The trickiest part of investing is finding the right fit between what an investor owns in his portfolio and how he feels when it goes up and down in value. Treasury bonds occupy the "safe" part of portfolios. But they're not for everyone. Investors need to understand the pros and the cons of these investments to truly utilize them in their investment strategies.
What Are Treasury Bonds
To finance its operations, the U.S. Government frequently borrows money from investors for varying periods of time: from under one year (treasury notes), up to 10 years (treasury bills) and from 20-30 years (treasury bonds). In return for such a loan, the U.S. Government is on the hook to both pay back the loan at the end of its life as well as make periodic interest payments to the bondholder. The interest rate paid on these bonds rises and falls along with interest rates fixed by the Federal Reserve Bank. Investors can purchase pieces of these loans, denominated in increments of $1,000. Treasury bonds can be bought at auction directly from the U.S. Treasury at TreasuryDirect. Stock brokers offer access to these bonds as well (keep in mind you may pay more if you buy them through an intermediary).
How Investors Get Paid
Treasury bonds make periodic payments to their holders. Twice a year, they pay their owners half of the yearly interest payments. Forexample, if an investor owned one treasury bond ($1,000) at 1% interest, she would receive semi-annual payments of:
$1,000 X 1%/2 = $5
Pros Of Investing In Treasury Bonds
Safety: When financial professionals begin describing different investment options and how risky they are, treasury bonds are in a category all their own. While bonds are generally considered safer than stocks, treasury bonds are described as "risk-free." The likelihood an investor loses all his money in a treasury bond is remote -- it would take the U.S. Government defaulting on its debt.
Diversify Away From The Stock Market: The stock market has been a good investment for investors over the long run, averaging almost 10% per year from 1926 - 2008. Over the short run, though, it can be disastrous. To protect themselves from market volatility, investors can add treasury bonds to their portfolios which provide a smaller return (5.7% over the same period) without the big swoons.
Slightly Better Than A Standard Savings Account: Banks pay interest on savings deposits, but because those funds can be withdrawn at any time, banks pay relatively low interest rates to their clients. Treasury bonds are longer term investments and in return for locking up your money, the Treasury generally pays interest rates above those of standard savings accounts.
Easy To Understand: Treasury bonds make sense. Wall Street is extremely creative in creating exotic investment products. Treasury bonds hearken back to a period of investment simplicity. The U.S. Government borrows your money and agrees to pay you back a fixed amount of interest in return.
Treasury Bonds Are Liquid: While T-bonds are designed for long-term investors, there's a pretty healthy secondary market for them. So if an investor needs to sell for whatever reason, he can probably find a buyer.
Predictable Income Stream: When deciding to purchase treasury bonds as part of a financial plan, investors know exactly what they're going to get. Interest payments don't fluctuate. Many investors and financial planners use treasuries as part of bond ladders, a strategy of buying bonds with incremental maturity dates. Investors can create a portfolio that matures at specific dates in the future when they might need it (college for the kids, buying a home, retirement spending).
Cons Of Investing In Treasury Bonds
Current Low Returns: An investor willing to lock up her money for 30 years by purchasing a treasury bond today would see a return of around 3% per year over the life of the investment. In return for the safety and predictability of a T-bond, investors have to give up a lot of upside potential in today's low interest rate environment.
Inflation Is A Silent Killer: Like high blood pressure, inflation is the silent killer of investment returns. Inflation chisels away at the value of money. Investors need to focus on the real returns of their portfolios -- how much money they're returning above inflation. With their low risk,low return profile, treasuries don't always perform better than inflation. In fact, inflation has recently averaged 3% a year so right now treasuries are losing the inflation battle.
Sovereign Risk: T-bonds are considered risk-free because of the credit quality of the U.S. Government. The U.S. can always print more money. But is investing in the U.S. Government really risk free? There are credible economists who believe that a U.S. default on its debt is not impossible.
Treasury bonds inject a sense of security and predictability into investment portfolios in a world that seems increasingly chaotic. But there's a price to be paid for smoothing out the ride. With returns dipping below inflation and the future possibility of real financial trouble for the U.S. Government , treasury bonds have some inherent risk.