Treasury notes

What Is Treasury Notes?

Treasury notes are intermediate-term debt instruments issued by the U.S. Department of the Treasury to help finance government operations. As a type of fixed-income securities, Treasury notes represent a loan made by an investor to the U.S. government, which promises to repay the principal amount, known as its par value, at the end of a specified period. Throughout the note's life, the government makes regular interest payments to the note holder. Treasury notes fall under the broader category of government securities and are typically issued with maturities ranging from two to ten years.

History and Origin

The U.S. government has historically relied on various forms of debt instruments to fund its activities, particularly during times of financial stress or significant expenditure. Early forms of "Treasury notes" existed even before the establishment of the Federal Reserve System in 1913, serving as short-term debt during periods like the War of 1812 and the Civil War. These early notes were often large-denomination, hand-signed, and bore interest, though they were not always legal tender.

Modern Treasury notes, as marketable securities, evolved significantly over time. The U.S. Department of the Treasury issues these securities, with the Federal Reserve assisting in the auction process. From 1955 to 1969, the Treasury issued notes with higher denominations to refund debt incurred during World War II.¹⁶ Over the decades, the Treasury adjusted the terms and issuance methods for these notes, for instance, redefining maturities in 1967 and introducing competitive auctions in 1970.¹⁵ Today, all U.S. Treasury notes are issued and held electronically.¹⁴

Key Takeaways

• Treasury notes are intermediate-term debt securities issued by the U.S. government, typically with maturities of 2, 3, 5, 7, or 10 years.
• They pay a fixed rate of interest every six months until their maturity date.
• Considered among the safest investments globally, they are backed by the full faith and credit of the U.S. government.
• Interest earned on Treasury notes is exempt from state and local income taxes, though it is subject to federal income tax.¹³
• The yield on Treasury notes, especially the 10-year note, serves as a significant benchmark for other interest rates across the financial markets.¹²

Formula and Calculation

The pricing and yield of a Treasury note involve its face value, coupon rate, and the current market interest rates. When purchased directly from the U.S. Treasury via auction, investors can submit competitive bids (specifying a desired yield) or non-competitive bids (accepting the market yield).¹¹

The interest payment (coupon payment) is calculated as:

This payment is made semiannually. The current yield of a Treasury note is calculated as:

For example, if a Treasury note has a par value of $1,000 and a coupon rate of 3%, it pays $15 every six months, for a total of $30 annually. If its current market price is $980, its current yield would be ( \frac{$30}{$980} \approx 0.0306 ) or 3.06%.

Interpreting Treasury Notes

Treasury notes are broadly interpreted as a benchmark for the risk-free rate in the U.S. financial system. Because they are backed by the U.S. government, they carry minimal default risk, making their yields a foundational reference point for pricing other assets like corporate bonds, mortgages, and consumer loans.¹⁰

The yield of a Treasury note reflects prevailing market interest rates and economic expectations. A rising yield on Treasury notes often signals expectations of higher inflation or economic growth, or potentially a withdrawal of accommodative monetary policy by the Federal Reserve. Conversely, a falling yield may suggest a flight to safety during economic uncertainty or expectations of lower interest rates. Investors closely monitor the 10-year Treasury note yield, in particular, as it influences long-term borrowing costs across the economy.⁹

Hypothetical Example

Consider an investor purchasing a 5-year Treasury note with a par value of $1,000 and a coupon rate of 4%. The purchase is made directly from TreasuryDirect at auction for its par value.

• Initial Investment: $1,000
• Annual Interest: $1,000 (Face Value) x 4% (Coupon Rate) = $40
• Semiannual Interest Payments: $40 / 2 = $20

The investor will receive $20 every six months for five years. Over the five-year period, the investor will receive a total of 10 payments (5 years * 2 payments/year), amounting to $200 in total interest payments. At the end of the 5-year maturity date, the investor will receive the original $1,000 par value back.

Practical Applications

Treasury notes serve multiple crucial roles in finance and investing:

• Diversification and Portfolio Stability: As highly liquid and low-risk assets, Treasury notes can provide stability to an investment portfolio, offsetting the volatility of riskier assets like stocks.⁸ Their inclusion can help reduce overall portfolio risk.
• Benchmark for Interest Rates: The yields on Treasury notes are critical benchmarks for pricing other debt instruments. For example, mortgage rates often move in tandem with the 10-year Treasury note yield.
• Liquidity Management: Due to their active secondary market, Treasury notes can be easily bought and sold before maturity, offering investors high liquidity.⁷
• Government Funding: For the U.S. government, Treasury notes are a primary mechanism for borrowing money to cover budget deficits and manage public debt. The U.S. Department of the Treasury issues these notes through TreasuryDirect.⁶
• Monetary Policy Tool: The Federal Reserve influences the Treasury market through its operations, affecting the supply and demand for Treasury notes and, consequently, their yields.⁵

Limitations and Criticisms

While generally considered low-risk, Treasury notes are not without limitations:

• Inflation Risk: The fixed interest payments of Treasury notes mean that their real (inflation-adjusted) return can erode if inflation unexpectedly rises. If inflation outpaces the note's fixed coupon rate, the purchasing power of future interest payments and the principal repayment decreases.⁴ This is a significant consideration for investors, as demonstrated by shifts in consumer inflation expectations, which can influence Treasury yields.³
• Interest Rate Risk: If market interest rates rise after a Treasury note is purchased, its market value in the secondary market will fall. This is because new notes will be issued with higher yields, making existing notes with lower yields less attractive. While holding the note to [maturity date](https://diversification.com/term/maturity date) mitigates this price risk for the original investor, selling before maturity could result in a capital loss.
• Lower Returns: Compared to riskier assets like stocks, Treasury notes typically offer lower potential returns. Investors accept this trade-off for the safety and liquidity they provide.

Treasury Notes vs. Treasury Bonds

The primary distinction between Treasury notes and Treasury bonds lies in their maturity date. Treasury notes have intermediate maturities, typically ranging from two to ten years. Treasury bonds, on the other hand, are long-term debt instruments with maturities of 20 or 30 years. Both pay fixed interest payments semiannually and are backed by the full faith and credit of the U.S. government. However, due to their longer maturities, Treasury bonds generally carry greater interest rate risk than Treasury notes. This difference in maturity influences their yields and their sensitivity to changes in market interest rates.

FAQs

How can one buy Treasury notes?

Treasury notes can be purchased directly from the U.S. government through the TreasuryDirect website. They can also be acquired through banks, brokers, or mutual funds and exchange-traded funds (ETFs) that invest in government securities.²

Are Treasury notes a safe investment?

Yes, Treasury notes are widely considered one of the safest investments because they are backed by the full faith and credit of the U.S. government, meaning the government guarantees repayment. This significantly reduces the risk of default.

What is the taxation of Treasury notes?

The interest income earned from Treasury notes is subject to federal income tax. However, it is exempt from state and local income taxes, which can provide a tax advantage for investors, especially those in states with high income taxes.¹

Can Treasury notes be sold before maturity?

Yes, Treasury notes can be sold before their maturity date in the secondary market. The price at which they are sold will depend on prevailing market interest rates, demand, and other economic factors, which may be higher or lower than the original purchase price.