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Buying US Treasury Bonds: Weighing the Pros and Cons

Updated on 2013-02-23 by Guest







Buying US Treasury Bonds is often touted to be one of the safest investments in the world. Issued by the US Treasury, this type of bonds has a maturity date of more than 10 years and issued in denominations of $1,000. This fixed-interest US government security pays interests semi-annually.


Understanding US Treasury Bonds Basics

Before investing into anything – regardless of how safe the asset is said to be – it is necessary to go into an in-depth study of how the asset is derived and how it works. While bonds doesn’t have the daring appeal of the stock market, investing in bonds always entails as much knowledge and planning as investing in stocks or other underlying assets.

Bonds are issued by the US government in order to finance a budget deficit. For example, during the war on terrorism following the September 11 attack, the US government has to raise the budget to finance the measures they organized. For this reason, the US Treasury issued bonds to raise the budget. To ensure that the government won’t go on a debt spree, the US Treasury was given a limit on how much it could borrow from the public as stipulated in the Second Liberty Bond Act of 1917. Other aspects of the debt securities, such as the maturity dates, interest rates, and type of instruments are decided on the US treasury’s discretion.


Understanding Bond Characteristics

Before you buy US Treasury Bonds, it is important to note that several factors plays into determining the market value of a bond. Here are some bond characteristics that you have to consider before deciding if buying US Treasury Bonds is a sound investment decision:

Face/Par Value – refers to the amount of money a bond holder will receive once the security matures. Newly issued bonds are available at face value. US Treasury bonds are issued with $1,000 par value. Face value should not be confused with bond price since its price always fluctuates due to a host of variables. Thus, there will be times when bonds are sold at a discount or below its face value; and times when bonds are sold at premium or above its face value.

Interest – sometimes referred to as “coupons” in bond investment lingo, this is a fixed percentage of the bond’s face value paid semi-annually to bond holders.

Maturity – the future date when the investor’s capital will be repaid. Us Treasury Bonds have a maturity date of more than 10 years; and therefore, generally pay higher interest rate than say, T-notes because long-term bonds are more exposed to price fluctuations than short-term bonds.

Yield – the amount of return an investor will get from a bond. If you buy US Treasury bonds at face value, the yield is equal to the interest. However, if the bond’s price fluctuates, so does the yield. For example, if you buy US Treasury bond with 10% interest rate ($100 coupon for $1,000 bond) at face/par value, the yield is 10%. Say after a year, the bond is traded $1,200 because latest bonds issued by the government have lower interest rates; the yield shrinks to 8.33% {$100 (coupon price) / $1,200 (bond price)}. Similarly, when the bond is traded at a discount, the yield increases; thus, bond price and percent yield are inversely proportional to each other.


Understanding Bond Risks

Understanding the relationship between percent yield and price is essential to measuring the risk of your investment. In addition, changing interest rates can also affect the price of the bonds. To illustrate this, say you bought a $1,000 bond 2 years ago at par value. Currently, if the interest rates are falling, the bonds that you bought 2 years ago may be deemed more valuable than current bonds because of its higher interest rate; thus, its trading price could be above par value. Conversely, if current interest rate rises, the bond you bought 2 years ago could be traded below its par value.


Investing in US Treasury Bonds Pros and Cons

Like investing in any other asset, the pros and cons of investing in US Treasury bonds should be weighed. Below, are common considerations to guide you in your investment decision:

Pros

• The US government is one of the most credible borrowers; thus, your investment is relatively safe.

• US Treasury bonds have fixed interest rates regardless of economic outlook so it offers fixed income semi-annually.

• This type of bond is a good hedge against economic downturns because of its fixed interest rates.

• Investing in US Treasury bonds could constitute as a good investment diversification plan.

• Fixed interest payments are exempted from state and local taxes (federal taxes, however, do apply).

Cons

• Because of the US government’s credibility, US Treasury bonds typically have lower yields than say, corporate bonds.

• Treasury bonds do not have call provisions – that is, you can’t redeem the security before its maturity.

• Due to price fluctuations, you can’t predict the price at which you have to sell the bond if you do decide to sell it before its maturity date.

While buying US Treasury bonds are generally a safer vehicle than other assets, it is still important to keep in mind your investment goals and do your due diligence. After all, in the world of finance, investment vehicles always come with risks – and so, as always, caveat emptor.









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