The Safest Investment
Aug 02 '00 (Updated Apr 10 '01)
The Bottom Line Invest in US government bonds if safety of principal and interest is your overriding concern. But remember that these bonds are subject to interest rate and inflation risk.
The United States government finances much of the federal debt as well as its short term working capital needs by issuing securities known as Treasury bills, Treasury notes, and Treasury bonds. These securities represent loans to the United States government.
Treasury Bills
Treasury bills (or T-bills) are short term securities, with maturities usually less than one year. You buy them at a discount to their face value (generally $10,000, but sometimes $1,000). They make no interest payments, but they effectively do pay interest because you get the full face value when they mature. For example, you might buy a T-bill for $9,500 and receive $10,000 when it matures after one year.
Treasury Notes and Bonds
Treasury notes (T-notes) and Treasury bonds (T-bonds) are similar to corporate bonds. They make semi-annual interest payments at a specified interest rate, and at maturity, you receive the full face value of each bond (usually $1,000). For example, you might buy a T-bond paying 6% interest with a maturity date of July 31, 2005. The bond would pay $30 interest every January 31 and July 31 and then pay the $1,000 face value on July 31, 2005.
The main difference between T-notes and T-bonds is that notes generally have a maturity of 1 to 5 years and bonds have a maturity of more than 5 and up to 30 years.
Taxation
The interest on all of these securities is subject to federal income tax. However, it is not subject to state and local income taxes. This can be advantageous to individuals who live in states with high state income taxes. If you sell one of these securities at a different price than the purchase price, or the face value you receive at maturity is different than the purchase price, you will realize a capital gain or loss which you must report on your income tax return.
Risks and Rewards of Treasury Securities
U.S. Treasury securities are the only investment for which there is theoretically no risk of default. They are backed by "the full faith and credit" of the United States. If you hold one of these securities you are certain to receive every interest payment and to get back the face value at maturity. In fact, the primary advantage of Treasury securities is this "safety." Because there is no risk of default, these securities pay lower interest rates than other types of bonds such as corporates and municipals. (In general, riskier bonds have relatively higher interest rates than less risky bonds and vice versa).
But that's not to say owning these securities is risk free. They are subject to other risks common to all types of bonds. The two most important are:
Interest rate risk. As interest rates go up, the value of any bond goes down and vice versa. Thus, if you need to sell your Treasury securities before maturity, they may be worth more or less than the face value, depending on the level of interest rates in general compared to the interest rate paid by the security. Anyone who has bought bonds during a period of rising interest rates has seen their value decline. Conversely, if you bought bonds before a period of falling interest rates, you have seen their value increase as interest rates fall. But remember, if you hold your bonds to maturity, you will get the full face value.
Inflation risk. If you own a bond that pays 6% interest, but inflation suddenly goes up to more than 6%, you find yourself "not keeping up with inflation." The value of your investment plus interest payments is actually declining. Even though you get the face value back at maturity, it is worth much less than it was worth originally because inflation has eaten away at its value.
Buying Treasury Securities
You can buy these securities directly from the U.S. Treasury, through your broker, or indirectly through mutual funds. Certain types of money market funds own substantial amounts of T-bills. If you buy these securities directly (rather than through a mutual fund) and hold them to maturity, you will receive the face value. However, if you buy a mutual fund that invests in these securities, there is no guarantee that you will receive your principal at any time in the future.
Who Should Buy Treasury Securities
For the most part, these securities are suitable for investors who have a very low tolerance for risk, who are willing to buy and hold until maturity, and are willing and able to accept a low rate of return compared to most other investments. Because of the low rate of return, few investors should devote a large percentage of their portfolios to these securities, but the may be used to reduce the volatility of a balanced portfolio that contains other more risky investments. Many brokers suggest a $25,000 minimum investment for people who want to buy individual securities directly, in order to get the best price.
There are various ways to achieve higher rates of return by using these securities to speculate regarding interest rate changes and inflation, but these are best reserved for professional investors.
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