve as a benchmark for other long-term interest rates.
Investors can purchase Treasury bonds directly from the U.S. Treasury via TreasuryDirect or through brokers in the secondary bond market.

Formula and Calculation

The price of a Treasury bond, like any other coupon bond, is the present value of its future cash flows, which consist of periodic coupon payments and the par value returned at maturity. The formula for the price of a bond is:

P = \sum_{t=1}^{N} \frac{C}{(1+r)^t} + \frac{F}{(1+r)^N}

Where:

(P) = Current market price of the bond
(C) = Annual coupon payment (coupon rate × par value)
(r) = Discount rate or yield to maturity (YTM)
(F) = Face value (par value) of the bond
(N) = Number of periods to maturity

For semi-annual coupon payments, the formula is adjusted:

P = \sum_{t=1}^{2N} \frac{C/2}{(1+r/2)^t} + \frac{F}{(1+r/2)^{2N}}

Where:

(C/2) = Semi-annual coupon payment
(r/2) = Semi-annual discount rate
(2N) = Total number of semi-annual periods to maturity

Interpreting the Treasury bond

The value of a Treasury bond is primarily interpreted through its yield to maturity (YTM), which represents the total return an investor can expect if they hold the bond until it matures. A higher YTM indicates a lower bond price, reflecting a potentially higher return for new investors, while a lower YTM suggests a higher bond price and a lower expected return.

Because Treasury bonds carry virtually no default risk, their yields are often considered the risk-free rate for long-term investments. Changes in Treasury bond yields can signal shifts in market expectations for future interest rates, inflation, and economic growth. For instance, rising yields may suggest expectations of stronger economic growth or higher inflation, while falling yields could indicate concerns about economic slowdowns.

Hypothetical Example

Suppose an investor purchases a newly issued 30-year Treasury bond with a par value of $1,000 and a coupon rate of 4% per year, paid semi-annually.

Coupon Payments: The annual coupon payment is 4% of $1,000, which is $40. Since payments are semi-annual, the investor receives $20 every six months.
Maturity: The bond will pay $20 every six months for 30 years (60 payments in total).
Principal Repayment: After 30 years, the U.S. Treasury will repay the initial $1,000 par value to the investor.

This stream of predictable income, combined with the assurance of principal repayment at maturity, makes the Treasury bond a staple for investors seeking long-term stability and income.

Practical Applications

Treasury bonds serve multiple crucial roles in the financial world. For individual investors, they represent a secure means of preserving capital and generating steady income, often forming a core component of a conservative portfolio. Their high liquidity means they can be easily bought and sold in the secondary bond market before maturity.

Institutional investors, such as pension funds and insurance companies, frequently hold substantial amounts of Treasury bonds due to their safety and predictable cash flows, aligning with long-term liability matching strategies. Central banks also use Treasury bonds in open market operations to influence interest rates and control the money supply.

Investors can purchase Treasury bonds directly from the U.S. government through the TreasuryDirect website, where they can bid on new issues in auctions.⁴ Alternatively, they can buy existing Treasury bonds in the secondary market through brokerage firms and banks.³

Limitations and Criticisms

While Treasury bonds are lauded for their safety, they are not without limitations. The primary drawback is their susceptibility to inflation risk. Although the principal is guaranteed, rising inflation can erode the purchasing power of future fixed interest payments and the principal returned at maturity. The inflation risk premium, for instance, reflects market participants' compensation for this risk.²

Another consideration is interest rate risk. If interest rates rise after a Treasury bond is purchased, the market value of the existing bond will fall, as new bonds will be issued with higher coupon rates, making older, lower-coupon bonds less attractive. While this does not affect an investor who holds the bond to maturity, it presents a capital loss risk for those who need to sell beforehand.

Furthermore, the sheer volume of outstanding U.S. federal debt, which Treasury bonds help constitute, is a subject of ongoing economic and political debate. The national debt, made up of intragovernmental holdings and debt held by the public, continues to be closely monitored as it impacts the government's future interest expenses and fiscal flexibility.¹

Treasury bond vs. Treasury note

While both Treasury bonds and Treasury notes are marketable securities issued by the U.S. Department of the Treasury, the primary distinction lies in their maturity periods. Treasury bonds are long-term instruments with maturities ranging from 20 to 30 years. In contrast, Treasury notes are medium-term debt obligations, typically issued with maturities between two and ten years. Both pay fixed interest (coupon) payments semi-annually and are backed by the full faith and credit of the U.S. government. The longer maturity of a Treasury bond generally exposes investors to greater interest rate risk compared to a Treasury note, meaning their prices will fluctuate more significantly with changes in prevailing interest rates.

FAQs

Are Treasury bonds a good investment?

Treasury bonds are generally considered a very safe investment due to the backing of the U.S. government, offering predictable income and capital preservation. However, their returns are typically lower compared to riskier assets like stocks or corporate bonds, and they are subject to inflation risk and interest rate risk. They can be a good choice for conservative investors or for diversification within a broader portfolio.

How do Treasury bonds pay interest?

Treasury bonds pay interest semi-annually, meaning twice a year. This regular payment is known as a coupon payment and is a fixed percentage of the bond's par value (or face value).

Can I sell a Treasury bond before maturity?

Yes, Treasury bonds are highly liquid and can be sold in the secondary bond market before their maturity date. The price you receive will depend on prevailing interest rates and market demand at the time of sale.

How do interest rates affect Treasury bond prices?

Treasury bond prices move inversely to interest rates. When interest rates rise, the price of existing Treasury bonds with lower coupon rates falls, making them less attractive to new investors. Conversely, when interest rates fall, existing Treasury bond prices tend to rise.