Between the various bailouts, rescues, and spending packages, the United States Treasury has been working overtime issuing debt. If you’re like me, you’re probably wondering how this is even possible and how the government goes about doing it. During the First World War and World War Two, we went through a similar period where the government needed to borrow a lot of money to help fund the war effort. That gave rise to the patriotic posters that called for ordinary Americans to buy war bonds to support our soldiers fighting the enemy on foreign soil. That same mechanism, public debt, is what we use today to help fund many of our programs.
Here’s the beginner’s guide to understanding the fundamentals of treasury bonds and securities:
Relative Safety of Treasury Bonds
Before I get into the various instruments, the basic idea behind government bonds is that they are the safest investments in the world and that they are “backed by the full faith and credit of the United States Government.” When you buy stock in a company, there is a chance the company goes bankrupt and your shares are worthless. When you buy a corporate bond, there is a chance that the company goes bankrupt and your bonds are worthless. When you put your savings into a bank account, there is a chance that the bank fails, an almost impossible chance that FDIC insurance fails, and your money is worthless. When you put your money into a government bond, the government will collapse before you will lose your money. Being backed by the full faith and credit of the United States Government is an ironclad guarantee that your money is safe.
That guarantee, while comforting, is a bit illusory because we use a fiat currency that has no inherent or intrinsic value. Our dollars, or federal reserve notes, are themselves given value by government order (fiat) rather than an inherent value. However, despite this minor technical note, government bonds are still safer, from a capital preservation perspective, than every other investment.
Types of Treasury Bonds
When it comes to debt instruments, the name “bond” only appears in four of the seven debt instruments the Treasury issues because only three are truly bonds. A Bond is a very general term, it typically refers to a debt security where the issuer of the bond owes the holder of the bonds a debt. The bond itself has a coupon or interest rate at a certain interval and return the principal at a future date. Companies issue bonds, municipal government issue bonds, and the government issues bonds.
The other four debt instruments are called “securities” or marketable securities because they can be traded on the secondary market. Here is the list of products and a brief discussion of each:
- Treasury Bills (T-Bills) – T-Bills mature in one year or less and do not pay interest. Instead, they are sold at a discount of the par value (face value) paid out at maturity. T-Bills are sold at auction every week in increments of $100 and an individual can purchase up to $5 million per auction.
- Treasury Notes (T-Notes) – T-Notes mature in two to ten years and offer a coupon or interest payment every six months. The 10-year T-Note is the Treasury most often quoted in discussions about the bond market. T-Notes are sold at auction every week in increments of $100 and an individual can purchase up to $5 million per auction.
- Treasury Bonds (T-Bonds) – T-Bonds mature in ten to thirty years, have a coupon payment every six months and are issued quarterly. T-Bonds are sold at auction every week in increments of $100 and an individual can purchase up to $5 million per auction.
- Treasury Inflation-Protected Securities (TIPS) – TIPS were introduced in 1997 and are inflation-indexed bonds, pegged to the Consumer Price Index, in maturities of 5-year, 10-year, and 20-year. The coupon rate remains constant by the principal is adjusted for inflation (and deflation) every six months, but you the principal will never adjust below the principal you paid. TIPS are sold at auction every week in increments of $100 and an individual can purchase up to $5 million per auction.
- I Bonds – Series I bonds are very popular now, I just bought Series I bonds for the first time this year, because they are sold at face value but have an interest rate that adjusts with inflation. Each bond has a fixed interest rate, that stays for the life of the bond, and a variable interest rate, which is indexed to the rate of inflation. The equation used is a little tricky to look at but easy to compute (here’s a Series I rate calculator).
- EE/E Bonds – Series EE bonds are issued at 50% of their face value and mature in 30 years, though as it accrues interest semi-annually, it is designed to reach face value in only 17 years.
- HH/H Bonds – Series HH bonds are no longer offered as of August 31st, 2004, but they were similar to EE/E bonds in that they were sold at a discount and mature in 20 years at face value.
Tax Considerations
One of the benefits of these products is that interest is exempt from income tax on the State and local level (but not Federal level). Some of the bonds, such as the Series EE/E and Series I Savings Bond, offer education tax savings. If you use the interest from a Series EE/E or a Series I Savings Bond to pay for eligible education expenses, it is tax-free! Couple that with the Lifetime Learning or Hope Credits and you can get some serious tax savings.
Risks
There are risks to buying Treasury Bonds and similar debt instruments. The two major risks are inflation risk and currency risk.
Inflation risk: Inflation risk refers to the risk that your purchasing power will fall as inflation increases. If you have a coffee can stuffed with a thousand dollars buried in your backyard, you can be pretty sure that the $1,000 will still be there when you dig it out of the ground in five years. However, the $1,000 is worthless in five years because the value of a dollar will have fallen due to inflation. The same is true for money saved in bank accounts, CDs, or anything else not pegged to inflation. If inflation is 5% a year, you lose five dollars out of every hundred dollars each and every year. This risk is dangerous because it’s difficult to see with your eyes. You still see your thousand dollars sitting there, but you forget that the jar of peanut butter you buy each month or the gallon of milk you buy each week has gotten a little more expensive (or they shrank the jar!).
Currency risk: Another risk you face is that the dollar loses its value against other currencies. This is important because you’ll probably be buying products manufacturer or produced overseas and so your purchasing power will once against be tested. If you lock up your funds in a bond or CD, the risk that the dollar’s value goes down will have an impact on your savings.
Are these two reasons enough to preclude you from putting your money into a bond (or CD or savings account)? I don’t think so, but you need to be aware of them.
Where & How To Buy
You can buy some of the bonds at your local bank but the best and easiest place to do it is through the government’s TreasuryDirect website. Setting up an account is fairly straightforward but be sure you get all the details right the first time. Making a change to your account will require a stamp from a bank official, which may be a pain to get if you’re working regular 9-to-5 hours at your job.
You can also buy paper bonds and convert them into electronic bonds, but having done that myself I have to say it was a little confusing. You have to create a Conversion Account that’s separate, but accessible, from your regular TreasuryDirect account. Then you have to create a manifest and mail in the paper bond with the manifest. It’s not impossible, but avoid it if you can.
Where & How To Sell or Redeem
So you have some savings bonds and you want to sell or redeem them, you have a few options based on what kind of certificates you have. Selling and redeeming a bond are two different things, though both result in the security or bond being taken away and replaced with money. Some of these investments, like TIPS, cannot be closed before they mature, so the only way for you to recover your money is to sell your TIPS. Some of these investments, like Series EE bonds, cannot be sold or transferred to another person, so the only way to recover your money is for you to redeem them. Now that we have that cleared up, here’s how you do either.
Electronic certificate: If you have an electronic bond you bought through TreasuryDirect, just log into your account and sell or redeem your bond through the website. In fact, if it’s a security, you don’t have to do anything because they will close the security and transfer the funds to your account. This is by far the easiest.
Paper certificate: If you have a bond, such as an I or EE bond, you can cash in your bond at most local financial institutions, call beforehand to confirm. You’ll need to bring some ID to prove it is yours. You can only redeem up to $1,000 in bonds at one time without having to subject yourself to further identification (beyond a driver’s license). Don’t sign the bond until you’re in the presence of a certifying officer at the bank and they should take care of the rest.
If you have a security, such as TIPS, you’ll have to sell it. To sell it, you’ll need to get your hands on a copy of the form “Security Transfer & Sale Request” from this page of Treasury forms. Sign the form in the presence of an “authorized certifying officer,” usually at a bank, and mail to:
Federal Reserve Bank of Chicago
Investment Division for Sell Direct
230 S. LaSalle St.
Chicago, IL 60604
At Chicago, the Federal Reserve Bank will sell your security to the highest bidder, deduct a $45 fee, and transfer the rest to your bank account.
Have you purchased any savings bonds or other Treasury securities?