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Treasurys for tricky times

Key takeaways

  • US Treasury securities remain a relatively low-risk source of income.
  • Relatively high interest rates make Treasurys more attractive than they've been in many years.
  • Treasury income is exempt from some types of taxes.

Bonds issued by the US Treasury have long been a popular choice for both institutions and individual investors. 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. Now, with interest rates back near historically normal levels, they also offer yields that are competitive with riskier assets such as stocks and corporate bonds. That may make this an excellent time to learn more about Treasurys and the role they could play in your income investing plan.

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.

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Three 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. Most financial planners recommend that you withdraw no more than 4% of the total value of your portfolio each year. As of July 15, 2023, it is possible to construct a portfolio of Treasurys of varying maturities that yields more than, or close to 4%. That means your portfolio's Treasury allocation may be able to support that withdrawal rate without eating into principal until your last Treasury bond matures.

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.

They 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. Yields are higher than they have been for a long time, but so is inflation. 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. However, over the past year, shorter-term Treasurys have been paying higher yields than longer-term bonds, due to investors' concerns about the direction of the economy. This unusual situation may increase the appeal of shorter-term bonds.

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.

That ability to offset unwelcome behavior from other assets in a portfolio may be even more valuable if the economy slows as it shows some signs of doing. Stocks, high-yield bonds and other more volatile types of investments have historically also 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, expects that history could well repeat in the next downturn. "I have bought 10-year Treasury bonds and 10-year bonds from good quality companies because they were yielding 4.25% to 7%. Even if you feel like there's a recession coming, these should be fine," he says.

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The views expressed are as of the date indicated and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments. The third-party contributors are not employed by Fidelity but are compensated for their services.

This information is intended to be educational and is not tailored to the investment needs of any specific investor.

As with all your investments through Fidelity, you must make your own determination whether an investment in any particular security or securities is consistent with your investment objectives, risk tolerance, financial situation, and evaluation of the security. Fidelity is not recommending or endorsing this investment by making it available to its customers.

Past performance is no guarantee of future results.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.

Lower yields - Treasury securities typically pay less interest than other securities in exchange for lower default or credit risk.

Interest rate risk - Treasuries are susceptible to fluctuations in interest rates, with the degree of volatility increasing with the amount of time until maturity. As rates rise, prices will typically decline.

Call risk - Some Treasury securities carry call provisions that allow the bonds to be retired prior to stated maturity. This typically occurs when rates fall.

Inflation risk - With relatively low yields, income produced by Treasuries may be lower than the rate of inflation. This does not apply to TIPS, which are inflation protected.

Credit or default risk - Investors need to be aware that all bonds have the risk of default. Investors should monitor current events, as well as the ratio of national debt to gross domestic product, Treasury yields, credit ratings, and the weaknesses of the dollar for signs that default risk may be rising.

Indexes are unmanaged. It is not possible to invest directly in an index.

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