Fixed rate treasury bond

What Is a Fixed Rate Treasury Bond?

A fixed rate treasury bond is a debt instrument issued by the U.S. Department of the Treasury that pays a fixed coupon rate of interest at regular intervals until its maturity date. As a type of government securities, these bonds are considered to have virtually no default risk because they are backed by the full faith and credit of the U.S. government. Investors who purchase a fixed rate treasury bond receive predictable income streams, making them a cornerstone of many fixed income portfolios. The fixed nature of their interest payments means that the coupon rate does not change, regardless of prevailing market interest rate risk fluctuations after issuance.

History and Origin

The U.S. Treasury has issued various forms of marketable debt to finance government spending since the Revolutionary War. While the earliest forms of government financing involved instruments like bills of credit, the modern era of marketable Treasury securities, including what we now recognize as the fixed rate treasury bond, developed significantly over time. Auctions became the primary method for selling Treasury securities in the U.S. in 1929, moving away from a fixed-price subscription system where the government set the price in advance. This shift allowed the market to determine pricing. Treasury bonds with their long maturities (20 or 30 years) have been a consistent feature of the U.S. debt landscape, though issuance of certain maturities was suspended and later reintroduced based on budget needs and market conditions¹⁰. The introduction of electronic book-entry systems in 1968 further streamlined the issuance and trading of these securities, including fixed rate treasury bonds⁹.

Key Takeaways

• A fixed rate treasury bond pays a predetermined, unchanging interest rate over its lifetime.
• These bonds are issued by the U.S. Treasury and are considered among the safest investments due to the backing of the U.S. government.
• They provide a predictable stream of income, making them attractive to investors seeking stability.
• Their value can be affected by changes in market interest rates and inflation, despite their fixed coupon.
• Fixed rate treasury bonds can be bought directly from the government via TreasuryDirect or on the secondary market.

Formula and Calculation

The price of a fixed rate treasury bond, like any bond, is determined by the present value of its future cash flows, which include its periodic coupon payments and its par value at maturity. The formula to calculate the present value (price) of a bond is:

Where:

• (P) = Current market price of the bond
• (C) = Annual coupon payment (coupon rate × par value)
• (r) = Market discount rate or yield to maturity
• (F) = Face value (par value) of the bond
• (N) = Number of periods to maturity
• (t) = Time period (from 1 to N)

For semi-annual coupon payments, the formula is adjusted by dividing the annual coupon rate by two, multiplying the number of years to maturity by two, and using the semi-annual discount rate.

Interpreting the Fixed Rate Treasury Bond

Interpreting a fixed rate treasury bond involves understanding its characteristics in the broader economic context. The primary attraction is the fixed coupon payment, which provides a steady and predictable income stream. For example, a 30-year fixed rate treasury bond issued with a 3% coupon will pay 1.5% every six months for 30 years, regardless of how market interest rates change. This predictability is valuable for investors seeking capital preservation and consistent income.

However, the fixed nature of its payments means a fixed rate treasury bond is susceptible to changes in market interest rates. If market rates rise after the bond is issued, the bond's fixed coupon becomes less attractive compared to newly issued bonds with higher rates. This typically causes the price of the existing bond to fall on the secondary market to offer a competitive yield to new buyers. Conversely, if market rates fall, the existing fixed rate treasury bond with its higher coupon becomes more valuable, and its price will likely rise. Therefore, investors must consider the current interest rate environment and their own investment horizon when evaluating these securities.

Hypothetical Example

Suppose an investor purchases a 10-year fixed rate treasury bond with a par value of $1,000 and a 2.5% annual coupon rate. The interest is paid semi-annually.

1. Coupon Payment Calculation: The annual coupon payment is 2.5% of $1,000, which is $25. Since payments are semi-annual, the investor receives $12.50 ( $25 / 2 ) every six months.
2. Total Income: Over the 10-year (20 semi-annual periods) life of the bond, the investor will receive 20 payments of $12.50, totaling $250 in interest.
3. Maturity Value: At the end of 10 years, the investor also receives the $1,000 par value back.
4. Scenario Impact: If market interest rates unexpectedly rise to 3.5% a year after the bond is purchased, newly issued 9-year bonds might offer a 3.5% coupon. This makes the existing 2.5% bond less appealing to potential buyers on the secondary market, and its price would likely fall below $1,000 if the original investor needed to sell it before maturity date. Conversely, if rates fell to 1.5%, the existing bond would become more desirable, and its price would likely trade above par.

Practical Applications

Fixed rate treasury bonds serve several crucial roles in the financial world for both individual investors and large institutions.

• Portfolio Diversification: For many investors, these bonds act as a cornerstone of portfolio diversification. Their low correlation with equities can help reduce overall portfolio volatility, particularly during periods of market stress.
• Safe Haven Asset: Due to their backing by the U.S. government, they are widely regarded as a "safe haven" asset. During times of economic uncertainty or geopolitical instability, investors often flock to fixed rate treasury bonds, driving up demand and typically lowering their yields.
• Benchmark for Other Rates: The yields on U.S. Treasury securities, including fixed rate treasury bonds, serve as a benchmark for interest rates across the entire financial system. Mortgage rates, corporate bond yields, and other lending rates are often priced as a spread over comparable Treasury yields.⁸
• Monetary Policy Tool: The Federal Reserve uses the purchase and sale of U.S. Treasury securities as a key tool for implementing monetary policy, influencing the money supply and interest rates in the economy.⁵, ⁶, ⁷ For example, through open market operations, the Fed can buy Treasuries to inject liquidity into the financial system or sell them to withdraw liquidity. Individuals can purchase these bonds directly through TreasuryDirect, the U.S. Department of the Treasury's online platform.³, ⁴

Limitations and Criticisms

While fixed rate treasury bonds are known for their safety, they are not without limitations or criticisms, primarily concerning their vulnerability to inflation and interest rate risk.

• Inflation Risk: The most significant drawback of a fixed rate treasury bond is its susceptibility to inflation. Since the coupon payments are fixed, an unexpected rise in inflation erodes the purchasing power of those future payments and the principal returned at maturity. If inflation outpaces the bond's fixed coupon rate, the real return to the investor can be negative.² This means that while the nominal value of the payments remains constant, their ability to buy goods and services diminishes.
• Interest Rate Sensitivity: Fixed rate bonds are sensitive to changes in prevailing interest rates. When interest rates rise, the market value of existing fixed rate treasury bonds falls, as new issues offer higher yields. Conversely, if rates fall, the value of existing bonds increases. This can lead to capital losses if an investor needs to sell the bond before its maturity in a rising rate environment.¹ This is particularly true for longer-maturity bonds, which have greater interest rate sensitivity than shorter-term Treasury bills or Treasury notes.
• Low Yield in Low-Rate Environments: In periods of low interest rates, the yields offered by fixed rate treasury bonds may be relatively low, sometimes barely keeping pace with, or even lagging behind, inflation. This can make them less attractive for investors seeking higher returns or struggling to preserve their purchasing power.

Fixed Rate Treasury Bond vs. Treasury Inflation-Protected Securities (TIPS)

A fixed rate treasury bond and Treasury Inflation-Protected Securities (TIPS) are both debt instruments issued by the U.S. Treasury, but they differ fundamentally in how they address inflation.

The key distinction lies in the principal value. A fixed rate treasury bond returns its original par value at maturity, along with fixed interest payments. TIPS, on the other hand, adjust their principal value based on changes in the Consumer Price Index (CPI). If inflation rises, the principal of a TIPS increases, and subsequent coupon payments (which are a fixed rate of the adjusted principal) also increase, thereby preserving the investor's purchasing power. This makes TIPS a direct hedge against inflation, while fixed rate treasury bonds offer no such built-in protection.

FAQs

How safe is a fixed rate treasury bond?

A fixed rate treasury bond is considered one of the safest investments because it is backed by the full faith and credit of the U.S. government. This means there is virtually no risk that the government will fail to make its promised interest payments or repay the principal at maturity.

Do fixed rate treasury bonds offer protection against inflation?

No, fixed rate treasury bonds do not offer direct protection against inflation. While they provide predictable nominal interest payments, an unexpected rise in inflation will reduce the real purchasing power of those payments and the principal returned at maturity. For inflation protection, investors typically consider Treasury Inflation-Protected Securities (TIPS).

Can I lose money on a fixed rate treasury bond?

While you are virtually guaranteed to receive your principal and all interest payments if you hold a fixed rate treasury bond until its maturity date, you can experience a loss if you sell it on the secondary market before maturity. If market interest rates have risen since you purchased the bond, its market price will likely fall below what you paid for it.

Where can I buy fixed rate treasury bonds?

You can purchase fixed rate treasury bonds directly from the U.S. government through TreasuryDirect, the official website for buying U.S. Treasury securities. Alternatively, you can buy them through brokerage firms or banks, which may also offer access to the primary market (new issues) and the secondary market (existing issues).