How Treasury Bills, Notes, and Bonds Work (2024)

Treasury bills, notes,and bonds are fixed-income investments issued by the U.S. Department of the Treasury. They are the safest investments in the world since the U.S. government guarantees them. This low risk means they have the lowest interest rates of any fixed-income security.Treasury bills, notes, and bonds are also called "Treasurys" or "Treasury bonds" for short.

The Difference Between Treasury Bills, Notes, and Bonds

The difference between bills, notes, and bonds are the lengths until maturity.

• Treasury bills are issued for terms of less than a year.
• Treasury notes are issuedfor terms of two, three, five, seven, and 10 years.
• Treasury bonds are issuedfor terms of 30 years. They were reintroduced in February 2006.

The Treasury also issues Treasury Inflation-Protected Securities (TIPS) in terms of five, 10, and 30 years. They work similarly to regular bonds. The only difference is that the Treasury Department increases its value if inflation rises.

How Treasurys Work

The Treasury Department sells all bills, notes,and bonds at auction with a fixed interest rate. Whendemandis high, bidders will pay more than the face value to receive the fixed rate. When demand is low, they pay less.

The Treasury Department pays theinterest rate every six months for notes, bonds, and TIPS. Bills only pay interest at maturity. If you hold onto Treasurys until term, you will get back theface valueplus the interest paid over the life of the bond. (You get the face value no matter what you paid for the Treasury at auction.) The minimum investment amount is $100. That places them well within reach for manyindividual investors.

Don't confuse the interest rate with theTreasury yield. The yield is thetotal returnover the life of the bond. Since Treasurys are sold at auction, their yields change every week. If demand is low, notes are sold below face value. The discount is like getting them on sale. As a result, the yield is high. Buyers pay less for the fixed interest rate, so they get more for their money.

However, when demand is high, they are sold at auction above face value. As a result, the yield is lower. The buyers paid more for the same interest rate, so they got less return for their money.

The uncertainty following the 2008 financial crisisheightened the popularity of Treasurys. In fact, Treasurys reached record-high demand levels on June 1, 2012. The10-year Treasury noteyield dropped to 1.47%, the lowest level in more than 200 years. This decline was because investors fled to ultra-safe Treasurys in response to theeurozone debt crisis. On July25, 2012, the yield hit 1.43%, a new record low. On July 5, 2016, the yield fell to an intra-day low of 1.375%. These lows had a flattening effect on theTreasury yield curve.

How to Buy Treasurys

There are three ways to purchase Treasurys. The first is called a noncompetitive bid auction. That's for investors who know they want thenoteand are willing to accept any yield. That's the method most individual investors use. They can go online toTreasuryDirectto complete their purchase. An individual can only buy $5 million in Treasurys during a given auction with this method.

The second is a competitive bidding auction. That's for those who are only willing to buy a Treasury if they get the desired yield. They must go through a bank or broker. The investor can buy as much as 35%of the Treasury Department's initial offeringamount with this method.

The third is through thesecondary market, where Treasury owners sell the securities before maturity. The bank or broker acts as a middleman.

You can profit from the safety of Treasurys without actually owning any. Most fixed-income mutual funds own Treasurys. You can also purchase a mutual fund that only owns Treasurys. There are also exchange-traded funds that track Treasurys without owning them. If you have a diversified portfolio, you probably already own Treasurys.

Price Fluctuations

Once treasury notes and bonds are issued, their prices fluctuate, so their yields remain linked to market prices. For example, let's say the government issues a 30-year bond with a 10% yield when interest rates are high. In the next 15 years, prevailing rates fall significantly, and new long bonds are issued at 5%. Investors will no longer be able to buy the older bond and still receive a 10% yield. Instead, its yield to maturity will fall, and its price will rise.

How Treasurys Affect the Economy

Treasurysaffect the economyin two important ways. First, they fund theU.S. debt. The Treasury Department issues enough securities to pay ongoing expenses that aren't covered by incomingtax revenue. If the United Statesdefaulted on its debt, then these expenses would not be paid. As a result, military andgovernment employeeswouldn't receive their salaries. Recipients ofSocial Security, Medicare, and Medicaid would go withouttheir benefits. It almost happened in the summer of 2011 during the U.S.debt ceilingcrisis.

Second, Treasury notes affect mortgage interest rates. Since Treasury notes are the safest investment, they offer the lowest yield.Most investors are willing to take on a little more risk to receive a little more return. If that investor is a bank, they will issue loans to businesses or homeowners. If it's an individual investor, they will buy securities backedby the business loansor mortgage.

If Treasury yields increase, then the interest paid on these riskier investments must increase in lock-step. Otherwise, everyone would switch to Treasurys if added risk no longer offered a higher return.

Frequently Asked Questions (FAQs)