U.S. Treasuries are securities that are issued by the United States government, which allow it to raise money to help cover the costs of operations and fund programs. These Treasuries are sold to investors, who are generally looking for the safest, lowest-risk investment available.
Treasuries come in the form of Treasury bills (T-bills), notes (T-notes), and bonds (T-bonds). T-bills are securities that have a short maturity span of up to a year. T-notes range from two to 10 years maturity rate, while T-bonds have a maturity rate of 30 years.
The options provided by these U.S. Treasuries, combined with Treasury Inflation-Protected Securities, Floating Rate Notes, Series I Savings Bonds, and Series EE Savings Bonds provide investors with government-backed investment options guaranteed to pay the face value when held to maturity. However, there are some risks involved, such as inflation and interest rate risk, but the risk is much less than investing in stocks and bonds on the market.
The Safest Investment
Treasuries are backed by “the full faith and credit” of the U.S. government, and, as a result, the risk of default on these fixed-income securities is next to nothing. Since the initial formation of the government in 1776, the U.S. Treasury has never failed to pay back its lenders.
The number-one reason U.S. Treasuries are considered to be safe investments is that when you buy a Treasury bill, bond, or note, you are guaranteed by the government to receive the face value of your investment, as long as you hold it to the maturity date.
Investors also tend to turn to T-bonds in times of economic recession. As prices fall during a recession, T-bond yields tend to increase. When the economy begins to recover and market interest rates go up, investors tend to turn away from T-bonds as prices fall.
However, the fact that a principal investment is protected does not mean that Treasuries are completely risk-free. In fact, holding Treasuries poses some very specific risks like inflation risk, interest rate risk, and opportunity cost.
Inflation Risk
If the inflation rate rises, the value of Treasury investments may decline. This is called inflation risk. Consider, for example, that you own a Treasury bond that pays interest of 3.32%. If the rate of inflation rises to 4%, your investment's rate is not keeping up with the rate of inflation. To put it another way, the value of the money you invested in the bond is declining. You’ll get your principal back when the bond matures, but it will have less purchasing power than when you invested it.
One way of minimizing this problem is to invest in TIPS—a Treasury Department investment vehicle called Treasury Inflation-Protected Securities. Alternatively, you could invest in mutual funds holding TIPS.
Interest Rate Risk
The second risk of holding Treasuries is interest rate risk. If you hold the security until maturity, interest rate risk is not a factor. You’ll get back the entire principal upon maturity. But if you sell your Treasury before it matures, you may not get back the amount of money you invested.
Remember, bond prices have an inverse relationship to interest rates. When one rises, the other falls. For instance, if you purchased a 4% Treasury note two years ago, interest rates may have risen, with a similar Treasury note paying 5% interest. The 4% Treasury note will sell at a discount and likely won't return all of the principal originally paid.
The 4% note will be discounted until the current yield equals or is very nearly equal to the 5% interest paid on similar Treasuries being issued. Depending on the interest rate difference, this can result in a substantial loss of principal.
Opportunity Cost
Treasuries are so safe that they don’t have to pay much to attract investors. As a result, the yields on Treasuries often fall short of the yields on even very safe, AAA-rated corporate debt (a Standard & Poor's credit rating—AAA is the highest). This doesn’t cause a loss of capital, but it could cost you the opportunity for a higher return on another investment.
This is called an opportunity cost, the difference between what you earn from an investment and what you could have earned if you had invested in something else. The lost opportunity cost of keeping more than small amounts of cash in a savings account, for example, is generally considered too high for nearly all investors.
Treasuries have higher interest rates than a savings account. Often, they don’t pay much more than a savings account rate. If you invest in Treasuries, more often than not you could have profited more with another safe bond investment. This is one of the biggest risks for Treasuries investors—that in being too afraid of risk, they've invested too heavily in low interest-rate Treasuries.
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Article initially published on thebalance.com
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