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Treasury bonds (T-Bonds) are long-term, semiannual bonds issued by the U.S. Treasury. Because they are backed by the full faith and credit of the U.S. government, T-Bonds are generally considered "risk-free" investments (at least when it comes to credit risk). Because of their low risk profile, investors typically flock to Treasury bonds during economic downturns. Treasuries have historically delivered solid gains during recessions and bear markets.
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A Regular Income Payment
When a Treasury bond is issued, it pays a fixed rate of interest, called a "coupon rate." For example, let's say you buy a 10-year Treasury worth $1,000 that carries a 4% coupon rate. If you hold it until it matures, you can expect to receive $40 a year in interest and get back your $1,000 in 2018.
If you sell the bond before it matures, however, the value of the bond will reflect changing interest rates. If interest rates on 10-year Treasuries were to rise next year to 5%, the bond you bought for $1,000 might sell for just $800, since an investor can earn more interest by buying a new bond at a higher coupon rate. At $800, the $40 in annual interest gives the bond ayield of 5% ($40/$800=5%). But if 10-year Treasury yields fell to 3%, your bond could increase in value to $1,333 to give it a yield equivalent to new Treasuries ($40/$1333=3%).
How Interest Rates Can Affect Bond Prices
Investors should note a bond's "duration." Duration is a complex calculation expressed in years that measures how volatile a bond can be as interest rates rise and fall. Simply put, if interest rates rise 1%, the price of a bond with a duration of five years is expected to fall by around 5%, but a bond with a longer duration of 10 years could lose some 10% of its value.
As you can see, investors who hold bonds with a longer duration (typically more than five years) may suffer greater losses when interest rates rise. But if rates fall, they could enjoy stronger returns since longer-duration bonds should rise faster than comparable bonds with shorter durations.
Like any metric, duration isn't foolproof. For example, inflation fears can hurt long-term bond prices even when interest rates are falling, but have less effect on shorter-term bonds. In addition, factors such as leverage, derivatives, or credit quality can make a fund more volatile than its duration would predict. As a rule of thumb though, a long-term Treasury bond with a duration of 10 years would be about twice as volatile to changes in interest rates as a Treasury bond with an average duration of five years. As such, shorter-duration funds are more appealing to long-term income investors since their returns tend to be more stable.
Investing in Inflation-Resistant Tips
Inflation is the bogeyman of the bond investor, and it can cut into the value of your bond holdings. If inflation is running at 5% per year but you're holding Treasuries paying 4% per year, then the real rate of return on your investment (after inflation) is actually -1%. So inflation is an ever-present threat to your hard-earned investment dollars.
To help minimize the threat of inflation, a good option might be to invest in Treasury Inflation-Protected Securities (TIPS). TIPS are linked to the Consumer Price Index, so their value increases as consumer prices, including food and energy, rise.
For instance, say you buy a 10-year, $1,000 TIPS bond in March. If by June inflation rises +1%, your bond principal would now be $1,010 (1.01 * $1,000). If you hold the bond until it matures in 2018, you will receive either the inflation-adjusted principal or the original $1,000, whichever is higher (if there isdeflation, the principal won't fall below its $1,000 par value). The bond's interest payments also rise with inflation, as they are calculated at a fixed rate on the inflation-adjusted principal.
Interest income on Treasury bonds, including TIPS, is taxable as ordinary income at the federal level, but is not taxed on the state and local levels. As such, bonds and bond funds are best held in a tax-deferred IRA or 401(k) account.
The Investing Answer
Treasuries and TIPS can be shining stars against a backdrop of doom and gloom in the financial markets. But when stocks rally, Treasuries lose some of their luster as investors rotate out of safety in search of growth potential. Still, with their risk-free payouts, Treasuries and the funds that hold them should provide a solid addition to any income portfolio.