Looking to take advantage of 5% Treasury Bond rates? We talk about what you need to know before you go to your broker. We will cover all you need to know to buy Treasury Bonds at your broker. We will discuss the different treasury bond types as well as compare them to CDs. Lastly, we will discuss accrued interest which is unique to bond trading.
Treasury Bond Types
There are categories of bonds offered by the Treasury, these are summarized as follows.
Broadly speaking, these are the characteristics to consider for Treasury Bonds.
- Fixed rate or Variable rate (the interest paid on the bond)
- Short, Medium, or Long Term (A few weeks to 30 years).
- Fixed price (savings bond) or market priced.
- Non-callable, Buybacks
Treasury debt is very similar to bonds available in the private market (corporate debt). In private bond markets, debt instruments can be callable, which means that the lender can call in the debt before it matures. Treasury debt isn’t callable, but the Treasury does have the ability to buy back debt of its own choice over time.
Savings Bonds
For most people their introduction to Treasury Bonds is through savings bonds. Savings bonds are very similar to CDs, bank accounts, and money market accounts. All of these investments do not have a market price. This means that if you buy $10K of bonds today, you can sell them or redeem them and get your $10K back at any time.
The savings bonds offered by the Treasury are Series EE bonds (which are fixed rate) and Series I bonds (which are variable rate determined by inflation rates). We won’t cover savings bonds in this article. Savings bonds can be purchased at the Treasury directly, not at your broker. We are not dissuading you from buying these bonds, but there are a few problems with them. First, the Series EE/I bonds have interest rates lower than current rates available today. Also, for the Series I bonds it is not possible to predict what interest rate they will have since they are variable rate.
In both of these cases, you can only buy $10K of these bonds each year on the website. This limits your ability to invest large amounts of money in them. Other types of Treasury Bonds at your broker essentially have no trading limit.
Market Priced Bonds
When you think of Treasury bonds, you are likely talking about fixed rates bonds that pay coupons over a time frame, then the bonds mature. The category of these bonds consists of the first (3) bonds in the table below: Bonds, Bills and Notes.
As of this writing, market priced treasury bonds are yielding 5% or more. These are more attractive than savings bonds or typical savings accounts due to the higher interest rates. The table below from Charles Schwab provides a recent summary of the bond yields available.
These treasury bonds offered for sale on the secondary market are market priced bonds. Market priced bonds can increase or decrease in value, meaning if you sell before they mature you can lose money. If you hold these bonds to maturity, you get all your money back, they are among the least risky assets in the world.
Treasury Bills are unique in that they don’t pay coupons over their term, only at the end when they mature. Another name for these bonds is ‘Zero Coupon’. These bonds are often resold on the open market at virtually any point during their existence.
What You Need To Know About Bonds/Bills/Notes
Let’s talk about what details you need to know about bonds before you start buying them. The table below lists out the characteristics for each bond type. We have thrown in there a CD to provide a useful comparison.
All of these securities are identified with a CUSIP – a unique identifier that is registered with the SEC (Securities and Exchange Commission). This can be useful for tracking – the CUSIP identifies the security regardless of what broker you use.
Certificates of Deposit (CDs)
The details about CDs are simpler, let’s start with that.
When you buy a CD, you get interest at its stated yield. In the example above, a 5% CD will pay you 5% interest over its term (in this case 3 months). Because the coupon rate is annualized, you would only get ¼ of that or about 1.25% when the CD matures 3 months later. This means that a $10K investment would pay about $125 of interest during the three months.
There is another annualized measure called APY – annual percentage yield. This measure tells you what the CD would earn if you reinvested the CD and all its interest for a year. The CD would yield 5.1% – which is higher than 5% – accounted for by the interest that was reinvested.
Bonds
Let’s review a bit more about Treasury Bills versus Bonds/Notes.
Treasury Bonds/Notes pay coupons. In the bond world, time is money. Whoever owns the bond is entitled to coupon payments. But what if the bondholder sells before he gets a coupon? The bondholder earns what is called accrued interest. This is simply a payment you make to the old bond holder that credits him for the time he owned the bond, but didn’t get a coupon. We will review this in more detail in a later section.
Treasury Bills have no coupons, so there is no accrued interest. The old bond holder would need to get credited for his interest in the bond price itself when he sells.
There is additional characteristic unique to Treasury Bills, called Original Issue Discount (OID). The OID is the initial bond price upon issuance that defined its interest rate, as a discount below face value. In the Treasury Bill above it was a 1 year term, so its interest rate was Face Value/OID, or 100/97 – about 3.1%.
In both of these cases, you will note that the coupon yield isn’t anywhere near 5%, as it was for the CD. The measure you need to pay attention to is the YTM – yield to maturity.
Treasury Bond YTM – Example
The CD example was pretty straight forward – you earned the interest at the same rate as the coupon yield. With bonds, however, this same calculation does not apply. For the Treasury Note listed above, it has 3 months left, has a coupon yield of 2.75% and yet yields 5.1% (YTM).
Why?
The reason is that the bond trades at a discount to its face value. This discount adds to the return as a “gain” instead of as interest. Let’s take a close look at the following bond to understand why.
In the above example, we have a bond that yields 2 1/8%. Since it trades below face value, the current yield is a little higher at 2.14%. The bond trades at a discount of 99.2 versus its face value of 100.
That 0.8% gain increases the return on the bond.
The YTM calculation is very complex and we won’t discuss it here. We will give you a more direct answer for bond yield that is simpler to understand.
The total gain for the bond is equal to the current yield plus the gain realized by buying it below par. However, the 0.8% gain, which is the difference from face value to purchase price (100-99.2) is only for 3 months. The YTM is an annualized measure, so we multiple that gain by 4, getting us to 3.2%. This gain is added to the 2.14% coupon yield getting us an effective yield of 5.34%. This is a simple explanation on how these measures differ.
Accrued Interest
When you buy a coupon bond (Notes/Bonds), you might see an additional cost called accrued interest. We briefly mentioned accrued interest, let’s go into this a bit more.
Accrued interest doesn’t affect your bond return – it essentially provides the old bond holder with their coupon for the time they owned the bond. The graphic below summarizes how accrued interest works.
The bond above pays 5%, or about $21/month. However, the bond only pays twice per year. In this example, you bought the bond on April 1st, but the coupon doesn’t arrive until June.
What happens?
As the new bondholder you will get the $125 coupon on June. However, you didn’t own the bond for 6 months, so you will pay the old bondholder $63 to compensate them for the time they owned it from Jan 1st to Apr 1st. You would see $63 added to the cost of your bond when you checkout at your broker.
Summary
When buying Treasury Bonds at your broker, these are the key points to understand:
- Treasury Bonds trade at a market price, unlike savings bonds, CDs and bank accounts. This means that you could lose money on these bonds if you sell them before they mature.
- Treasury bonds can either pay coupons along the way, or at maturity.
- The coupon yield of the bond doesn’t tell you about the total return of the bond. Use YTM (yield to maturity) to get the total return picture.
- Treasury bonds sometimes require you to pay accrued interest to previous bond holder. This payment does not affect your bond return.