U.S. Treasury Securities
The history of U.S. public debt dates back to revolutionary times. To support war efforts, many states issued debt certificates, bonds and other forms of IOUs. Unfortunately, by the end of the war most states were unable to meet their financial obligations. In 1789, Alexander Hamilton, the first U.S. Secretary of the Treasury, wrote a proposal in which he outlined the plan for the federal government to pay off the states’ obligations and to fund new national debt. More than two centuries later, U.S. government bonds are considered to be high credit quality investments and regarded as the benchmark against which other securities are measured.
On August 8, 2011, as expected, S&P also lowered ratings on related issues, including Fannie Mae and Freddie Mac.
S&P Downgrade of United States’ Long-Term Credit Rating
On August 5, 2011, Standard & Poor’s announced that it has lowered its long-term sovereign credit rating on the United States of America to ‘AA+’ from ‘AAA’ and affirmed the ‘A-1+’ short-term rating. The outlook on the long-term rating is negative. Standard & Poor’s also moved the short- and long-term ratings from CreditWatch negative. On August 2, 2011, the U.S. government’s ‘Aaa’ bond rating was confirmed by Moody’s with a negative outlook. More about ratings is available at standardandpoors.com, moodys.com and fitchratings.com.
On August 8, 2011, additional releases will be issued by Standard and Poor’s “concerning affected ratings in the funds, government-related entities, financial institutions, insurance, public finance, and structured finance sectors,” according to its Research Update issued on August 5, 2011.
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 imbedded “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.
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. 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 of 30 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 every six months to reflect changes in the Consumer Price Index (CPI). 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.”
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 STRIP. The unique nature of these securities requires thorough understanding of their features, risks and benefits.
Investment Risks
Unlike other fixed income investments, U.S. Treasury securities are backed by the full faith and credit of the government, assuring investors of timely interest and principal payments.
Market prices of fixed income securities may be affected by several risks, including without limitation: interest rate risk - a rise (fall) in interest rates may reduce (increase) the value of your investment, default or credit risk - the issuer’s ability to make interest and principal payments, and liquidity risk - the inability to sell bonds promptly prior to maturity with minimal loss of principal.
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. Investors should consult a professional tax advisor for additional details.
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 professionals.
U.S. government securities 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 the Treasury’s Bureau of the Public Debt at publicdebt.treas.gov and Securities Industry and Financial Markets Association at investinginbonds.com.