U.S. Treasury securities ("Treasuries") are debt securities issued by the U.S. Treasury Department (a branch of the U.S. government) to finance the government's operations and programs. Investors who buy and own Treasuries are, in effect, lending money to the U.S. government until the maturity dates of the securities.

In return, the Treasury Department makes guaranteed interest payments on the loans to the debt holders and guarantees full repayment of the face amount of the debt securities (their "principal") to their owners. These guarantees of interest payments and principal repayment are backed by the "full faith and credit of the U.S. government"-the government's ability to generate tax revenue and print currency. The Treasury Department has never defaulted (failed to pay interest and repay principal when due).

Little or No Credit Risk (Lowers Interest Rates)

That's why Treasuries are widely considered the safest of all investments. They are viewed in the financial markets as having little or no credit or default risk because of the high probability that investors will receive their interest and principal payments on time.

This unique level of safety means that the interest rates and yields for Treasuries are generally lower than for other debt securities, such as corporate bonds, that have higher default risks (generally, the greater the risks, the more interest or yield investors demand/require).

Easily Bought and Sold (also Lowers Interest Rates)

Another important factor that increases investor demand for "marketable" Treasuries (raising their value and lowering their interest rates and yields) is their high liquidity-they are very easily bought and sold in the securities markets and are heavily traded. Because Treasuries trade so frequently in large volume, the transaction costs are lower than for other securities. Not all debt securities have this key benefit.

In fact, not all Treasury securities are actively traded in the securities markets-some are described as "non-marketable" Treasuries, which are issued directly to subscribers and cannot be transferred through market sales. The best-known of these non-marketable Treasuries are U.S. savings bonds.

Types of Marketable Treasuries (based mainly on maturity)

Most marketable Treasuries can be divided into four categories:

  1. Treasury bills (T-bills)
  2. Treasury notes (T-notes)
  3. Treasury bonds (T-bonds)
  4. Treasury Inflation Protected Securities (TIPS)
T-bills mature in 12 months or less. They do not pay interest prior to maturity; instead they are sold at a discount (priced less than their face value) with the interest rate factored into the difference between their discounted purchase price and full value at maturity. Many regard T-bills as the least risky investment available to U.S. investors. They meet short-term investment or saving needs similar to money market funds, certificates of deposit, and savings accounts. They can provide a "parking place" for money an investor may need quickly for an emergency or other purposes. The T-bill market is even more liquid than the Treasury market in general; investors can quickly convert T-bills to cash through a broker or bank.

T-Notes mature in two to 10 years. They pay interest every six months, and are commonly issued with maturities of two, three, five, or 10 years. These notes can be purchased to match specific future expenses at their maturity date, such as college tuition, or used to generate cash during retirement. The 10-year Treasury note yield has become the yield most frequently quoted in the financial media when discussing the performance of the U.S. bond market and is used to convey the market's take on economic growth and inflation. It's also used as a benchmark for long-term mortgage interest rates.

T-Bonds have the longest maturity, 30 years. They pay interest every six months, like T-Notes. Also like T-Notes, T-Bonds can be purchased to match specific future expenses at their maturity date or used to generate cash during retirement.

TIPS are the inflation-indexed bonds issued by the U.S. Treasury. Their principal is adjusted to the Consumer Price Index, the most widely-used measure of U.S. inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-, 10- and 20-year maturities.

Treasuries' Role in Investment Portfolios

Because the payments from Treasuries are so predictable, many people invest in these securities to preserve capital and to receive a dependable income stream-to help meet living expenses during retirement, for example, or to fund specific objectives, such as paying for a college education.

The predictability of Treasuries is enhanced by the fact that they generally do not have "call" provisions. Call provisions, common in municipal and corporate bonds, permit the issuer to pay off the bond in full when interest rates decline; the issuer can refinance its debt to obtain lower prevailing interest rates, just like home owners can refinance mortgages when rates fall. When calls occur, bond investors are forced to reinvest their money at lower interest rates. On the other hand, investors who own Treasuries with no call provisions know exactly how long their current income stream will last.

Another advantage of Treasuries is that they are available with a wide range of maturity dates. This allows investors to structure portfolios to specific time horizons. Some investors strive to structure their bond portfolios to reduce market risks (see below) and take advantage of market opportunities. One such strategy is called "laddering," in which the portfolio is structured so that securities mature at regular intervals, allowing the investor to make new choices with available cash.

An added benefit of Treasuries is that their interest payments are exempt from state and local income taxes (but not federal taxes). This has the effect of increasing the after-tax benefits of these investments. Investors in high-tax states should take special note of this benefit.

Market Risks of Treasuries

Although Treasuries are considered free from credit risk, they can be affected by other types of risk, especially interest-rate and inflation risks, if they are sold prior to maturity. While investors are effectively guaranteed to receive interest and principal as promised, the underlying value of the securities may change prior to maturity, depending on the direction of interest rates.

As with all fixed-income securities, if interest rates in general rise after Treasuries are issued, the value of the Treasuries will fall, since bonds paying higher rates will come into the market. Similarly, if inflation increases, the value of fixed interest rate payments declines. TIPS were created to help address inflation risk, but it's important to remember that TIPS, like all other Treasuries, are still susceptible to interest-rate risk.

Finally, Treasuries, like all things that are bought and sold, are affected by the laws of supply and demand, which can push market interest rates and prices up and down. For example, during recessions and other periods of heavy government spending, the Treasury will need to issue more debt, and the supply of Treasuries will increase, putting upward pressure on yields and downward pressure on prices. Or, when stock markets crash and investors seek safety, heavy demand for Treasuries can push up prices and drive down yields.

These price and yield movements aren't as relevant when investors hold Treasuries until maturity (when full repayment is guaranteed), but they become much more so if the securities need to be sold prior to maturity to meet financial needs.