Treasury Debt

Treasury debt in summary:
  • Our country has a huge amount of debt outstanding and continues to pile it on (call your Congressman to complain if you’re all about being political and stuff).
  • Treasury instruments are seen as a risk-free benchmark that serves as the baseline for determining the required return on all other asset classes.
  • The return on Treasury debt comes primarily from semi-annual “coupon” payments of interest (which are taxed at your marginal tax level by the federal and state governments), and to a lesser extent from the daily change in the price of the bond.
  • Investing in Treasury debt is not risk-free. The daily movement of interest rates changes the value of Treasury investments … in some cases significantly.
  • The returns for taking on such little risk by investing in Treasury securities are not attractive and should not be used as a long-term investment choice for young professionals.

In order to finance the daily activities of the Federal government, the Treasury Department issues I.O.U.’s to investors and governments around the world. As of the end of 2017, the Treasury had more than $20 trillion dollars in outstanding debt obligations. Based on a U.S. population of just over 327 million, this amounts to roughly $61,000 in federal government debt per citizen (gulp!).

The Treasury Department frequently holds auctions with major banks to issue new debt. All Treasury debt securities are backed by the “full faith and credit” of the United States government – which means Uncle Sam pinky-swears that he will repay you. The major credit rating agencies (Standard & Poors, Moodys, Fitch) assign repayment probability ratings to debt instruments, and in August 2011 Standard & Poors made history by downgrading the credit rating of the U.S. from the highest rating for the first time in more than 70 years.  The U.S. has never failed to repay its debt, but the concerning increasing trend of total debt outstanding (see graph below) coupled with huge looming commitments to the baby boomer generation in the form of Medicare and Social Security could put our country in a tight financial picture within the near future.

Source: treasurydirect.gov. Note how from 2003 through the end of 2017 debt has increased 221 percent or $14.1 trillion – nothing to sneeze at!

Treasury debt securities are offered in ten different maturity dates – or ten varying lengths of when they will give you your initial investment back. The linear plot of every yield (the annual interest return on investment you receive when holding this debt) of each of these ten securities forms what is known as the Treasury Yield Curve. This curve has importance since it is the basis of return for basically all other assets. Since these Treasury instruments are generally perceived as “risk-free” then all other riskier assets of a similar maturity must provide a return above the baseline Treasury yield.

 

Some highlights of important levels of the Treasury Yield Curve:

  • 3-month = The Federal Reserve Bank actively buys and sells short-term Treasury debt as one of their main tools to influence economic growth. To encourage growth, the Fed tries to lower this rate to make borrowing money easier. The rate on this Treasury security has a direct influence on the return of money market funds.
  • 10-year = This Treasury security is generally seen as the baseline for the 30-year mortgage rate. When you apply for a mortgage when buying a home, the rate you will receive on your loan (depending on your credit) will be close to 1.5-2 percent above this rate.

Treasury debt is broken down into 3 general classes based on how they pay an investor and their maturity lengths:

  • Treasury bills = This includes the one-month, three-month, six-month, and twelve-month Treasury securities. These instruments provide a return to the investor through being issued at a discount. This means Uncle Sam says if you give me $975 now I will give you $1,000 in (1, 3, 6 or 12) months. 
  • Treasury notes = These Treasury securities have maturity dates of 2, 3, 5, 7 or 10 years. These IOU’s agree to pay investors a fixed “coupon” every six months, and they return the full amount of the initial investment upon maturity. This “coupon” is a basic feature of many longer-term debt instruments, where investors receive an interest payment semi-annually based on a fixed percentage of the value of the bond. Thus the term “fixed-income” is used when referring to debt instruments of all forms.
  • Treasury bonds = This term refers to the longest maturity dates of Treasury debt including all instruments that are over 10 years in maturity. Bonds also pay a fixed coupon every six months similar to Treasury notes and return the full amount of the investment upon maturity. In normal cases, the longer the amount of time, until you get your initial investment back, leads to a higher coupon rate. So, your coupon will likely be larger if you loan money for 30 years instead of 2.

The biggest misconception about investing in Treasury securities is that it is risk-free. Yes, you are almost certain to get the full amount of your initial investment back when your security matures whenever in the future since the U.S. government will likely not default. But, if you don’t intend on holding the Treasury security until it matures, then you are at risk of losing money!

Say you buy a note that matures in 10 years that carries a yield of 2.00 percent. Then say economic conditions change and interest rates go up (interest rates change every day, so be ready to expect this). In the earlier months of 2010 the 10-year note yielded close to 4.00 percent, so imagine that is where rates go over the next few years. If you own an IOU that agrees to pay you a 2 percent coupon, but there are now similar IOU’s that agree to pay you 4 percent, then your 2 percent IOU is crap! (This is the general logic of why bond values move “inversely”/opposite to interest rates, with your bond price going down when rates go up, and your bond price up when rates go down). If this change in interest rates happened overnight then the value of your investment in the 10-year Treasury will have dropped about negative 16 percent! If you need the original money you invested then you will be forced to take a sizable loss when you sell your investment.

Another important item to note here is the pitiful returns you will receive if you invest in these Treasury securities. If you agree to give Uncle Sam your money for 5 years and the yield on that note is 1.75 percent, then you are nearly assured that you will lose money over this period since inflation (the general rise in prices over time normally averaging 2-3 percent per year) will most likely be greater than this. Additionally, there are significant transaction costs in order to buy an individual bond, and all interest received on Treasuries are taxed at your marginal tax bracket level at the federal and state level, both of which further eat into your returns.