Treasury Bond

A Treasury bond is a debt security issued by the United States Treasury for a term of 20 or 30 years, paying a fixed rate of interest every six months until it matures. TreasuryDirect states the term plainly: "We sell Treasury Bonds for a term of either 20 or 30 years." The rate is set at auction, does not vary over the life of the bond, and is never less than 0.125 percent. The minimum purchase is $100, in increments of $100. Because the security is marketable, a holder can keep it to maturity or sell it beforehand at whatever the market will pay.

Two naming problems are worth clearing up, because both are common and only one of them is harmless. First, Treasury names its marketable securities by maturity band: bills run a year or less and pay no periodic interest, notes run 2, 3, 5, 7 or 10 years, and bonds run 20 or 30 years, with notes and bonds paying a fixed rate every six months. In ordinary speech people say "Treasury bonds" for all of them, and no harm comes of that until the differences start to matter, which they do the moment a price is involved. Second, and less harmlessly, a Treasury bond is not a savings bond. TreasuryDirect puts a notice on this exact point: "Treasury Bonds are not the same as U.S. savings bonds." Series EE and Series I savings bonds are sold directly to individuals, cannot be traded, and have no market price; a Treasury bond has all three of the opposite properties.

The most useful thing to understand about the long end is that safety and stability are different properties, and this security has one without the other. The credit is the strongest available in dollars, so the question of whether the promised payments arrive is about as settled as a financial question gets. The question of what the security is worth on any particular day is not settled at all. A 30-year bond has a very long duration, meaning its price moves a great deal for a given change in yields, and a holder who needs to sell after rates have risen can take a substantial loss on an instrument usually described as risk-free. The phrase risk-free refers to credit and to nothing else. This is the inversion worth carrying away: within Treasury's own range, the securities with the least credit risk carry the most price risk, because price risk comes from length and Treasury's longest securities are the ones nobody doubts will pay.

The same length that moves the price also concentrates inflation risk. A fixed payment stretched across three decades is a fixed payment exposed to three decades of price changes, and the promised dollars are nominal dollars. That is not a defect in the security. It is what a nominal long bond is, and it is why Treasury also sells an inflation-linked version of the same credit.

The state and local tax exemption is federal law rather than Treasury's policy. 31 USC 3124(a) exempts obligations of the United States government from taxation by a state or a political subdivision of a state, with narrow carve-outs including a nondiscriminatory franchise tax on a corporation and estate or inheritance taxes. TreasuryDirect states the practical result for bonds as federal tax due each year on interest earned, with no state or local taxes. Because the rule is federal rather than each state's choice, the answer does not vary by state. Set beside a municipal bond, whose interest is generally exempt federally while its state treatment depends on where the holder lives and who issued it, and a corporate bond, whose interest is taxable both ways, the three complete a set: each is exempt from a different half of the tax system, or from neither.

How they are sold, and what STRIPS means on the page. Treasury holds four original-issue auctions a year plus eight reopenings, where a reopening sells more of an existing bond with the same maturity date and interest rate as the original. Individuals almost always place a noncompetitive bid, which accepts whatever rate the auction sets. Treasury bonds are also eligible for STRIPS, the program that separates the interest payments from the principal repayment so each can be held and traded as its own zero-coupon security. A stripped principal payment has a Macaulay duration equal to its remaining term, because there are no interest payments at all to pull its average timing forward.

You buy at auction through TreasuryDirect or through a bank or broker, or in the secondary market from another holder. Interest arrives every six months. At maturity Treasury repays the face value. In between, the bond has a market price that rises when yields fall and falls when yields rise.

A hypothetical example, using a round coupon rather than any current rate. Kenji buys $10,000 of a 30-year Treasury bond at face value with a 4 percent coupon. He receives $200 every six months, so $400 a year, for thirty years, and $10,000 back at the end. Over the full term that is $12,000 of interest ($400 × 30) plus his principal.

Now the price. Suppose, purely to illustrate, that this bond's modified duration is 15, and that yields on comparable bonds rise by 1 percentage point shortly after he buys. The estimated price change is 15 × 1 = 15 percent, so the bond would sell for roughly $8,500 rather than $10,000. Nothing about the government's promise changed. Kenji's $400 a year and his $10,000 at maturity are exactly as they were, so if he holds the bond the decline never becomes a loss he takes. If he needs the money that year, it is a very real one.

For contrast, the same 1 percentage point rise on a two-year note with a modified duration of about 2 would cost roughly 2 percent, or $200 on the same $10,000. One issuer, one credit, one rate move, and the size of the effect differs by a factor of seven and a half. That difference is the reason maturity is a decision rather than a detail.

Pros

• A direct obligation of the United States, so there is no intermediary whose failure could cost the holder the principal.
• Interest is exempt from state and local income tax, which raises the after-tax return for a holder in a state that taxes income.
• The rate is locked for the whole term, so a buyer who wants income fixed for decades can have exactly that.
• Marketable, with a deep and active secondary market, so the position can be sold on any business day rather than surrendered.
• The $100 minimum makes the longest maturities available at small sizes, and the auction price is the same for a small buyer as for a large one.

Cons

• The longest maturity Treasury sells is also the most price-sensitive, so a sale after rates rise can produce a large loss on the one security whose credit risk is effectively nil.
• A fixed nominal payment stretched over 20 or 30 years is heavily exposed to inflation, and the bond offers no adjustment for it.
• Interest is fully taxable federally in the year it is received, whether or not the holder wants the income.
• Reinvesting each interest payment is the holder's problem, and the rate available for doing so is unknown in advance.
• It pays a fixed amount and nothing more, so it cannot benefit from anything that goes well in the economy over three decades.