Nominal treasury securities: Meaning, Criticisms & Real-World Uses

What Are Nominal Treasury Securities?

Nominal treasury securities are debt instruments issued by the U.S. Department of the Treasury that promise to pay a fixed stream of interest payments and return the principal amount at maturity date. These securities belong to the broader category of fixed income securities because their coupon payments are set at the time of issuance and do not adjust for subsequent changes in inflation. The nominal rate of interest (or yield) is the stated rate on the security, which does not account for the eroding effect of inflation on purchasing power. Investors who hold nominal treasury securities receive predictable payments, but the real value of these payments can diminish if inflation rises.

History and Origin

The history of U.S. Treasury securities is deeply intertwined with the nation's need to finance government spending. During the American Revolution, the Continental Congress initially issued paper money, known as bills of credit, to fund the war effort. This early form of government financing proved problematic, as the paper Continental Dollars rapidly devalued.⁹ A more structured approach to government debt began to emerge with the establishment of the Department of the Treasury in 1789.

Modern U.S. Treasury marketable securities, including various forms of nominal treasury securities like Treasury Bills, Treasury Notes, and Treasury Bonds, have evolved significantly. The auction system, which is now the primary method for selling these securities, was first introduced for Treasury bills in 1929, replacing an earlier fixed-price subscription system. Competitive bidding for Treasury bonds was introduced in 1963.⁸ The U.S. government suspended issuing 30-year Treasury bonds for a period from 2002 to 2006, but later reintroduced them.⁷ Today, the U.S. Department of the Treasury, through TreasuryDirect, regularly auctions these securities to finance government operations.⁶

Key Takeaways

Nominal treasury securities offer fixed interest payments and a principal repayment at maturity, making their cash flows predictable in dollar terms.
The returns on nominal treasury securities are not adjusted for inflation, which means their real purchasing power can erode over time.
These securities are considered to have minimal credit risk because they are backed by the full faith and credit of the U.S. government.
Their value is inversely related to changes in prevailing market interest rates, a concept known as interest rate risk.
Nominal treasury securities are widely used as benchmarks for other fixed income investments and are a cornerstone of many investment portfolio strategies.

Interpreting Nominal Treasury Securities

Interpreting nominal treasury securities involves understanding that the stated coupon rate and par value are fixed amounts. When an investor purchases a nominal treasury security, they are assured of receiving these specific dollar amounts. However, the true return on the investment, in terms of what that money can buy, is affected by inflation. If inflation rises unexpectedly, the purchasing power of the fixed interest payments and the principal repayment at maturity will be lower than anticipated.

Market participants often analyze the yield to maturity of nominal treasury securities, which represents the total return an investor can expect if they hold the bond until it matures, taking into account the current market price, par value, coupon interest rate, and time to maturity. This yield reflects market expectations about future interest rates and, implicitly, inflation. A higher yield on nominal treasury securities suggests that the market demands greater compensation for holding the debt, often due to concerns about future inflation or rising interest rates.

Hypothetical Example

Consider an investor, Sarah, who buys a newly issued 10-year nominal Treasury Note with a face value of $1,000 and a 3% coupon rate. The security pays interest semi-annually.

Purchase: Sarah invests $1,000 in the nominal treasury security.
Coupon Payments: Every six months, Sarah receives a coupon payment. The annual payment is 3% of $1,000, which is $30. So, semi-annually, she receives $15.
Maturity: After 10 years, on the maturity date, Sarah receives her original principal of $1,000 back.

Over the 10 years, Sarah receives a total of $300 in interest payments ($15 x 20 payments) plus the $1,000 principal repayment. Her nominal return is exactly as specified. However, if the average annual inflation rate over those 10 years is 2.5%, the purchasing power of the $15 coupon payments and the $1,000 principal will have eroded. For instance, the $1,000 she receives at maturity will buy less than $1,000 worth of goods and services at the time she initially invested due to the effect of inflation. This illustrates the fundamental characteristic of nominal treasury securities, where the dollar amounts are fixed, but their real value fluctuates with inflation.

Practical Applications

Nominal treasury securities play a crucial role across various facets of finance, serving as essential instruments in investment, market analysis, and economic policy.

Benchmark for Interest Rates: Yields on nominal treasury securities, particularly the 10-year Treasury Note, are widely considered benchmarks for long-term interest rates globally. Many other interest rates, such as mortgage rates and corporate bond yields, are often quoted as a spread over the equivalent-maturity Treasury yield.
Safe-Haven Investments: In times of economic uncertainty or market volatility, investors often flock to nominal treasury securities, particularly Treasury Bonds, due to their perceived safety and high liquidity. This demand can drive up bond prices and push down their yields.
Monetary Policy Implementation: Central banks, like the Federal Reserve, use open market operations involving nominal treasury securities to influence the money supply and short-term interest rates as part of their monetary policy. The Federal Reserve Bank of St. Louis notes that changes in inflation directly impact the real value of government debt and can influence future borrowing costs.⁵
Portfolio Diversification: While offering lower potential returns than riskier assets, nominal treasury securities can provide diversification benefits within an investment portfolio due to their typically low correlation with equities.
Government Finance: The issuance of nominal treasury securities is a primary mechanism through which the U.S. government finances its operations and manages the national debt. Information on upcoming auctions and recent results of these securities is regularly published by TreasuryDirect.⁴

Limitations and Criticisms

While highly regarded for their safety, nominal treasury securities come with notable limitations, primarily related to inflation and interest rate fluctuations. The most significant criticism is their susceptibility to inflation risk. Since the interest payments and principal repayment are fixed in nominal dollars, an unexpected increase in the rate of inflation erodes the purchasing power of these future cash flows. As PIMCO explains, "A bond's stated or nominal interest rate does not take inflation into account, so investors only earn that amount when inflation is zero."³ This means that the real return on nominal treasury securities can be negative during periods of high inflation. The longer the maturity of the security, the more pronounced this effect becomes.²

Another key limitation is interest rate risk. Bond prices move inversely to interest rates. If market interest rates rise after a nominal treasury security is purchased, the market value of that existing security will fall. While holding the security until maturity date will still result in the investor receiving the full principal, the opportunity cost of having locked into a lower interest rate can be substantial. Furthermore, despite their reputation for safety, even nominal treasury securities are not entirely free from risk. While default risk is negligible for U.S. Treasuries, the combination of inflation and interest rate risk can still lead to a loss of real capital for investors, especially in environments where inflation outpaces nominal yields.¹

Nominal Treasury Securities vs. Treasury Inflation-Protected Securities (TIPS)

The primary distinction between nominal treasury securities and Treasury Inflation-Protected Securities (TIPS) lies in how they address inflation. Nominal treasury securities, such as Treasury Bills, Notes, and Bonds, pay a fixed coupon rate on a fixed principal amount. The interest payments and the principal amount received at maturity are set in stone in dollar terms, regardless of changes in the cost of living. This characteristic exposes holders of nominal treasury securities to inflation risk, as unexpected inflation can diminish the real purchasing power of their returns.

In contrast, TIPS are designed to protect investors from inflation. Their principal value adjusts semi-annually based on changes in the Consumer Price Index (CPI). When the CPI rises, the principal value of a TIPS increases, and consequently, the fixed coupon rate is applied to this larger principal, leading to higher interest payments. If deflation occurs, the principal value can decrease, but it will not fall below its original par value at maturity. This mechanism provides a measure of protection against inflation that is absent in nominal treasury securities, which offer only a fixed nominal return. Investors seeking to preserve purchasing power often consider TIPS, while those prioritizing predictable nominal cash flows and higher liquidity may opt for nominal treasury securities.

FAQs

What does "nominal" mean in nominal treasury securities?

In the context of nominal treasury securities, "nominal" refers to the stated or face value of the interest payments and the principal. These amounts are fixed in dollar terms and do not adjust for inflation.

Are nominal treasury securities risk-free?

Nominal treasury securities are considered virtually free of credit risk because they are backed by the full faith and credit of the U.S. government. However, they are subject to interest rate risk and inflation risk, meaning their market value can fluctuate, and their real return can be eroded by rising prices.

How do rising interest rates affect nominal treasury securities?

When interest rates rise, the market value of existing nominal treasury securities with lower fixed coupon rates typically falls. This is because newly issued bonds will offer higher yields, making older, lower-yielding bonds less attractive by comparison. This inverse relationship is a key aspect of bond prices.

Can I lose money with nominal treasury securities?

While you will receive your full principal back if you hold a nominal treasury security until its maturity date, you can experience a loss if you sell it before maturity and market interest rates have risen, causing the bond prices to fall below your purchase price. Additionally, inflation can erode the purchasing power of your returns, meaning you might have less "real" money even if the nominal dollar amount is the same or higher.