As the Federal Reserve pushed up interest rates to fight inflation, bonds issued by the US Treasury offered investors an opportunity to earn increasingly attractive yields with very little risk. But now that the Fed is cutting rates, is the opportunity in Treasurys over?
Not necessarily.
In fact, since the Fed announced its rate cut in mid-September, yields on many Treasurys have actually risen. That surprising fact means it still may be a good time for income-seeking investors to consider Treasurys and the role they could play in their investing plan.
The rise in Treasury yields despite the Fed's rate cut shows that other factors besides interest rates can affect yields. Bonds are bought and sold in the market each day, and their yields and prices move up and down in opposite directions. That means, for example, when traders and investors are fearful that an economic slowdown is approaching, demand for Treasurys may rise and that demand pushes up prices and pushes down yields. However, if investors and traders believe the economy is likely to keep growing for a while, they may sell Treasurys and seek opportunities in other investments, causing Treasury prices to fall and yields to rise in the process.
What are Treasurys?
Treasurys are bonds issued by the US government, specifically the Treasury department. Each bond represents a loan by the buyer of the bond to the government to help pay for its operations and the services it provides. In return for making the loan, the bond buyer receives a promise from the government to repay the loan, plus interest at an agreed-upon date in the future.
3 Types of Treasurys
If you want to loan some money to Uncle Sam in return for his promise to pay you back with interest, you can choose from 3 types of Treasury securities: Notes, bonds, and bills. Notes and bonds differ only in name and in the length of time before you get your money back. Notes are available with maturities ranging from 1 to 10 years while bonds can have maturities of as long as 30 years. Both pay you interest every 6 months at a rate that is set at the time you buy the bond. Even if rates on newly issued notes or bonds rise or fall during the time you own your Treasury security, the rate you were promised when you bought it will remain unchanged.
The Treasury also sells securities called Treasury bills that do not pay interest on a regular basis. Instead, they are sold at prices below their face value (also referred to as "par value") and buyers receive the full face value when the bills mature in 4 to 12 months. Bills are also known as Original Issue Discount (OID) bonds, since the difference between the price at issuance and the face value at maturity represents the total interest paid in one lump sum. Treasury bills may be attractive to some investors because the lump-sum payments eliminate the need to keep track of regular coupons.
Why Treasurys?
If you seek a low-risk way to earn reliable income, Treasurys may play a role in your income strategy. Because they offer very low risks of default and reliable interest payments, they can simultaneously protect your capital, pay you income, and reduce your exposure to—and anxiety about—volatile stock markets.
Treasurys and taxes
Interest income from Treasury bonds is exempt from state and local income taxes, but subject to federal income taxes. There may also be tax consequences when you sell Treasurys that you bought on the secondary market. If you buy a bond for less than face value on the secondary market and either hold it until maturity or sell it at a profit, the gain will be subject to federal and state taxes. This is different than buying a Treasury bill at Original Issue Discount (OID). When a bond is sold or matures, gains resulting from purchasing a bond at a discount in the secondary market are treated as capital gains while OID gains are taxed as income.
Are Treasurys risky?
Treasurys are considered low-risk investments because they're backed by a promise from the US government to repay the bond's face value amount plus interest. That promise in turn is backed by the government's ability to raise the money necessary to make those payments through taxes, as well as by the relative strength of the US economy.
Treasurys are also some of the most widely traded of all securities. That makes it easy to buy and sell them at the price you expect to pay or receive, which is not the case for some other types of bonds. Bear in mind, though, that Treasury prices in the market are always changing and you could lose principal if you sell your Treasury bonds before they mature.
Inflation is also a concern for those who look to Treasurys for income. Inflation has come down recently, but may rise over the longer term. If you want the benefits of Treasurys but believe that inflation is likely to remain high, or even increase, you may want to consider Treasury Inflation-Protected Securities (TIPS), whose yields adjust based on changes to the Consumer Price Index.
How to add Treasurys to your portfolio
If you’ve decided that you want Treasurys, your next decision may be what kind of Treasurys to buy. As with other types of bonds, one of the most important differences among the various types of bonds is the length of time before they mature. Typically, bonds with longer maturities pay higher yields as compensation for the fact that they lock up your cash for a longer period of time. Over the past 2 years, shorter-term Treasurys have been paying higher yields than longer-term bonds, but that unusual situation appears to be changing.
Richard Carter, Vice President for Fixed Income Products and Services explains, “We appear to be returning to the normal situation where you can receive a relatively higher yield for longer-term maturities than shorter ones. This normalization could result from either short-term yields falling or long-term yields rising—or a combination. Nobody knows exactly how it will play out.”
Besides the question of which maturities you may want, you'll also need to consider whether to buy newly issued individual bonds from the US Treasury, existing individual bonds in what is known as the secondary market, or shares of a mutual fund or ETF that holds Treasury bonds.
Newly issued bonds are offered at regularly scheduled auctions held by the Treasury. The price you pay—and the yield you receive—of a new-issue Treasury bond reflects what others are paying at the auction and may differ slightly from what you may have expected to pay and receive.
If you don’t want to wait for the next scheduled auction of new bonds, you can buy existing bonds. If you choose the secondary market, you’ll receive a quote that tells you the price you will pay and the yield you will receive. Whether you choose new or used, Treasury securities are backed by the full faith and credit of the US government and both types of orders can be placed through Fidelity.
You can also get exposure to Treasury securities through mutual funds and ETFs whose managers buy and sell Treasurys in the course of managing these funds. Many funds use Treasurys to provide ballast for their overall volatility and offset exposure to potentially higher-yielding but more volatile bonds and stocks.
Longer-maturity Treasury bonds also may help you sleep at night by delivering reliable income and diversification when the economy eventually slows. Stocks, high-yield bonds, and other more volatile types of investments have historically struggled when economic conditions have worsened, while Treasurys and other high-quality bonds have performed better. Jeff Moore, manager of the Fidelity Investment-Grade Bond Fund (