How Do Treasury Bonds Work

The name is bond, treasury bond! However, unlike Fleming's 007 who pulls off all sort of risky stunts, this bond is the most risk free investment you can make. They are low yield bonds, but returns on them are guaranteed by none other than the treasury of the US government. How do treasury bonds work? To answer this question, first let us define and understand what we mean by a 'bond'.

What are Bonds?

A bond is a like a loan, it is an agreement between a lender and a borrower. It says that the borrower will pay an interest on the principal amount periodically and return the full amount in due time. The interest rate of a bond is called the 'coupon rate' and the period after which the principal amount has to be returned is called 'maturity'.

Many institutions issue bonds like they issue stocks. The issuing institution needs to raise money for an investment and so it borrows money from investors. It promises a periodic interest return, till the maturity period expires. Thus a bond is much like a stock in nature but yet very different because unlike stocks, bonds do not give an equity share of the company to the investor and they have a fixed maturity period. So a bond is a purely time bound investment in a company with fixed periodic interest returns. There are many types of bonds which vary in their terms and conditions of maturity and interest rate. The bond market is one of the biggest trading markets in the world with turnover in billions.

What are Treasury Bonds?

A treasury bond is a special type of bond. It is issued by the US government to raise money for their own initiatives. So when you buy one, you are loaning to the US government. The credentials of the US government as a borrower are beyond question. Rather, if you can't trust the US government to pay back the money, whom can you trust? The maturity period of a US government bond is in excess of 7 years and ranges up to 30 years. The interest rate amount is strictly paid bi-annually, that is paid every six months. Calling a bond is an option that the issuer of the bond has by which he can return the bond premium amount along with interest before maturity. In the case of treasury bond, the issuer is the US government. This option of calling the bond is mostly not available for these bonds anymore. It is still available for certain old bonds available in secondary market and it can be exercised within 5 years of the maturity date. The treasury bonds are issued in various denominations. A denomination is the amount you want to buy. The amounts of denominations range from $1000 to $1 Million.

The best feature of a treasury bond is that it is not taxed by the federal government of USA. The bonds are sold through an auction by the government. If the bidding is competitive, the maximum amount that can be purchased is $5 Million. However, if the bidding is non-competitive, the maximum amount of bond purchased by a bidder can be only 35% of total amount offered. In a non-competitive bid, the bidder has no control over the price of the bond, which is pre-set and has to be accepted, as it is.

Post auction, the bonds can be resold in the secondary market at a higher price, which is called selling at a 'premium' or could be sold at a lower price which is called selling at a 'discount'. There are two values of a bond, the 'face value' and the 'price value'. The face value is the original agreed buying price from which the coupon interest rate is calculated. The price value is the price at which the bond is sold in the secondary bond market.

Example of How a Bond Works

Enough of pure 'bond' theory, let us understand how a bond works through an example. Say, you have bought a treasury bond at face value of $1000, at a coupon interest rate of 6%, at an auction and it has a maturity period of 10 years. If you have no plans of its resale in the secondary market and are happy with the bi- annual return of $30, then your annual return will be $60. Considering you will get paid $60 a year, your income over 10 years uptil maturity will be $600.

Suppose, you do not buy the bond at the auction and buy it second hand in a 'secondary' bond market, at a price of say $1200. Then you have bought the bond at a premium and your coupon interest earned will still be $60 a year. However your yield will be 5 % as you bought it at a premium. If on the other hand, you bought the bond at $800, then your yield will be 7.5% as you bought the bond at a discount. Yield is calculated from the price value which fluctuates according to the demand and supply in the market. Yield percentage is calculated so that, no matter what the price at which the bond is resold, the coupon amount remains the same. So, the profit for a reseller of a treasury bond is the coupon interest accrued till he sells it plus the extra profit he makes if the bond is sold at a premium.

The treasury bonds thus give you two different opportunities. If you are not interested in trading in the bond market, just hold on to your bond and quietly collect your coupon interest. If you are a bounty hunter, who wants more and is interested in trading, the bond market is open for you. They are the safest bet in recession times as the risk factor is very low. Thus if you are looking for a long term investment with modest but assured returns, treasury bonds are the choice for you!