No matter your age or investing goals, it's a good idea to have at least a small percentage of your portfolio in bonds. Bonds provide a steady, guaranteed source of income and tend to thrive in the financial environments that cause stocks to tumble, making them the perfect counterbalance to heavy stock investments. And Treasury securities – the bonds issued by the US federal government – are the safest of high-quality bonds and make a great linchpin of your bond portfolio.
Characteristics of all Treasury securities
All versions of Treasury securities share certain traits. They're backed by the full faith of the US government, so their default risk is seen as almost nonexistent. Because there's so little risk involved in these securities, their payment rates are typically low compared to corporate or municipal bonds. You can buy them from Treasury Direct, the official Treasury Department website for managing Treasury bonds; many brokers also allow you to buy and sell Treasury securities within your brokerage account. However, brokers often require a minimum $1,000 purchase for Treasury securities, whereas on the Treasury Direct website, you can buy most securities in $100 increments. The interest paid on Treasury securities is exempt from state and local taxes, but is subject to federal tax.
Technically, all the securities discussed here are bonds, but the federal government uses the term "Treasury bonds" to refer specifically to its long-term basic security. Treasury bonds are always issued in 30 year terms and pay interest every six months. However, you don't have to hold the bond for the full 30 years; you can sell it any time after the first 45 days. As with all long-term bonds, Treasury bonds carry a significant risk that the interest rates will rise during that 30 year period, reducing the value of your bond. As a result, long-term issues often pay a higher rate of interest to compensate the bond purchaser for that risk. As of this writing, Treasury bonds in recent auctions have offered an interest rate of around 3%.
Treasury notes are the intermediate-term Treasury security, and are currently issued in terms of two, three, five, seven, and 10 years. Intermediate-term bonds are good compromise between the relatively high risk of long-term bonds and the low payouts of short-term bonds, so they are an excellent place to start investing in Treasury securities. Interest rates vary depending on the bond term, with longer-term notes usually paying higher interest rates. At the time of this writing, rates offered at recent auctions on Treasury notes ranged from 1.25% interest on two-year notes to 2.375% interest on 10-year notes.
Treasury bills, or T-bills as they are affectionately known, are the short-term version of Treasury securities and are offered in terms of four, 13, 26, or 52 weeks. A special version of the T-bill, called the cash management bill, is typically issued in terms of just a few days. Unlike Treasury notes and bonds, Treasury bills don't make interest payments; instead, T-bills are sold at a discount. For example, if a T-bill is issued at 1% interest, then an investor would buy a $1000 T-bill for $990. When the bill matures, the Treasury Department would pay the investor $1000: the $990 he forked over to buy the bill, plus $10 in interest. Not surprisingly, Treasury bills usually pay the lowest relative rates of all the various Treasury securities; as of this writing, rates offered at recent auctions ranged from 0.964% for four-week issues to 1.243% for a one-year T-bill. Given that it's possible to find Internet bank savings accounts that pay more than that, T-bills are not a great buy right now – of course, that may change in the future as interest rates do.
Treasury Inflation-Protected Securities (TIPS)
TIPS are a special kind of Treasury security that give the buyer "inflation insurance." In brief, the biggest risk when buying any bond is that interest rates will rise; TIPS' principal balance increases with inflation and decreases with deflation, and since the interest payments you receive are based on the amount of principal, your interest payments will likewise vary with inflation. Naturally, you'd want to buy TIPS when you believe that inflation is going to climb in the future. TIPS are sold at five, 10, and 30 year maturities. Their built-in inflation insurance does come at a price; TIPS pay at a lower rate of interest than standard Treasury securities of the same term. As of this writing, rates at recent auctions ranged from 0.125% for five year TIPS to 0.875% for 30-year TIPS.
Unlike the other types of Treasury securities, savings bonds can only be bought directly through the US government. They are designed as a tool for saving money rather than an investment option; the interest paid on these bonds is typically very low, with EE bonds currently paying 0.1%. I bonds are an inflation protected savings bond that pays a combination of a fixed rate of interest (currently 0%) and a semi-annual inflation rate (currently 0.98%) that rises and falls with inflation. For both types of savings bond, you can redeem the bond after one year, but if you redeem it before five years have passed you lose the last three months' worth of interest. Savings bonds mature at 30 years and stop paying interest at that point.
Choosing Treasury securities
For most investors, Treasury marketable securities make a lot more sense than savings bonds. Consider making Treasury notes the backbone of your bond investing strategy; 10-year Treasury notes are a great option for bond ladders. Keeping a portion of your bond money in 10-year TIPS will help protect your portfolio in case of rising interest rates/inflation. Treasury securities are best kept inside a tax-deferred retirement account, since that will keep you from being taxed on the interest payments. This is particularly helpful for TIPS, since both your interest payments and any increases in principal are taxable during the year they occur. Finally, as you get closer to retirement, increase your percentage of bonds compared to stocks. Once you retire, you'll be able to enjoy the safe and steady flow of income from your portfolio of Treasuries.