Treasury note

What Is a Treasury Note?

A Treasury note (T-note) is a marketable U.S. government debt security with a fixed coupon rate and a maturity date ranging from two to ten years. As a type of fixed income security, Treasury notes pay interest every six months until they mature, at which point the investor receives the par value of the note. These instruments are considered among the safest investments globally due to the backing of the full faith and credit of the U.S. government, classifying them as highly liquid government securities.

History and Origin

The issuance of various forms of U.S. government debt dates back to the nation's founding, evolving significantly over centuries to finance public spending and manage national debt. Treasury notes, specifically, gained prominence as a key component of the U.S. Treasury's borrowing strategy, offering a mid-range maturity option between short-term bills and long-term bonds. The process of issuing these securities, including Treasury notes, relies heavily on a structured auction system managed by the U.S. Treasury and supported by the Federal Reserve. Early forms of Treasury auctions helped establish the framework for modern debt issuance.⁵

Key Takeaways

Mid-Term Maturity: Treasury notes typically mature in 2, 3, 5, 7, or 10 years, placing them between short-term Treasury bills and long-term Treasury bonds.
Semiannual Interest: Investors in Treasury notes receive fixed interest payments, known as coupons, every six months until the note reaches its maturity date.
Government Backing: Backed by the full faith and credit of the U.S. government, Treasury notes are considered to have virtually no default risk.
Market-Driven Yield: While they have a stated coupon, the actual yield an investor receives is determined by the price paid at auction or in the secondary market.
Benchmark for Rates: The yields on Treasury notes, particularly the 10-year Treasury note, serve as critical benchmarks for various other interest rates in the financial markets.

Formula and Calculation

The pricing of a Treasury note, like other bonds, is based on the present value of its future cash flows, which include regular coupon rate payments and the repayment of the par value at maturity. The formula for the present value (PV) or price of a bond is:

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

Where:

(PV) = Present Value (or price) of the Treasury note
(C) = Coupon payment per period (Annual coupon rate / number of payments per year)
(F) = Face value (par value) of the Treasury note, typically $1,000
(r) = Yield to maturity (discount rate) per period
(N) = Total number of periods until maturity

This formula demonstrates the inverse relationship between the price of a Treasury note and its yield: as yields rise, the price of existing notes falls, and vice versa.

Interpreting the Treasury Note

The yield on a Treasury note provides key insights into investor expectations about interest rates and economic conditions. A rising yield might suggest market participants anticipate higher inflation or stronger economic growth, leading to higher future interest rates. Conversely, a falling yield could indicate expectations of slower economic activity or disinflation.

The 10-year Treasury note yield is particularly significant, widely regarded as a proxy for the risk-free rate and often used to price other financial assets, including mortgages and corporate bonds. Its movements are closely watched by investors, economists, and policymakers as an indicator of broader trends within the financial markets.

Hypothetical Example

Imagine an investor purchases a 5-year Treasury note with a par value of $1,000 and a coupon rate of 2% at an auction.

Initial Purchase: The investor pays $1,000 for the note.
Semiannual Interest Payments: Since the coupon rate is 2% annually, the note pays $20 per year ($1,000 * 0.02). These payments are made semiannually, so the investor receives $10 every six months.
Maturity: After five years, on the maturity date, the investor receives the final $10 coupon payment plus the $1,000 par value of the note.

Throughout the note's life, the investor benefits from predictable fixed income cash flows, contributing to their investment portfolio's stability.

Practical Applications

Treasury notes play a multifaceted role across investing, financial regulation, and economic analysis:

Investment Portfolios: They are a cornerstone of many investment portfolios, particularly for conservative investors and those seeking capital preservation and regular income. Their high liquidity also makes them attractive.
Benchmark for Lending Rates: The yields on Treasury notes, especially the 10-year, are widely used as benchmarks for other lending rates, including those for mortgages, corporate bonds, and consumer loans. This makes them central to understanding the broader cost of borrowing in the economy.
Monetary Policy Tool: The Federal Reserve uses operations involving government securities, including Treasury notes, to implement monetary policy. By buying or selling these securities in the secondary market, the Fed influences the money supply and short-term interest rates.⁴
Government Funding: The U.S. Treasury conducts regular auctions to issue new Treasury notes, along with bills and bonds, to finance federal government operations and manage the national debt. These auctions are a primary mechanism for the government to raise capital.³

Limitations and Criticisms

While highly regarded for their safety, Treasury notes are not without limitations or criticisms:

Interest Rate Risk: The most significant risk for Treasury note holders is interest rate risk. If market interest rates rise after a Treasury note is purchased, the market value of the existing note, with its lower fixed coupon rate, will fall. This inverse relationship means investors selling before maturity date could receive less than their initial investment.²
Inflation Risk: Although considered a safe haven asset, the fixed interest payments of a Treasury note mean that its real (inflation-adjusted) return can be eroded by unexpected increases in inflation. For investors concerned about inflation, Treasury Inflation-Protected Securities (TIPS) might be a more suitable alternative.
Low Yield in Low-Rate Environments: In periods of low interest rates, the yield offered by Treasury notes may be minimal, potentially offering returns that barely keep pace with, or even fall below, the rate of inflation, impacting purchasing power.

Treasury Note vs. Treasury Bond

The primary distinction between a Treasury note and a Treasury bond lies in their original maturity date. Treasury notes have maturities ranging from two to ten years, making them mid-term instruments. In contrast, Treasury bonds are long-term debt instruments, typically issued with maturities of more than ten years, commonly 20 or 30 years. Both pay semiannual coupon rates and are backed by the U.S. government. The choice between a Treasury note and a Treasury bond often depends on an investor's time horizon, yield objectives, and sensitivity to interest rate risk, as longer-maturity bonds typically exhibit greater price sensitivity to interest rate changes.

FAQs

What is the minimum investment for a Treasury note?

Treasury notes are typically sold in increments of $100, though they are usually auctioned in multiples of $1,000. Individual investors can often purchase them directly through TreasuryDirect with minimum investments starting at $100.¹

How do Treasury notes pay interest?

Treasury notes pay fixed interest payments (coupons) every six months until their maturity date. At maturity, investors receive the final interest payment plus the par value of the note.

Can I sell a Treasury note before it matures?

Yes, Treasury notes are marketable securities, meaning they can be sold on the secondary market before their maturity date. The price an investor receives will depend on prevailing market interest rates and the note's remaining term.

Are Treasury notes taxable?

The interest income earned from Treasury notes is subject to federal income tax but is exempt from state and local income taxes. This tax treatment is a unique feature of government securities compared to corporate or municipal bonds.