US Treasury Bonds

HISTORY LESSON:
The U.S. government knew that the costs of World War I would be great, and the question of how to pay for the war was matter of intense debate. The resulting decision was to pay for the war with a balance between higher taxes and government debt. Traditionally, the government borrowed from other countries, but there were no other countries from which to borrow in 1917: U.S. citizens would have to fully finance the war through both higher taxes and purchases of war bonds. The Treasury raised funding throughout the war by floating $21.5 billion in 'Liberty bonds.'

TYPES
A United States Treasury security is a government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries. There are four types of marketable treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation Protected Securities (TIPS).

Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. Many regard Treasury bills as the least risky investment available to U.S. investors. Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year).

Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment every six months, and are commonly issued with maturities dates of 2, 3, 5, 7 or 10 years, for denominations from $100 to $1,000,000.

Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from twenty years to thirty years. There are 2 types, a coupon bond with payment every six months like T-Notes, or a without a coupon called a zero coupon bond. They are commonly issued with maturity of thirty years. The secondary market is highly liquid.

Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of 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-year, 10-year and 20-year maturities. This is not good for a long term growth investment.

TREASURY YIELD CURVE
The different time durations have different interest rates and when plotted on a graph form a curve. Some of the rates from yesterday are: 3 month = 0.15%, 6 month = 0.24%, 2 year = 1.06%, 5 year = 2.50%, 10 year = 3.57%, and 30 year = 4.43%. Note that the rate grows with time to compensate for the time risk of holding for a longer time period. This is normal and the shape is called a normal yield curve.

INTEREST RATE CHANGES AND LONG TERM BONDS
The price of the bond changes with the interest rate and the longer the time duration the bigger the change. To best illustrate this point, a 30 year zero coupon will be used. The value of the bond, the price to buy or sell, is shown below for different interest rates.

1% = $749, 2% = $563, 3% = $424, 4% = $320, 5% = $243

6% = $185, 7% = $140, 8% = $107, 9% = $82, 10% = $63

Notice how fast the value drops with rising interest rate. Imagine buying a $1,000 bond with interest rates are at 4%, about like now, and paying $320 and then selling it when the interest rate is at 5% and only having a value of $243 and losing 25% of your money, OUCH. Imagine buying a $1,000 bond with interest rates are at 7% and paying $140 and then selling it when the interest rate is at 5% and having a value of $243 and making 70% of your money, BEAUTIFUL. To get a capital gain you want to buy long bonds when interest rates are falling.

What is the bottom line: With the massive amount of US government spending and having a record deficit, $1.27 trillion so far this year, $180.7 billion in July alone, interest rates are going to go up. DO NOT OWN LONG TERM BONDS NOW, YOU ACCOUNT WILL GO OUCH!!!!!!!!