What you need to know about the risks of fixed income investing.
For many Americans, there comes a time when supplementing earnings with income from a reliable source can assure that life’s financial needs are being met. In this case, investors look to U.S. Treasury securities, which provide dependable, steady cash flow and preserve invested principal, if held to maturity. In general, bonds serve as a solid foundation upon which a successful investment portfolio may be built. The embedded “safety” of government bonds, certainty of income stream and a variety of maturities may help investors meet current and future financial needs, including, but not limited to, education funding and retirement planning.
What are U.S. Treasury Securities?
When investors buy Treasury bills, notes and bonds at auction, they are lending money to the U.S. government. Treasury securities are issued in a wide range of maturities, from four weeks to 30 years. Generally, they are non-callable and the interest payments are exempt from state and local taxes – especially important for investors residing in high-tax states. Because of their safety advantage, government bonds pay relatively lower interest rates than other fixed income securities.
The current market size of marketable U.S. Treasury securities is more than over $22 trillion. Marketable securities are those traded on the open market. Generally, the U.S. Treasury debt market is considered very liquid as it provides the highest degree of pricing and trading efficiency. Nevertheless, there may be times when liquidity is affected by various market conditions.
Types of U.S. Treasury Securities
Bills are short-term investments with maturities of less than one year. Like other zero-coupon bonds, bills are generally sold at a discount from par value.
Notes are intermediate-term investments with maturities from two to 10 years at the time of issuance. These securities have a stated interest rate, make semi-annual payments, and may be purchased to meet future expenses or provide additional retirement income.
Bonds are long-term securities with maturities greater than 10 years. They pay interest semi-annually and may be used for supplemental income, retirement and estate planning.
TIPS, or Treasury Inflation-Protected Securities, are notes and bonds intended to provide inflation protection. The principal is adjusted daily to reflect changes in the Consumer Price Index (CPI-U). A fixed coupon rate is paid on the adjusted principal. Since the interest is paid on the adjusted principal, the semi-annual payments may fluctuate. At maturity, an investor receives either the higher adjusted principal (usually during inflationary periods) or the face value (usually in deflationary periods), whichever is higher. In either case, an investor is protected against shifting inflation rates. In return for inflation protection, investors agree to receive slightly lower interest rates. For more information, read “TIPS – Treasury Inflation-Protected Securities.”
U.S. Treasury floating rate notes (FRNs) are debt instruments that have a floating coupon payment. The rate is pegged to the 13-week Treasury bill discount rate. FRNs pay interest and adjust payments quarterly and carry a two-year maturity. FRNs are traded in the secondary market as well. The security’s floating-rate feature will likely keep price volatility low as the coupon rate adjusts with interest rate changes. FRNs are tied to short-term interest rates and therefore may or may not reflect longer-term interest rate movement.
STRIPS, or Separate Trading of Registered Interest and Principal of Securities, are a special kind of Treasury bond created by a process called “coupon stripping.” Principal and interest are separated and sold individually as zero-coupon bonds at a discount from their par value. For example, stripping of a 15-year bond will result in 30 coupon STRIPS and one principal STRIPS. The distinct nature of these securities requires a thorough understanding of their features, risks and benefits.
Investment Risks
Unlike most other fixed income investments, U.S. Treasury securities are backed by the full faith and credit of the government, assuring investors timely interest and principal payments. The market value of these securities is affected by interest rate and inflation risks, and is subject to credit rating changes, among other factors.
Interest rate risk
During the life of a bond, its market value may change depending on the direction of interest rates. Bond prices and interest rates enjoy an inverse relationship. This means that after a Treasury bond is issued, if interest rates rise, its market value will fall because newly-issued higher coupon bonds will be in greater demand. On the other hand, if interest rates fall, the older Treasuries with higher coupon rates will become more attractive and their prices will rise. So, if bonds are sold prior to maturity, the proceeds received may be more or less than the invested principal (at a profit or loss). Zero coupon bonds, such as STRIPS, may have higher price fluctuations since there are no regular interest payments. Investors who hold Treasury bonds until maturity will receive back the full face value.
Taxation
Interest income from Treasury securities is subject to federal income tax but exempt from state and local taxes. Income from Treasury bills is paid at maturity and, thus, tax-reportable in the year in which it is received. Although not paid until maturity, income from zero-coupon STRIPS is taxable in the year in which it accrues. Increases in TIPS principal value as a result of inflation adjustments are taxed as capital gains in the year they occur, even though an investor does not collect these gains until TIPS are sold or mature. This is known as a “phantom income” tax. Conversely, decreases in the principal amount due to deflation can be used to offset taxable interest income from other investments.
How to Buy and Sell Treasury Securities
Treasuries are generally sold and bought through an investment company or a commercial bank. Investors may participate in a Treasury auction to purchase new government securities. The auctions are conducted on certain days of the week, depending on the offering. Many broker/dealers maintain secondary markets for Treasury securities. Investors wishing to sell or buy previously issued securities may do so through the secondary market.
Whether buying a new or secondary offering or needing to sell prior to maturity, investors should consult their financial and tax professionals.
U.S. government securities may offer many benefits, including high credit quality, predictability of interest income, liquidity and tax advantages – all to help meet the needs of risk-conscious investors and enhance the performance of their portfolios. For more information about these investment alternatives visit treasurydirect.gov and Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds.
Investing involves risk and you may incur a profit or a loss. The value of fixed income securities fluctuates and investors may receive more or less than their original investments if sold prior to maturity. Bonds are subject to price change and availability. Investments in debt securities involve a variety of risks, including credit risk, interest rate risk, and liquidity risk. Investments in debt securities rated below investment grade (commonly referred to as “junk bonds”) may be subject to greater levels of credit and liquidity risk than investments in investment grade securities. Investors who own fixed income securities should be aware of the relationship between interest rates and the price of those securities. As a general rule, the price of a bond moves inversely to changes in interest rates. Diversification does not ensure a profit or protect against a loss. Past performance is no assurance of future results.
The information contained herein has been prepared from sources believed reliable but is not guaranteed by Raymond James & Associates, Inc. (RJA) and is not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Trading ideas expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Investors are urged to obtain and review the relevant documents in their entirety. RJA is providing this communication on the condition that it will not form the primary basis for any investment decision you may make. Furthermore, because these are only trade ideas, investors should assume that RJA will not produce any follow-up. Employees of RJA or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. RJA and/or its employees involved in the preparation or the issuance of this communication may have positions in the securities discussed herein. Securities identified herein are subject to availability and changes in price. All prices and/or yields are indications for informational purposes only. Additional information is available upon request.
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